The Quarterly Outlook takes a quantitative look at the trends across four indicators: Interest Rates, Inflation, Real GDP Growth, and Earnings, in order to help us create a picture of the broader macroeconomic environment and the subsequent impact on asset valuation. There is no doubt that the trend leading up to the fourth quarter of 2021 has been one of increasing GDP growth, increased asset price volatility, higher inflation, and low interest rates. The indicators hint at a different picture headed into the fourth quarter of 2021 and continuing through 2022.
Interest Rates. The overall forecast takes a cue from the futures markets. According to the recent data, the 10-year bond yield appears to have troughed during the third quarter and is expected to increase during the fourth quarter. During the same time span, the short end of the market is expected to rise and continue rising through 2022 and 2023, thus the market is pointing to a steady and sustained increase at the short end of the yield curve as depicted in Figure 1 below.
What does this expected interest rate structure mean for the economy? First, we must determine whether the expectations of an increase in interest rates portend an increase in the short-term inflation rate, a credit tightening, an acceleration of economic growth, or a reverse flight to quality? To arrive at any answer with some degree of confidence, we need to do some further digging and continue completing the macroeconomic picture. Next, we focus our analysis on Inflation.
Inflation. The pandemic has introduced some transitory elements to the year-over-year comparisons of the CPI. As a result, we contend that the current inflation measures are overstating the true inflation rate. Once these transitory effects are netted out, the supply chains return to normal and we continue to make progress on the COVID front, we expect the year-over-year inflation rate, as measured by the PCE price index (PCE and CPI are slightly different, but interchangeable measures of inflation), to return to the Fed’s 2% target rate. Our forecast suggests that the return to the 2% inflation target will be gradual, as shown in Figure 2.
We look for the inflation rate to decline to 3% to 3.5% by year’s end. If our forecast materializes and the inflation rate does begin to decline, it will be interesting to see whether the Fed’s expected tapering materializes, especially in the face of decelerating economic growth. This brings us to our next indicator, Real GDP Growth.
Real GDP Growth. To recap thus far, we are forecasting increasing interest rates and decreasing inflation. Now we turn our attention to the broader economy and real GDP growth. Our forecast calls for a peak in the trailing four quarters real GDP growth rate during the second half of 2021 which means that our best growth days are behind us. We look for a deceleration of GDP growth to continue into 2022 and possibly beyond. That is not a bullish sign. Our forecast calls for the US real GDP to decelerate to a 1% real GDP growth rate by the end of 2022, as shown in Figure 3.
Overall, the data points to a steady deceleration in the pace of economic activity. Our expected probability of the GDP growth rate exceeding its long-term trend of 3% by the end of 2022 and 2023 is 12.5% and 20%, respectively. In addition, the likelihood of an economic contraction in 2022 and 2023 is estimated to be 50% and 33%, respectively. Again, not a bullish sign.
Earnings A year ago, we looked for economic activity to experience a short-term acceleration during 2021, followed by deceleration during 2022 and going forward, to approach its long-term real GDP growth rate. We argued that if our forecast about the pace of economic activity during the coming four quarters is correct, 2021 should be a good and healthy year. Back then, the forecast called for solid double-digit earnings growth during 2021. Sadly, our outlook is not as bullish as it was a year ago. Because our current forecast calls for the inflation rate to return and quite likely drop below the 2% target range by the end of 2022, and real GDP growth rate likely falling below the trend line, our forecast points to a significant decline in the nominal and real earnings growth rate.
Figure 4 below shows how the surge in earnings matched the V-shaped recovery. As the economy returns to trend in 2022, we expect the earnings growth to decline accordingly. Our model estimates the odds of a double-digit earnings growth in the 15% range during 2022 at better than 40% and the likelihood of earnings growth in the single-digit range at 33%.
To recap, our forecast points to a declining inflation rate, a decelerating pace of economic activity (with a strong likelihood that real GDP growth will fall below the trend line), and the inflation rate below the Fed’s 2% target rate by late 2022 or early 2023.
What type of valuation will such an environment produce?
The forecast adds up to a slowdown in the earnings growth. Add to this the market expectations of higher interest rates, and a not so bullish outlook begins to emerge. Although we expect positive stock market returns, our forecast suggests that a double-digit stock market gain over the next 12 months is a bridge too far.