After two surreal years in the economy and markets, what lessons should we draw from the recent past and what can we expect from 2022?
00:04 - 00:32
Everybody, welcome to The Pulse, where we cover trends in the economy, the markets, and asset allocation for long-term investors. I'm Matt Palazzolo, Senior Investment Strategist at Bernstein and Head of our Investment Insights, and I'm excited to be joined here today by my colleague and good friend, Moira McLachlan, also a Senior Investment Strategist. And today we're going to look back to 2021. What a year, and we're going to look forward to 2022. So Moira, you've been on our show a number of times. Welcome back to our show.
00:33 - 00:34
Thanks for having me back.
00:34 - 00:54
So Moira, let's start by looking back. Wow, 2021, I guess on top of another wow, which was 2020, but 2021 brought us a number of surprises. Some pretty good returns in the markets. Overall, extraordinary. Your thoughts on the year that just passed?
00:54 - 01:13
Well, you're right. It has been extraordinary, even if we just think back to where we were about a year ago. Less than a year into the worst pandemic in a century, vaccines were just starting to be rolled out. The economy hadn't really come back yet, but markets were already roaring ahead in anticipation.
01:14 - 01:17
Absolutely. And you know, it's interesting getting prepared for this.
01:17 - 02:12
This podcast today, I went back and I looked at at the work that we had published at the end of 2020, the beginning of 2021, and we laid out there, I don't know, a bull case for what 2021 would look like, the bear case for what 2021 would look like, and just a just a cover, level-set everybody before we get into what actually happened. You know, our bull case was that first there'll be some pent-up demand amongst consumers that would be unleashed, that corporations would keep a lid on costs and that would be beneficial to margins and profitability, that low interest rates would push investors out on the risk curve. And I think it's fair to say that we were in line with that broadly positive landscape and backdrop. And you know, we still had to acknowledge that there were some risks, but overall we were we were fairly constructive on what the year could be at that point in time.
02:12 - 03:01
But there was the bear case and there were many investors out there that that were anchored to the bear case, which at that point in time was that there would be some economic scarring that stuck around post the deepest part of the recession because of COVID, that there would be a debt overhang, that there would be damage done to those folks at the bottom end of what we were calling then the K-shaped recovery, when people at the upper end of the income spectrum would do fine or even better than they were in 2019, but the people at the bottom of the income spectrum would continue to face meaningful headwinds. And then there was all those concerns about rising interest rates and PE multiples. So there was that bull case. I think it's fair to say, Moira, that that it kind of came to be that that that was what played out in 2021. Would you agree?
03:01 - 03:30
Yeah, absolutely. I think that it was the bullish end of our bull case that actually played out. You know, the vaccine rollout was largely successful, some hiccups early on, but made huge progress there. We've seen the strongest economic growth that we've seen in decades. Pent-up demand from the pandemic-induced shutdown was really supercharged by high levels of savings rates, which increased over the course of the pandemic.
03:31 - 04:23
And really importantly for investors, that corporate earnings story that you highlighted held up, right. Margins were strong and that contributed to 48 percent earnings growth for the S&P 500, relatively unheard of, right? Not something that we've seen in recent history, that's for sure. And earnings were not only strong versus the low base that was set in the year of sort of the peak pandemic in 2020, but also up around 25 percent versus 2019, which is really quite extraordinary. As a result, as we record this today and in early December, stocks are up 25 percent this year, really impressive returns. But even with those impressive returns, the PE multiple has actually compressed this year as a result of that, that strong earnings growth.
04:23 - 04:51
You know, there's a lot of big surprises for 2021. That is one of the big surprises that I still believe is underappreciated by many investors, which is that PE multiples with all the complaints that people have about PE multiples, how they're extended, all of that, they came down in 2021. Given the denominator in that case, the earnings growth, was meaningfully higher than many people had expected. That led to the strong returns that we saw, but that PE multiples contracted.
04:51 - 05:23
I know that's just where we are today, who knows about what happens in the future, particularly given the possibility that interest rates might go up in the not too distant future. That's something that we and others have talked about often, is that relationship between interest rates and PE multiples and the potential for there to be a headwind to stocks if interest rates were to move meaningfully higher. Now we'll talk about that in just a second as we move into our comments on 2022.
05:24 - 05:45
But I want to close our 2021 first and particularly these other two big surprises that stand out to me as we look back over the past 12 months, the Delta wave was a big one that I think we all thought about variants, but we weren't exactly sure what that would look like or how that would manifest itself in the economy and the markets, and then also inflation. Those two big surprises. Your thoughts there?
