e have been consistently bullish since March of 2020. Our bullishness was based on confidence that a tsunami of money printing by the Federal Reserve would keep pushing financial market higher. The Fed will shut down its printing press in 2022, and this period of smooth sailing for equity investors will come to an end. Navigating financial markets over the coming year is likely to be much more challenging.
For experienced (older) investors, current market conditions feel like déjà vu all over again. In the year 2000, a very expensive equity market endured a sudden withdrawal of Fed liquidity support. Strong economic growth limited the overall equity market to a relatively mild -9% pullback. Pricey technology stocks, by contrast, suffered far more significant price declines (the 2000 “tech wreck’).
We think similar conditions in 2022 could result in a similar -5% to -10% decline in the overall market. Most of the market drop could once again be concentrated in the most speculative, overvalued, and liquidity driven sectors of the market. Specifically, we think growth stocks at ridiculous valuations, cryptocurrencies, and bonds of all types could suffer significant inflation adjusted price declines.
We expect economic growth to remain strong in 2022 despite the Omicron COVID variant. Most US consumers have decided on a COVID strategy (either vaccinate and mask or ignore COVID altogether). Omicron will not change their behavior. As in 2000, a strong economy could allow low volatility, dividend, and other value-oriented market sectors to substantially outperform the overall equity market.
One of the oldest and most trusted investing maxims is “Don’t Fight the Fed.” When the Fed is pouring money into financial markets, as they have for the past 2-years, the safe bet is that financial markets will enjoy a powerful bull market. If the Fed is actively trying to contain inflation by draining money out of financial markets, smart investors prepare for a market decline.
Inflation is forcing the Fed to shut down its money printing program in the first quarter of 2022. If wage gains and service inflation continue to be a concern throughout 2022, as we expect, then in Q2 the Fed will start draining liquidity from financial markets (“unprinting” money) and raising interest rates. According to Fed policy statements, next year they will drain enough money from financial markets to raise rates to 0.75%. Fed policy will shift from a big tailwind for financial markets to at a minimum a mild headwind.
Chart 1 illustrates the magnitude of the Fed policy tailwind. The Fed has printed over $5 trillion since restarting its printing presses in September of 2019. In contrast with the Fed’s quantitative easing (QE) policies from 2008 to 2014, the newly printed money was injected into a healthy US banking system. As a result, US banks recirculated nearly every newly printed dollar back into financial markets and the US economy. The result was the dramatic surge in the US money supply shown in Chart 1.
All this newly created money circulating in the economy and financial markets has, predictably, led to too much money chasing too few goods (inflation) and too much money chasing too few assets (asset bubbles). As the Fed begins draining this excess money from financial markets and raising interest rates, they hope inflationary pressures will quickly subside and financial markets remain calm. We are concerned that the Fed could be disappointed on both fronts.
Our primary concern for financial markets in 2022 arises from a US budget deficit projected at between $1.1 and $1.5 trillion. Washington’s dramatic COVID policy response has overshadowed the original motivation for the Fed’s renewed money printing and bond buying program. The Fed cranked up its printing press in September of 2019, months before the COVID virus was identified.
In September of 2019, a key bond market financing mechanism (the repo market) collapsed under the weight of trillion-dollar US budget deficits. Overnight interest rates hit 10% and threatened to dramatically raise rates across the US economy. The Fed raced to the rescue by immediately printing about $160 billion and buying government bonds, effectively bailing out the Trump administration. For the first time since the 1970s, the Fed resorted to its strongest policy medicine without a recession to justify such a dramatic policy response. The US government has been dependent upon monthly Federal Reserve bond purchases ever since.
Economists will argue for the next 20-years whether the Fed should have acted as it did in September of 2019 (that is what economists do). However, what is undeniable is that the US government has never been able to finance a $1 trillion deficit without help from the Federal Reserve. Next year’s deficit is on track to be more than $1 trillion (as shown in Chart 2). The Fed will no longer buy $120 billion government bonds every month. Without help from the Fed, we are concerned that the US government will face the same challenges in 2022 that it faced in 2019.
Without monthly $120 billion liquidity injections from the Fed, will there be enough market liquidity next year to fund private sector loan demand, government borrowing, and a continued bull market in stocks and bonds? There was not in 2019 and we fear there will not be in 2022. The difference is that inflation may prevent the Fed from bailing out President Biden the way it bailed out President Trump.
