We looked at some of the factors affecting market performance in 2021 in our last post. Next, let’s look at where we are now and examine the headwinds and tailwinds that could affect the direction of economic growth and financial markets in 2022.
Economic and Financial Indicators - Pre Pandemic
To create some context about where we stand today on various factors, let’s start by examining where we stood just before the pandemic began. After a stretch of good economic performance, conditions in February 2020 were mixed, though still positive. You can see a number of positive indicators, including monetary policy, consumer spending, interest rates, and perhaps most notably, inflation and energy.
There were some cautionary signs about the future, such as the economic outlook, equity valuations, leading economic indexes, and corporate profit growth.
The only two factors of concern were geopolitical risk and the domestic political environment at that time.
Economic and Financial Indicators - Mid Pandemic
Now, let’s fast forward to November 2020. By then, we appeared to be beyond the worst days of the economic lockdowns and COVID cases. The overall outlook was cautious.
While monetary policy, inflation, corporate profit growth, and leading economic indexes were trending positive, there were more cautionary signals, most significantly in consumer spending, energy costs, business sentiment, and labor market weakness. There was also double the number of negative indicators from February, most notably equity valuations and disposable personal income.
Economic and Financial Indicators - Current
Now, let’s review what these financial and economic indicators tell us about today’s current state.
As you can see, 17 of the 20 indicators are green, which suggests that the economy and markets are in a good position in 2022. Only three are flashing some warning signals, such as equity market valuations. After the run-up in values in 2021, this shouldn’t come as too much of a surprise. There are no outright negative indicators here.
Leading Economic Index (LEI)
Let’s delve a little deeper into one of those speedometers: the Leading Economic Index (LEI).
This includes ten components, ranging from stock prices to manufacturing orders. When examined together, this data may give a clearer view of where we are.
Leading economic indicators suggest that economic expansion is trending higher into 2022, though supply chain bottlenecks cannot be overlooked as a factor that may frustrate this outlook. As you can see, a rise in the Index of Leading Economic Indicators has never been followed by recession, so that’s encouraging. However, no model is flawless, especially with COVID still hanging over global economies.
It’s important to remind people that past performance does not guarantee future results. But, as we review charts like these, history can help suggest where we are in the economic cycle. It’s also important to remember that forecasts are based on assumptions and subject to revisions over time. Financial, economic, political, and regulatory issues may cause the actual results to differ from the expectations as you see them expressed here.
From the leading economic indicators and the economic speedometers, we just saw that the economic outlook is looking positive for 2022. However, the economy and the financial markets will have to withstand some potential headwinds to meet these optimistic expectations.
The first headwind may be the emergence of Omicron, the latest variant of the COVID-19 virus, along with a resurgence of the Delta variant. While few expect the sort of economic shutdown that accompanied the 2020 pandemic given the progress of vaccinations, any moves to restrict social contact may adversely impact economic growth similar to the Delta variant surge last year.
Inflation remains a big challenge for the economy, as higher prices may sap consumer spending power and consumer confidence. We will take a deeper dive into inflation’s implications for the market later in the presentation. We may also see rising yields as bond investors look for higher yields to compensate for rising costs.
At the end of last year, the Fed announced that it would be quickening the pace of its wind-down of its monthly bond purchases and signaled that as many as three rates hikes might follow in 2022. The Fed’s policies have been a major factor in driving stock prices higher.
However, the Fed is looking to return to a more normalized monetary policy amid a healthy economy, a rebounding labor market, and accelerating inflation. It’s uncertain how investors will react once supports are removed, and interest rates move higher.
We saw an example of this at the beginning of the year. Think back to January when the minutes from the Fed’s December FOMC meeting indicated that a rate hike might come sooner than expected, which led to a sharp sell-off. One result of higher rates may be a revaluation of stock prices to reflect higher interest rates.
However, if the Fed finds itself behind the curve in fighting inflation, it may be forced to use its monetary brakes, which could adversely impact markets.
As 2021 came to a close, there were early indications of slowing economic growth in China in large part due to its zero-COVID policy that shut down whole cities at the first report of infections. As its wealth has grown, China has become an increasingly larger importer of foreign consumer goods and raw materials. Any reduction in demand will be a drag on a wide range of companies globally.
The midterm elections also create a degree of uncertainty. The markets will be looking to see if there is a shift in Congressional power and what that may mean for future economic policies.
Finally, geopolitical tensions are always a potential headwind. Tensions in countries bordering Russia, China’s threats toward Taiwan, and Russia’s leverage over Europe’s energy supply are just some examples of where tensions may flare.
The economy is expected to expand in 2022. The level at which economic growth serves to propel markets higher, of course, will be a function of how healthy that growth is.
Though the Fed is reducing its monthly bond purchases, they are not expected to end until June or July. Moreover, the Fed has indicated that any rate hikes will likely be in the year's second half. The takeaway here is that monetary policy remains quite accommodative, despite these early steps toward normalization.
Corporate profits were solid in 2021. As mentioned earlier, one of the primary determinants of stock prices over the long term is corporate earnings. Provided earnings continue to expand in 2022, this may justify current valuations and serve as a catalyst for higher prices. Of course, past performance does not guarantee future results. And the return and principal value of stock prices will fluctuate as market conditions change.
Also, the consumer appears healthy, as net worth has grown from pre-pandemic levels. Financially-strong consumers should continue to support further consumer demand for goods and services. That said, there is one important caveat to this tailwind. Consumer confidence is actually at a cycle low owing to the sharp and continued rise of inflation. Watching the cost of basic consumer goods, like food and energy, take up an increasing amount of personal budgets is not only psychologically dispiriting, but it could reduce the amount of discretionary income consumers have at their disposal.
There is another side to what inflation may do to consumer spending. Inflation may increase spending in the short term since behavioral experience suggests that consumers frequently choose to buy today if they believe prices will be higher tomorrow.
Despite this kernel of uncertainty regarding the consumer, we expect that consumers will be a net positive force for propelling economic expansion.
Before we move on to our discussion of 2022 forecasts, let’s examine this chart to see where stock prices are trending against historical averages.
The most common way to do this is to look at the P/E or price-to-earnings ratio, which measures what investors are willing to pay for a company’s earnings.
If you look at the dotted line in the middle, you can see that the P/E for the last 25 years is, on average, 16.80.
You can also see that the P/E moves quite a bit, with a peak during the dot-com boom and a trough during the credit crisis.
As of October 2021, the P/E was at 21.40, which is higher than its 25-year average. It may bear mentioning that the big technology stocks, which because of their growth prospects typically sport higher P/Es, represent a greater proportion of the S&P 500 than ever, so a comparison to the past may have limited value.
These higher valuations may also be in line considering the current low interest rate environment.
This was a look at we are now. In our final State of the Markets Report post, we'll take a look at 2022 forecasts. If you have any questions about the market, please contact one of our financial advisors today.