05:45 - 06:36
Yeah, well, absolutely. I think coming into the year, the risk of new variants emerging was very much on the horizon last year. Of course, we did see the Delta wave contributing to a second or perhaps a third wave of COVID cases over the course of the summer. Now we've got Omicron sort of on the horizon and causing concerns. You know, this certainly was a constraint to the economic recovery that we've seen. It has had some impact on the labor market, but I think it's really amazing when you think about it against that, how well companies have held up, how well economic growth has held up. And certainly one of the things that we have been seeing is that the economic impact of COVID-19 is diminishing as time goes on. And maybe that's as we are adjusting.
06:37 - 06:38
Pandemic becomes endemic.
06:39 - 07:30
Well, I'm not sure that we're there yet, but it looks as though we could be on the way to that. Absolutely, for sure. Yeah. And then in terms of inflation, obviously inflation has been one of the biggest stories, certainly in the last few months, but also for much of this year. And I think it's going to continue to be a major preoccupation for investors going forward. We certainly anticipated inflation would pick up as a result of surging demand really colliding with capacity constraints and supply chain issues stemming from the pandemic. Some of that is, sort of could be, evidence of that economic scarring that we mentioned. I think we did underestimate how prolonged the inflation might be or how severe the inflation might be in particular areas of the economy.
07:30 - 08:16
Of course, we've all read about enormous backlogs in semiconductors. I think there are a lot of other individual areas that we can point to, where there have been supply constraints, certainly much easier to shut down capacity than to bring it back up to get the workers back. And that's something that is persisting. And then, of course, supply chain, disjointed supply chain issues. That's something that is going to take a little bit longer than we had originally anticipated to work out. Well, the other thing that we expected was to see demand shift back from goods into services, and that's something that I think has been perhaps impacted by these successive waves, the rise of Delta and potentially whatever happens next.
08:16 - 08:39
Yeah, it's always important to highlight when you were wrong, not you in particular. Any investor should highlight when they were incorrect with their assumptions, and we did, we assumed that the inflationary backdrop would ease earlier than it, than it looks like it's going to. And I think that's, I think that's fair, and I want to dig a little bit deeper into inflation, Moira, with you in just a second.
08:39 - 08:58
But let's now pivot to 2022. Inflation is obviously going to be, I think, the big story. It's the story for 2022. We'll come back and revisit at the end of 2022. But I think at this point it is the key story. But beyond that, what are those areas that you're watching closely for 2022? And then I want to dig in a little bit more on inflation.
08:58 - 09:56
Well, inflation, absolutely. That is a really big topic, and that's very much related to the, what that means ultimately for the Fed and the Fed's interest rate policy. And also, of course, what happens to market rates. Earnings growth again is going to be a really big story that is key, a key driver for equities over time. Fiscal policy, also related and important. You know, we've got this large infrastructure package that's on the table right now. I'm talking about Build Back Better. But relative to the spending that we've seen in terms of infrastructure spending, even this massive bill will be lower than what we've seen overall since really the onset of the pandemic. And we can think about that perhaps being fiscal drag. The question, a key question there is to what extent will consumer demand make up some of that gap.
09:56 - 10:48
So let's tick through these key issues or themes, whatever you want to call them for 2022. Let's start with inflation. As, I mentioned a second ago I think that's the big issue everybody is focused on, it have been for quite some time and just to level-set all of our listeners for what we think inflation will will be looking like at the end of 2022. We've pencilled in something on the order of about two and a half to maybe three percent inflation in the back-end of 2022. That is a meaningful deceleration relative to where we're standing today with inflation rates, at least, you know, year over year or month over month inflation rates, and four or five, six percent. It's a slowdown from where we are today. I'm not going to get into transitory or not transitory. I think that's been beaten pretty well. But the point is that in our expectation, there will be a slowdown in inflation levels as we move through the next 12 months.
10:48 - 11:19
And there's been a lot of of influences on inflation leading us to where we stand today, whether that be the meaningful increase in demand. You know, by our calculations, demand for goods is running about 10 percent higher than you'd normally expect based on long-term trends and the supply isn't there. And supply is constrained in it because of a number of reasons, whether it be shipping or labor and the inability to find labor or to get to the logistics in order to deliver goods to ports or to the stores.
11:19 - 12:12
And then there's key areas, key sectors that are facing severe challenges, more acute than others. Semiconductors stands out. Hopefully in our early indications we are showing that the supply for semiconductors is starting to catch up with the demand, and that's a good sign that should eliminate over time some of the constraints that we're seeing on a lot of key goods like cars. Cars stands out as one that has been meaningfully impacted by the shortfall in the ability to get semiconductors, and I think there's other areas. Shipping too stands out as well, where maybe that second derivative is getting better. So we'll hopefully see some easing of inflation pressures in the not too distant future. And then of course, there's the labor market and workers' ability to get higher wages if they're being hired or if they're already employed, and then housing as well. Another meaningful area that we need to watch closely.
