The Quarterly Outlook takes a quantitative look at the trends across four indicators (Interest Rates, Inflation, real GDP growth, and corporate earnings), in order to help us create a picture of the broader macroeconomic environment and the subsequent impact on asset valuation. While the prevailing trend in 2021 was one of increasing GDP and corporate earnings growth, we see a different picture emerging in 2022; one of deceleration. What will this do for investment returns? Let’s examine each of our indicators.
Interest Rates. Our Interest Rate and 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 fourth quarter of 2021 and is expected to increase about 10 basis points during the first quarter of 2022. During the same period, the short end of the market (T-bills) is expected to rise 12 basis points and continue increasing at a 20-basis point clip during the remaining quarters of 2022. By the end of 2022, the futures markets expect the short end to rise to 88 basis points and to 158 basis points by the end of 2023. The market is pointing to a steady and sustained increase at the short end, Figure 1. The increase at the short end is expected to flatten the slope of the yield curve, which raises the possibility of a yield curve inversion sometime in the next couple of years.
Investors must ascertain what the flattening of the yield curve means for the economy. Is a flattening and possible inversion a harbinger of an economic slowdown? To answer the question, investors 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, additional information is needed. The next few paragraphs incorporate some information that we believe helps us anticipate and identify the forthcoming economic environment. Our next piece of the puzzle is 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, to return to the Fed’s 2% target rate. Our forecast suggests that the return to the 2% inflation target will be gradual and that by the end of 2022 the Fed will significantly overcorrect, pushing inflation below its 2% target rate, as shown in Figure 2. We also expect that in an attempt to reverse course and bring the inflation rate back up to its 2% rate, the Fed will overshoot its target again and the inflation rate will surge to 3% in 2023. We look for the inflation rate to decline to the 1% range by the end of 2022 and to rise to 3% by the end of 2023.
Real GDP Growth. Our model calls for a steady deceleration of the rate of economic expansion throughout 2022. That is not a bullish sign. Our forecast calls for the US real GDP growth rate to decelerate to around 1.5% by the end of 2022, Figure 3. However, there is a silver lining to the forecast. We expect the economy to bounce back to the 3% growth rate range by 2023.
Overall, the data points to a steady deceleration on the pace of economic activity going into 2022 and an acceleration during 2023. In fact, we estimate a 20% likelihood of the economy’s trailing four quarter real GDP exceeding 3% by the end of 2022, with the odds increasing to 50% by the end of 2023. In contrast, the likelihood of an economic contraction in 2022 and 2023 is estimated to be 16% and 10% respectively; in other words, there is a very low likelihood of an economic contraction in the next 12 to 24 months.
Our final piece of the puzzle is corporate earnings growth.
Earnings. A year ago, we looked for economic activity to experience a short-term acceleration during 2021, followed by a deceleration during 2022, and a return to its long-term real GDP growth rate by 2023. We argued that if our forecast about the pace of economic activity turned out to be accurate, 2021 would be a good and healthy year, and so far, despite the volatility, it has been. The forecast called for solid double-digit earnings growth during 2021, which has been the case. Sadly, our outlook for 2022 is not as bullish as it was a year ago. Our current forecast calls for the inflation rate to drop to the 2% target range by the end of 2022. Add to this a mean-reverting real GDP growth rate, with a strong likelihood of falling below the trend line, and our forecast points to a significant decline in the nominal and real earnings growth rates.
Figure 4 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 that there is a 40% chance that 2022 earnings growth will be around 15%, and the odds that earnings will be in the single digits is around 50%. In other words, it’s pretty likely that earnings growth in 2022 will be in the high single-digit to low double-digit range.
What type of valuation will such an environment produce?
The combined forecast paints the following picture for the coming 12 months: A declining inflation rate and a decelerating pace of economic activity with a strong likelihood that the real GDP growth rate will fall below the trend line and the inflation rate will fall below the Fed’s 2% target rate. The forecast adds up to a slowdown in 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 points to high single-digit or low double-digit returns during the next 12 months.