We're getting into our outlook on the economy and the financial markets as we end 2021 and enter into 2022.
We discuss key challenges we faced in the economy and financial markets throughout 2021 as well as dive into what we can expect to see in 2022 with regards to the strong consumer, COVID's effect on the economy, and inflation.
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Welcome, everyone, to our 2022 economic and market outlook. My name is Doug Throneburg, Managing Director of Wealth Advisory at First American Bank and I am Kurt Funderburg, Director of Equity and Economic Research at First American Bank.
On today's podcast, Kurt and I will discuss the outlook for the economy and the financial markets as we end 2021 and enter into 2022. There's a lot to cover. So, let's go ahead and dive right in.
Kurt, there's numerous factors to consider when discussing economic outlook and what I'd like to do today is really discuss the 3 major headwinds/tailwinds for the economy. Let's start with the positive. So, what do you see as the positives as we go into 2022 as it concerns the economy?
Well, I think the biggest thing is that the consumer remain strong and that's very important since consumer spending makes up about 70% of the US economy. So, a strong consumer should mean good economic growth as we enter 2022.
When we talk about the consumer, we talk about you know the unemployment numbers have come out and we have, you know, historically low unemployment at this time. Does that lead into kind of that strong consumer you're talking about?
Yeah! We have a buoyant labor market, people are going back to work, many people who have lost their jobs during the pandemic and the ensuing recession have gone back to work. I think we're still something like 3 million below the peak employment number that we had immediately before the pandemic began. So, the labor market is strong—that means people have jobs, that means people are earning money, and for a change that we have not seen for very extended periods over the last 20 years, wages are getting higher too. So, people are going back to work and a lot of times they're going back to work for a wage and hourly wage that is higher than it was when they lost their job prior to the pandemic or if they kept working. Many people have switched jobs specifically so they can make a higher wage and make more money. So, that accrues to the benefit of the consumer; the other things to think about I think are because of the fiscal aid that was provided by the federal government during the Pandemic, there's a very high level of savings among consumers. So, there's extra money to spend beyond the wages that they earn and, even going into the pandemic, consumer debt was relatively low and because of low interest rates, that service payments as a percent of disposable income, were low. So that means consumers should have money to spend. They should be confident and confident consumers with money to spend tend to point to decent growth in the economy.
So, you mentioned the consumer. You mentioned they really account for 70% of our overall economy. What about the other 30%? What about the corporations?
Corporations I think also are largely in good shape. The picture isn't quite as clear there but most businesses, especially very large businesses, publicly traded companies, came through the pandemic in very good shape because they were able to borrow money to bolster their balance sheets, were able to get aid packages to keep their employees on the payroll, and with the other side of the equation, when consumers have money to spend, who are they spending it with? They’re spending it with companies. So, those companies are benefiting from the strong consumer spending trend, which I think will continue, and they should do well also. On the other side of it, in addition to what the consumer does, you have what the businesses have to do on the investment side in order to be able to serve the consumer demand. So, you're seeing businesses increase CapEx plans, whether it's building plants, whether it's buying equipment, whether it's investing in technology to enable automation to deal with not as many employees as they would like to have in their facilities. All those things should contribute to strong economic growth and then I think, perhaps most importantly, but underappreciated, we've all heard about the supply chain issues. The supply chain issues have led to almost record low inventories in many sectors of the economy relative to end demand and so we're going to have to spend a lot of 2022 rebuilding a lot of those inventories up to more historical levels and that should benefit the economy for the year as well.
So, when we look at the positives that we go in, we have a strong consumer, rising wages, corporations appear to be in good shape, and you mentioned with the inventory build, that all sounds good, but I guess, you know, I don't see a lot of that in the news on a daily basis, Kurt. But what I do hear a lot of is COVID, inflation, and the Fed, and you know these are typically viewed as the headwinds going into next year. So, if you wouldn't mind you know, just kind of discussing a little bit of those and how we see that impact in the economy over next year.
