The quarterly economic forecast has a dual purpose. One is to produce a forecast that accurately captures the economic environment for the coming quarter. The second objective is to present the forecast with a parsimonious and coherent description of the foreseen economic environment.
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 third quarter of 2020 and has risen to 3.33 and is expected to remain at that level through the end of 2022. During 2022, the short end of the yield curve is expected to rise to 3.05 by the end of the quarter and continue rising to 3.63 by the end of the year, peaking at 3.81 in the first quarter of 2023. The yield curve appears to have risen across the board and is flattening. The question that remains is whether the yield curve will invert?
Investors must ascertain what the expected interest rate structure means for the economy. Is a flattening or possible inversion of the yield curve a harbinger of an economic slowdown? In an earlier piece (Is an Inverted Yield Curve a Recession Harbinger?) we examined the relationship between the two since 1962 and found that six of the nine recessions were proceeded by a yield curve inversion; a 66% batting average. As far as recessions are concerned, the predictive power of a yield curve inversion is better than the flip of a coin. However, 3 of the inversions in the data studied were not followed by a recession. Why? To answer the question, investors must determine whether the expectations of an increase in interest rates portend a decrease in the short-term inflation rate, a credit easing, a deceleration of economic growth, or a 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.
Inflation The Core PCE is running at an annual rate of 6%, three times the Fed’s target rate. Recently, the Fed changed its posture and is now attempting to slay the inflation dragon with a combination of aggressive rate hikes and a reduction of its balance sheet. While we view this development as positive for the inflation outlook, we still believe that the Fed has lost its compass, and as a consequence, it overshot its inflation target. Without a compass, it is likely to overcorrect and undershoot the 2% inflation target. We expect the year-over-year inflation rate, as measured by the Core PCE inflation, to decline as the year progresses (Figure 2).
Real GDP Growth Our model calls for a steady deceleration of the rate of economic expansion throughout 2022 and bottoming out in the first quarter of 2023. That is not a bullish sign. We expect US real GDP growth rate to decelerate to below 1.5% by the end of 2022 (Figure 3), and bounce back to 2% growth rate range by 2023. A new, ‘new normal’?
Overall, the data points to a steady deceleration on the pace of economic activity going into 2022 and lasting through 2023. We estimate the likelihood of the economy growing at 2% being slightly less than 50%. In contrast, the likelihood of an economic contraction in 2022 and 2023 is estimated to be 15%. This indicates that while growth likely won’t be negative, it will slow down.
Earnings A year ago, we looked for economic activity to experience a short-term acceleration during 2021, followed by a deceleration during 2022, and 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. The forecast called for solid double-digit earnings growth during 2021. Sadly, our outlook is not as bullish as it was a year ago. Our current forecast calls for a mean reverting real GDP growth rate, with a strong likelihood of falling below the trend line. Our forecast points to a significant decline in the earnings growth rate.
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 the odds that 2022 earnings growth will be in the 10 to15% range at better than 10% and the likelihood of earnings growth in the single digit range at 50%.
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. 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 points to mid to high single digit returns at best during the next 12 months.