12:12 - 12:32
So there's a lot of moving pieces. Needless to say, a lot of moving pieces related to inflation going into 2022. But what we've got pencilled in at the moment certainly is a deceleration to levels closer to two and a half percent compared to where we are in the mid-single digits. And that, Moira, has a meaningful impact on Fed policy, doesn't it?
12:33 - 13:09
Right. Absolutely. I mean, that's a big part of the reason that the market is so obsessed, right, around inflation, what it looks like, how long it takes for it to sort of decelerate, the rate of inflation that we've seen to decelerate. And a really big question, you know, the Fed had signaled that they were going to move to average inflation targeting. They signaled last August, so August 2020, that they were moving to this average inflation targeting and that they would be willing to let inflation run a little bit hotter in service of full employment, right.
13:09 - 13:45
So the question, a critical question here is how much inflation can the Fed really tolerate before they raise rates. And when we're thinking about Fed policy, of course, there's two big questions. One is lift-off, right, when they start to normalize rates. And then the other is tapering. At what point do they reduce bond purchases in upcoming months faster than had previously been anticipated? So when do they start raising rates and when do they start really pulling in that quantitative easing? And what is the pace of that going to be?
13:45 - 14:30
I think ideally what we'd love to see is sort of a Goldilocks scenario where the Fed starts normalizing policy, but in a way that engineers a soft landing. The risk is that they undershoot on rates, right? And we see inflation a little bit too hot, to go back to continue with the Goldilocks analogy there. On the other hand, there is a risk that they might hike rates too early. Right. And then we'll see that having a negative impact on growth and maybe, you know, see inflation sort of fall off, right, and contribute, of course, to lower growth overall and higher unemployment for longer.
14:30 - 15:14
I think a key takeaway, Moira, tell me if you agree, is that certainly with inflation, we have more uncertainty now, both in the near term and the longer term than we have had in decades. Meaning if you were to try and forecast out inflation levels 12 months from now, much less five years from now, there's meaningful upside risk to whatever number you're going to put on a piece of paper and meaningful downside risk to there. I think most listeners would think that there's more upside risk, but we have to acknowledge that, now that the Fed could act, that could be successful, or the economy could slow down enough to drive or keep inflation at a lower level than most people expected. And that's a risk, too, and we have to acknowledge that uncertainty at this point in time.
15:15 - 15:47
I think you're absolutely right. You know, inflation is one of those things that is notoriously difficult to forecast. It's one of the economic variables that economists tend to get wrong most often, and I think you're absolutely right, from where we sit today, the range of potential outcomes is even wider than it usually is. You may recall that post global financial crisis and during the European debt crisis, the European Central Bank moved to normalize too soon, and they ended up with a Goldilocks too-cold situation. Yeah.
15:47 - 16:21
And I want to move on to earnings growth and some of the other areas that you highlighted for the themes for 2022. But I can't let the opportunity go by without saying, look, we're in the business of providing advice. And so the advice right now would be for those clients that would be meaningfully impacted, or investors in general. You know, just forget about clients, investors in general that would be meaningfully impacted by inflation, if it were to occur, to take action today to sensitize your portfolio to those occurrences, if they were to occur, because it would be meaningful to spending levels, to portfolio values in real
16:21 - 16:50
So that's the one bit of advice, I guess, coming out of this conversation. We are on the move to to earnings growth. You highlighted that, I think you said earlier that earnings growth was close to 50 percent in 2021. Obviously, it's not going to be that high in 2022. It will slow down like inflation should slow down, but companies have done a good job of containing costs, that's been beneficial to margins and profitability. But what's the earnings picture look like over the next 12 months?
16:50 - 17:10
Well, of course, earnings growth is critical for stocks and other risk assets. We know that stocks typically do well in an economic expansion. But of course, for that to happen, we need to see growth, earnings growth be stronger than the tailwind that may come from rising rates or normalizing interest rates.
17:10 - 17:57
Our economics team is currently forecasting above trend economic growth to continue into 2022. Depending on inflation, and of course, what happens to corporate margins that should translate into above-trend earnings growth right now. Earnings growth for all geographic regions, so the U.S. developed international markets and emerging markets is expected by sort of consensus to be in the mid to high single digits. So, you know, depending on where we're talking, on average, five to 10 percent. Of course, if economic growth comes in above our expectations, then there may be room for those estimates to rise. And of course, that's something we're going to be watching very closely.