Sure, so let's start out with COVID which has been the primary challenge for the economy for consumers and for businesses since March of 2020. It has not gone away yet. The picture has improved dramatically from where we were in the spring of 2020. We now have vaccines. We now know more about the virus. We now have some treatments for the virus but it has not gone away as a challenge. We have seen the Delta variant, which I believe originated or became prominent this past summer, spread around the world. It currently is the biggest challenge we face in the United States and in many foreign countries is the Delta variant, which spreads more easily than past variants and, while it doesn't necessarily cause more severe sickness, it does make people very sick, a lot of people when they get it. On top of the Delta variant, we now have Omicron, which has gained prominence over the last month or so. Information is still a little bit sparse on what Omicron means. It’s clearly much more transmissible, much easier to spread even, than Delta was. So, a lot of people are getting it. It originated in southern Africa and we've seen it become the dominant strain there. What isn't clear yet are a couple of things. Number 1, how severe is the sickness that Omicron causes? There's some initial data to suggest that it isn't as severe as some of the other strains we've seen, which would be a positive if that turns out to be true. Also, it appears to some extent that both in inherent immunity, in other words, you've had COVID before and you have some immunity from that and perhaps even the vaccines are not as effective at preventing infection with Omicron as they are with Delta. Again, a lot remains to be seen because this is such a new variant and we haven't had the opportunity to do in-depth studies on it. But I think Omicron will be the primary variant that we are dealing with into 2022. Hopefully, as I said, even though it's very transmissible, if the severity of the disease is less than it is than the previous variants, I think that would end up being a good thing and it may be an important step on the way to making COVID something that's endemic. In other words, something that is prevalent in the environment, that we deal with. Eventually I think COVID will be pretty much like a common cold or like the flu. You get it. You get sick. But in most cases, it doesn't kill you or cause you to go to the hospital. It's more of a nuisance. When we get to that, I think we'll truly return to a fully open economy like we remember before the pandemic began.
So, we talk about the headlines that are, you know, dominating the news today. We talk about COVID but also, we can't get very far without hearing inflation and certainly the Federal Reserve's impact on that. So those two certainly go hand-in- hand when we talk about inflation and then the Fed. Talk about what you think the inflation's going to be throughout next year as well as the Fed's reaction to that.
Sure. So, starting with inflation. We've seen inflation surge to 6% or more on the consumer price index, which is the most prominent measure of consumer inflation we have in the United States—that's what the media talks most about. We're talking about rates of inflation that very few people as adults at least have seen. Baby boomers, maybe the older baby boomers, will remember inflation in the seventies. Few people who are to the baby boom generation were old enough to appreciate that even if they were alive at that time. So, we're seeing sort of unprecedented rise in inflation here. Prices are going up across the board in many sectors. It's providing a challenge both for consumers and for businesses in dealing with these higher cost levels. I think we probably will start to see inflation ease a little bit in 2022 but not reverse. So, as I said we're running at about 6% consumer inflation now. I think it will continue near that level for the rest of 2021 and into the first part of 2022. As we move into the second quarter of 2022 and beyond, I think for a variety of reasons inflation will begin to ease but it will still remain historically high. In other words, we won't be at the 6% level we are now, but I think it's likely that for most of 2022 we'll probably still be at 3% or 4% inflation which is much higher than most people that are consumers in the economy now have ever experienced. So, the challenge won't go away. It will become a little bit less of a challenge than it is right now, and I think eventually 2023 or beyond, maybe 2024, we should be able to get back to sort of the 2% target rate that the Fed has for inflation. That's not guaranteed. There are things that could go wrong that cause inflation to remain persistently in that 3% to 4% range. But I think eventually we will get past this, but it'll remain a challenge for 2022 certainly. As far as the Fed goes, you've seen the Fed recognize inflation as a bigger problem for most of this year. As inflation took off, the term that the Fed used was transitory. Transitory is open to interpretation. Transitory really means something that begins and ends so it doesn't last permanently. So, you can put whatever definition you want on transitory. Something that lasts 12 months could be transitory. Something that lasts 12 years could be transitory because it does have an endpoint. I think most people, including the Fed, thought we wouldn't be facing 6% inflation as 2021 came to a close. I think they believe, and many believe that we would be past the worst of the inflation now. It's not the case, and so the Fed has been forced to recognize that and they're taking steps to address it. Number 1, they've already begun tapering, in other words, they've already begun to reduce the amount of purchases they make of US treasury securities and mortgage-backed securities in the market on a monthly basis. It was one hundred and twenty billion and now they're pulling back with the idea that they would be done probably sort of mid to late next year and that in that taper and would have completely halted purchases by then. I think now they're thinking they need to be quicker with that taper, in other words, reduce the purchases even more rapidly and maybe be done with the taper in the first half of 2022. The other thing you're seeing is most people did not think that there would be rate hikes. The Fed would not do a rate hike of the discount rate at any point in 2022. Now the market believes there will be at least 2 maybe 3 rate hikes in the year. It's unclear whether or not the Fed will move that quickly but I think there is a growing concern at the Fed and in the people who watch the Fed, and the federal government, and in the business world, that they may have already got behind the inflation curve too far and you don't want to continue waiting because, if you wait too long, then to fight inflation you really have to throw the brakes on the economy with significantly higher interest rates which can send us back into a recession. That's the outcome the Fed does not want. It’s a delicate balance in dealing with inflation while not killing the economy and we'll be anxiously waiting to see how they handle that. But I think that's the significant threat that the markets will be focused on in 2022.