Inflation requires two conditions, too much money and too few goods. It can be alleviated if one or both of those conditions change. We expect the supply of “stuff” to improve markedly in 2022. By contrast, services and housing cost could continue to rise throughout the coming year. Since these sectors account for about 70% of US GDP, headline inflation may not improve as much as the Fed hopes.
With oil prices nearly triple their lows of 2020, US oil exploration is up more than 80% in 2021. New supply should keep downward pressure on oil prices throughout 2022. Automobile and electronics prices should also come down as persistent chip shortages and other supply chain disruptions are resolved.
Perhaps the biggest potential deflationary pressure for stuff is from the sharp slowdown in China’s economic growth. As shown in Chart 3, an escalating financial crisis across major Chinese property developers has cut housing starts by about 30%. Real estate accounts for about one third of China’s economy, so the dramatic fall in home construction has slashed demand for virtually everything China makes (Chart 3 shows the impact on steel). To keep employment high and the Chinese people happy, President Xi is likely to increase subsidies for Chinese companies and encourage them to dump excess production on overseas markets.
Unlike stuff, inflation in housing and services could remain a concern throughout 2022. This could force the Fed to keep tightening monetary policy beyond the proposed 0.75% rate target. Home prices and rents soared in 2021. Government statistical smoothing techniques mean that most of this 2021 housing inflation will impact inflation data in 2022.
The COVID pandemic and major gains in equity and home prices encouraged about 3 million baby boomers to retire ahead of schedule. This “great resignation” adds to an existing 3 million worker shortfall due to Trump administration cuts to legal immigration. The combined effect of 6 million missing workers is widespread job vacancies, record job resignations, and the fastest wage gains in more than 20 years.
We see little sign that these pressures are abating and expect wages and therefore expect service inflation to accelerate throughout 2022. As shown in Chart 4, inflation thus far has been concentrated in stuff. Although we expect goods prices to fall next year, rising prices in the much larger service sector could more than offset improvement in goods price inflation.
The bull market of 2020/2021 has been driven by more than just the Fed’s printing press. For the past 6 quarters, corporate earnings have beaten analyst expectations by the biggest margins ever recorded. Record fiscal stimulus, corporate bailouts, and resilient consumers pushed corporate earnings to all-time highs both in absolute terms and as a percentage of the overall economy. As shown in Chart 5, these good times are coming to an end. Thus far in Q4, companies are posting far more earnings disappointments than upside surprises.
Input materials costs are rising rapidly, and wages are increasing at the fastest rate in more than 20 years. Companies are attempting to pass these costs on to consumers, but Producer Price Data and the earnings picture from Chart 5 indicate that costs are rising faster than revenues. As discussed previously, we expect materials costs to moderate in 2022 but wage gains will continue to accelerate. Since wages are frequently 70% of corporate costs, we see little prospect for earnings to return to the powerful growth seen for much of the past 2 years.
Market conditions in 2022 could be very similar to the market environment in the year 2000. As in 2000, the market enters 2022 at very expensive valuation levels. Investors are likely to experience a similar sharp deterioration in both earnings growth and liquidity support from the Fed. US economic growth was strong in 2000 and is likely to be strong in 2022, which should prevent a severe bear market. However, the most speculative and overvalued sectors of global markets could once again endure a much needed correction to more reasonable valuation levels.
By contrast, we think strong economic growth could, as in 2000, support market sectors that were left behind in the speculative frenzy. Low volatility, dividend, and value stocks could provide a refuge from the broad market volatility. As shown in Chart 6, value-oriented market sectors tend to outperform once the Fed starts increasing interest rates.
An unprecedented money printing spree by the Federal Reserve has pushed equities, home prices, and investor net worth to record highs. We strongly suggest that investors protect these gains by moving their most speculative portfolio assets to boring, overlooked sectors of the equity market. If we are wrong, the likely risk is simply making less money than a more aggressive positioning might have made. If we are correct, a move toward low vol and other value sectors could avoid giving back gains made in 2021. The Fed has made it clear that in 2022 they will take away the monetary punch bowl. We think it is time to leave the party.