What We Can Expect In 2022
There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.
-J.K. Galbraith
As Yogi Berra famously said, “It’s tough to make predictions, especially about the future.” And this is especially true when it comes to forecasting the economy or financial markets. Economics is not an exact science like physics; the global economy involves billions of people making individual and often idiosyncratic decisions in response to market prices, interest rates, and fiscal policy. Participants in financial markets attempt to “price in” all currently-known information into today’s prices, thus making it even harder to predict the future movement of financial asset prices. And even if we were able to make correct predictions based on what we know today, there are always unexpected events, the Rumsfeldian “unknown unknowns”, that can (and always do) occur and that make a mockery of our forecasts.
Still, with those caveats in mind, it is useful to take a look at the market landscape as 2021 comes to a close, and create a baseline for what we should be expecting come 2022.
To use a common buzzword of 2021, all these factors that generated the strong economic performance this year are extremely transitory.
The U.S. Economy
Real U.S. GDP growth in 2021 will end up somewhere between 5% and 6% (depending on how the fourth quarter looks), the best performance since 1984. Much of this economic growth was driven by employment growth due to people unemployed by Covid-related restrictions going back to work. Total employment increased this year by around 6 million people (4%) this year, and the unemployment rate fell from 6.7% to around 4%.
Government policy in 2021 was extremely accommodating by historical standards. Fiscal stimulus was on overdrive with a total of $2.8 trillion in Covid relief and social spending passed last December and in February, leading to a 2021 fiscal year budget deficit of $2.77 trillion, or 12% of GDP. Monetary policy was also pedal-to-the-metal this year with more than $1 trillion in quantitative easing through bond purchases and a real short-term interest rate of around -7%, creating a huge incentive for borrowing and spending and disincentive for saving.
Why am I going through this set of statistics? To use a common buzzword of 2021, all these factors that generated the strong economic performance this year are extremely transitory. Economic forecasters are currently predicting economic growth in 2022 in the neighborhood of 3% to 3.5%, a figure which is well above the average GDP growth rate of the last two decades. To me, that seems a number based on everything going just right, something that is unlikely to happen.
Let’s go through all the headwinds that the U.S. economy will be facing next year:
1. There are not that many more unemployed people to employ. The unemployment rate hit a low of 3.5% in February 2020 and we will already be at around 4% in December 2021. There might also be some additional people who will enter the workforce due to a tight labor market, but most of the people who left the workforce due to Covid were people near retirement who decided it was a good time to retire, and these retirees are not going to go back to work.
2. A lot of the fiscal stimulus from last year is ending and is unlikely to be extended, especially after Senator Joe Manchin’s announcement yesterday that he will not support the Biden multi-trillion dollar social spending bill.
3. The Federal Reserve is quickly tapering its bond purchases and has announced plans to start raising interest rates to prevent inflation from getting out of control. If inflation continues to persist or gets worse, it will force the Fed to be even more aggressive in raising interest rates, perhaps enough to cause a recession as Paul Volker did in the early 1980s. In either case, monetary policy will be much less stimulative next year than this year.
4. We still can’t predict the evolution of Covid over 2022. We’ve seen three major variants that swept the world over the last twelve months (Alpha, Delta, and Omicron) so we should be expecting to see at least a couple more in 2022. While major economic restrictions are unlikely to return to the United States, more risk-averse individuals will still react to new waves caused by variants by staying home to limit their exposure to the virus. International travel restrictions during these waves will have a negative effect on tourism. The travel and entertainment industries are all likely to suffer economically during such waves.
The overall economic effect of Covid could be limited, as it was in 2021, or if a more severe variant generates a wave, it could be more significant. Furthermore, if Asian countries, especially China, continue to follow a zero-Covid policy, there will likely be continuing supply chain problems when they close factories to reduce virus transmission.
In summary, I can list a lot of reasons why economic growth in 2022 might be weaker than the current forecasts and not a lot of reasons why it might be stronger, so my forecast would be on the more pessimistic side, perhaps around the recent historical average of 2% real GDP growth, with significant risk of a recession.
Contrary to conventional wisdom, the stock market is not more likely to underperform next year just because the Fed will likely be raising interest rates.
The U.S. Stock Market
Stock return forecasts have extremely wide confidence intervals, but we can still look at some data to get an idea of what market participants are expecting. First, based on current stock prices and predicted cash flows (earnings, dividends, etc.), we can back out the implied discount rate that investors are using to price stocks. Currently, these estimates suggest an equity risk premium of 4.7%. Adding this to the 10-year Treasury yield of 1.4% would imply that the average annual stock market return over the next ten years will be in the neighborhood of 6%, much lower than what we saw in the last decade.
We can also take a look at how the stock markets historically moves during Fed tightening cycles. In theory, all of this information should be already priced in today, but in reality, investors could underreact to monetary policy leading to predictable movements. Going back to 1982 when the Fed returned to targeting the Federal Funds rate, major tightening cycles occurred in the following years: 1988, 1994, 1999, 2004, 2005, 2006, 2017, and 2018.
Long-term investors should ignore short-term stock market volatility and take advantage of downturns to invest their money at better prices.
The average equity premium during the years when the Fed tightened (over the period from 1982 to 2019) was 7.9%, while the average equity premium in years that the Fed didn’t tighten was a very similar 8.4%. The difference is not statistically significant. This finding suggests that, contrary to conventional wisdom, the stock market is not more likely to underperform next year just because the Fed will (likely) be raising interest rates.
A more worrisome issue is that the stock market rally could be overextended. The S&P 500 index is up more than 23% this year after rising 18% last year and 31% in 2019. As the chart above shows, over the last 13 calendar years, the index has increased by double-digit percent in 10 of those 13 years. The only “bad” years were 2011, 2015, and 2018, and even in those years the stock market was basically flat. The froth this year in the stock market and even other asset classes like real estate and cryptocurrencies is a good sign that greed and FOMO (fear of missing out) has led to good news being fully priced in and more risk to the downside than the upside.
Conclusion
Peter Lynch famously said that “far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections.” Long-term investors should ignore short-term stock market volatility and take advantage of downturns to invest their money at better prices. Still, after the amazing run over the last thirteen years, we should all make sure to adjust our expectations for the market returns we will earn over the next decade.
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