So, you mentioned the market. So, let's talk about the financial markets for a second. So, you know, we see the stock market continues to set record highs. Interest rates remain historically low and, you know, folks are asking important questions. Where do the markets go from here? Discuss the impact that when we talked about inflation you talked about the Fed but if you could talk about the impact that inflation has on interest rates, particularly those that are invested in money markets or fixed income securities.
Yeah, so traditionally the way that the Fed deals with inflation is they push interest rates up. Interest rates go higher, it costs more to borrow money that
tends to cool the economy down, tends to make demand diminish somewhat and, as demand diminishes, the law of supply and demand still holds. So as demand diminishes, that tends to take some of the steam out of the economy, demand is not quite as strong, and so inflation tends to pull back when demand comes off the boil, so to speak, and isn't as strong as it was before. That is probably what the Fed is going to have to do to deal with it. They're going to have to raise interest rates to some extent. The question is, how much and how rapidly. I think most of our listeners understand that in the fixed income market, when you want to bond, when you purchase a bond, if the interest rates go up above the level they were when that bond was purchased, the value of the bond goes down because it has to provide the same level of return as is prevalent in the market at any given time. So, if we are forced that the Fed is forced to raise rates that will not most likely do good things for the bond market and it's also not particularly friendly to equity markets either because the discounting mechanism of the equity markets is you measure the future earnings, the first future cash flows, of businesses and the lower interest rate you use for that discount mechanism, the more those future earnings and cash flows are worth, so, if interest rates go up, the future cash flows of the companies that make up the equity markets would theoretically become less valuable. Now, important caveat to put in here. When we can't just think about interest rates that you see that on the bonds you purchase or interest rates you see on your money market account we have to go to another step and consider what's known as real interest rates and what a real interest rate is is the interest rate you see on your bond minus the rate of inflation. So, if you have a bond that's yielding 2% and the rate of inflation is 4%, you're effectively losing 2% of your money on that investment. So, you're getting a 2% coupon on a bond inflation that’s 4%. The higher cost of living is taking 2% of your nominal, stated return off of that bond. So, you're essentially earning a negative return. Negative real interest rates, which is where we are now—very good for stocks because it means that there's not really a lot of alternatives to equities as far as generating positive returns in financial markets. So, if you can't buy bonds to get a positive return, you're most likely going to turn to stocks. Stocks have done very well. If we see interest rates rise to the point where real rates are after inflation rates are no longer negative, that's going to make people think a little bit about stocks versus bonds. They may want to come back to the fixed income market if interest rates become positive on an after-inflation basis again. It may be a good use for a portion of their money that's currently in the equity markets to pull it out and put it in bonds. We saw this phenomenon in 2017 and 2018 at times when interest rates were going up. People said you know what? I'll take some of the of the stability of the bond market if I can get an above inflation in return on my investments. I’ll take a little bit of my equity investments out and put it in bonds. We haven't seen that certainly in 2020 or 2021. We may see it at some point in time in 2022, I don't know, but I think from a long term perspective, it's important for investors to remember that equities over long periods of time have historically produced the most attractive returns. I think that relationship continues into the future. Not that we wouldn't have volatility if interest rates rise, not that that wouldn't give us maybe a small correction in the market, but over the longer period of time we want to own equities because they grow along with the market. They grow their cash flows, they grow their earnings, and that, to some extent, is going to provide you some protection from inflation. So, when you talk about, you know, real interest rates and it appears to me that really one or two things or both things need to happen in order for that to turn positive. Interest rates are going to have to increase, and inflation is going to have to come down. You talked about the Fed, you know, their mandate basically is to lower that inflation rate. They're going to do that primarily by raising interest rates. But when we look at the alternative and you mentioned the stock market. How do you reconcile this conflicting thought of the need to earn a higher return with the fact that the stock market continues to hit new records seemingly every week or every month and so how do you look at valuation and does the fact that the market is hovering at or near all-time highs mean that it's overvalued?