17:57 - 18:10
You also mentioned earlier fiscal drag, right? Given the spending that has occurred to this point, potentially the lack of spending or the degradation decrease in spending next year. How does that all come into play?
18:10 - 19:06
Well, of course, government spending is one of the main components of GDP after the massive amounts of fiscal spending that we've seen really since the early days of the pandemic. It's going to have to come down. And even with this new infrastructure plan that is being discussed, it looks as though government net spending in 2022 is likely to be about one and a half trillion dollars less than it was this year. And again, that's what we really think about in terms of fiscal drag. There's basically a one and a half trillion dollar gap that the private sector is going to have to fill with demand and production, consumer spending, business spending, etc. So that's going to be a really important question in terms of economic growth overall, which again, going back to that inflation question, of course, it's all related.
19:07 - 20:04
We've got one more topic that I think you noted was important. But before we get to that, which is just savings on the sideline or the consumer, let's just encapsulate what you've highlighted so far. I totally agree that these are the main issues as we look forward over the next 12 months. We've got inflation. As I said, that's the big issue. And then the implications for Fed policy, you know, coming off of that, we've got earnings growth. We've got this fiscal drag issue, which you just mentioned and then savings on the sideline or the consumer, right, the consumer has really done their fair share over the last 12 months in helping the economy to recover, to help retailers spending on goods that will translate into spending on services as that becomes more available. But what are your thoughts on the importance of the savings that consumers currently have on the sidelines compared to normal?
20:05 - 20:36
Well, of course, that was a big part of the story coming into 2021, and I think I mentioned that's one of the things that sort of turbocharged the pent-up demand that we've seen this year, and that's going to remain important going into 2022. You know, consumers are coming out of this recession. Consumers and businesses, I'll add, are coming out of this recession in the best shape that they've ever been in during this stage of the business cycle. And that, of course, has been a function of the very strong fiscal
20:36 - 21:04
The policy response that we saw. The Fed and our analysis suggest that households have put aside over a trillion dollars cumulatively over the pandemic, over and above what they would have saved had it not been, right, in a normal environment. So a really big question is where is that money today and what are folks going to do with that money. If folks spend it, it will continue to fuel strong demand for
21:04 - 21:37
And, you know, as the environment feels a little safer for folks and services, feeding into growth, feeding into corporate investment, maybe feeding into inflation, TBD, but on the other hand, if they don't want to spend it and they simply get tired of it sitting in low yielding money market funds, maybe they move it into stocks, right? And push stocks and other risk assets higher. And then, of course, that will have implications, obviously, for stock market returns over the course of next year. And of course, market multiples.
21:37 - 22:16
That's a metric that a lot of people in our industry watch closely is flows; flows into and out of markets at particular points in time, using it as an important indicator for timing. But also sentiment, investor sentiment. So, Moira, let me again, let me just encapsulate what I've heard from you. Inflation a big issue over the next 12 months, policy from the Fed coming off of that, earnings growth, fiscal drag, and then the consumer in general catalyzed by all the savings that they have on the sidelines. I think that's a real good summary on what we should be watching closely in 2022.
22:16 - 23:11
Interestingly, we don't have COVID in there. We don't have the pandemic as, or at least you didn't. And again, I would agree if only because of a point that you made earlier that the market's reaction to news about COVID has become less and less meaningful as we have gotten further and further away from March of 2020. And I think the reason is because it's having less and less of an economic and profit impact on corporations and on the economy, at the end of the day, you know, news is news, but at the end of the day, stock markets go up and down and bond markets go up and down based off of profitability and interest rates. And that is something to anchor to through time, but particularly now, as we will undoubtedly get more and more news flow on the pandemic. I'm going to wrap it up here. I want to, first of all, thank you for coming back and joining us as a good friend and colleague. It's always great to have you on the show.
23:12 - 23:13
Thank you. I've enjoyed being here.
23:13 - 23:49
And so to all of you listening today, thanks for joining us and we'll continue to monitor these key trends in the economy and the markets and the risks. We're certainly going to have Moira back at some point during 2022 to check in on where we stand with this conversation that we've just had. And if you enjoyed this podcast, please subscribe and rate us on Apple Podcasts or Google Play, Spotify, wherever you listen to this podcast and e-mail us your thoughts or your questions, or any feedback that you might have to insights@Bernstein.com and be sure to find us on Twitter or Instagram at BernsteinPWM. Thanks a lot. Be well and we'll talk to you in 2022.
- Matthew D. Palazzolo
- Senior Investment Strategist—National Director, Investment Insights