Valuation is a very difficult concept to grasp and to be correct on consistently. Yes, I agree with you. Equity markets are at historically high valuations. To some extent, that is justified by the very low interest rates that we're seeing now. As I said, it's a discounting mechanism. Low interest rates tend to favor a stronger growth rate in the economy and low interest rates make future earnings, and cash flows that companies are going to earn, more valuable. But, you know, nothing grows to the sky. That said, valuations in and of themselves typically do not cause stock market corrections and are typically not a good thing to solely base your investment decisions on. Most likely, in my opinion, the way the valuation discrepancy gets corrected over time is not necessarily a crash, not necessarily even a series of rolling 10% or 15% corrections. Over time equities are going to have a return that at least resembles the growth rate of the economy and the growth of overall profits in the economy. So, we've had a five-year period here where we've had strong double digit returns every year in the equity markets. I don't think that necessarily continues for the long term. But if we're in a moderate inflation environment, let's say a 2% inflation environment, which is what the Fed's target is, equities are going to return 5%, 6%, 7%, 8% per year which I think is a realistic expectation over the long term. You're still going to do very well versus inflation. Your purchasing power is going to not only be preserved, it's going to grow over time. So, while I look at equity valuations very closely and they guide what we try to do with our equity investment portfolios here at First American Bank you can't get overly caught up in them because there are a lot of other factors that go into what drives equity prices higher over time.
So, as we look to wrap up this edition and provide a summary of the outlook on the economy over this coming year…we talked about the strong consumer, who will most likely continue to lead the economy, whether that's with rising employment or rising wages and the corporation needing to rebuild the inventories. Those are all the positives that we're looking at as we go into 2022. Of course, the things that we need to still be cognizant of are COVID, whether or not there's continued new variants that come out in the effect that they have on the world economy. Then of course what the Fed's reaction is to inflation. Those are certainly going to be things that we are going to monitor throughout the year and look to counteract that going forward. So, when we talk about the equity markets just a summary of the equity markets really, you're looking at more of a positive return than we are in the bond market going forward and of course always look to take more of a longer-term review and to match up what your goals and objectives are and to make sure that your allocation is prudent as such. Any other final comments you look to have in there Kurt?
Just to say that our outlook for the economy is that growth in 2022 in the US should continue to be above trend. Long-term trend growth is for 2 to 2 and a half percent GDP growth per year. We think the economy does better than that in 2022. Probably at least 3%, perhaps even 4%, if a lot of things go right. And the equity markets as we said should continue to move higher at a moderate pace. We would want investors to be mindful that volatility very likely, as we've seen high volatility for the last quarter or two, we think that volatility continues but we would use that more as an opportunity than we would see it as a threat to portfolios over the long term because we think equities will continue to outperform over very long periods of time and that's what we're recommending our investors wait their portfolios toward equities at this point.
Great. Thank you, Kurt. I appreciate all the valuable insights and I wish you and everyone a happy holiday season and a prosperous 2022.
That wraps up today's episode of First Forward Podcasts by First American Bank. Tune in to our other episodes and stay up to date with us on social media @firstambank.
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