Where the puck is heading
2022 outlook extremely positive despite temporary indigestion from rising yields.
Stocks are suffering a bit of indigestion of late from the rise in the 10-year Treasury yield as bond markets grapple with a Fed pursuing its employment goals above all else—at least at the moment. Although the overall market has been rising gradually within a +/- 3% range all year, under the surface the action has been far more volatile. On the one side, small-cap value indexes are up nearly 25% year-to-date, while the large-cap growth indexes are down 1%. And inside those averages are individual stock moves considerably greater in both directions.
While we expect this value-tilted, choppy environment to continue until rates stabilize, perhaps around 2% on the 10-year, by the back half of this year and much of next, we see an incredibly supportive environment for equity investors. No surprise, we are sticking with our 4,500 call on the S&P 500 for this year. But perhaps more importantly now, the controversy is about to center on 2022, so we are weighing in. Some Wall Street houses have grown more qualitatively cautious about next year, which if correct would make buying stocks now somewhat like trying to pick up a dime in front of a steamroller. Contrarily, our view on 2022 remains constructive, and we see no reason at all to change our longstanding 5,000 target by the end of next year. Here’s why:
Unusually positive growth drivers understimated by traditional models
I’ll try to be brief here as we’ve written about this extensively already. The Covid lockdown-induced collapse in global economic activity was almost the first of its kind to occur and broke the backs of traditional economic modeling. At no time in modern economic history have we ever experienced a synchronous global economic contraction not caused by normal fundamental factors such as an overcapacity buildup leading to price cutting and eventually dramatic capacity cutbacks, excess growth leading to high levels of inflation or central bank hikes designed to effectively spark a recession.
The 2020 recession was very much an artificial, non-organic economic collapse, and we will soon be entering an artificial, non-organic recovery unlike any other we’ve seen. Even better, policymakers’ easy-to-understand overreaction to the contraction—in the form of global stimulus measured in tens of trillions of dollars—is now about to overlay on top of an already explosive economic situation as the vaccines roll out around the world and lights go on country by country in succession. And P.S.: We are now talking more about a sequential global recovery with rocket boosters firing in stages as vaccine laggards such as Europe and Latin America fall in behind the recovery that will be going full bore in the U.S. and U.K. by mid-summer. In some ways, given already developing supply-chain issues, this may be even better than the fully synchronous recovery with a simultaneous July 4 celebration we had been anticipating until lately.
If you do the math on all this, the GDP growth numbers ahead for the U.S. seem too nutty to even state publicly. Suffice to say that as actual data come in, Wall Street economists continue to trip over themselves raising their 2021 forecasts. By 2022, though, most economists expect the economy to take a breather, partly because most models show historically high U-6 unemployment—also known as underemployment as it includes both part-time and discouraged workers—that occurs in recessions takes years to fix.
We don’t agree with this view. Unlike all historic periods before, this recession was both artificial and focused excessively on a sector of the economy that previously never existed in size: the so-called “gig economy,” mostly in the services area. And as Americans begin traveling, eating out and generally splurging en masse this summer after the long darkness of the past year, that gig economy is going to come roaring back, fueling an already supercharged situation.
Again, if you just do the math, 2022 will need to be at least as big as 2021, in the 6% to 7% growth range, just to get close to trend GDP before the artificial drop of last year. And that doesn’t even count the additional impact of the stimulus money, which by some measures is 15% of GDP in the U.S. Net net, Federated Hermes has again raised its GDP estimates for both years and my guess is we are still too low at 6.8% for this year and 6.2% for next. When you throw the higher expected inflation numbers on top of this, you get nominal GDP growth for this year and next that’s nearly double digits. With companies’ pricing power generally higher after the shakeout of competition over the last several years, that should translate into outsized gains in corporate profits and with them, our 5,000 S&P target.
Where we stand on 3 big risks that have emerged
If we are wrong about 2022, it will be because one or more of three following risks upend everything:
- Inflation Given the sharp economic acceleration that even consensus estimates are starting to reflect, and the Fed’s stated goal of getting unemployment (especially the broader U-6 measure) back to pre-crisis levels as quickly as possible, the concern is near-term supply shortages across nearly all the key inputs to the economy—commodities, chips, and yes, labor—will drive price inflation considerably higher. We agree with this, though we do expect that by mid-2022, the global forces that had been keeping inflation well controlled (the digital revolution, continued expansion of the global economy to emerging economies, the biotech revolution, automation, etc.,) will come back to the fore and bring inflation under control naturally. So net net, we view this issue as a positive, not a negative, particularly for stocks whose cash flow and earnings streams should expand with inflation and nominal GDP growth.
- Interest rates At the end of the day, the 10-year Treasury yield is the discount rate on risk assets, so the higher this goes, the lower the value of long-duration risk assets. The longest duration of these are high-growth stocks, last year’s darlings, which explains why they are at least temporarily under attack. The debate now, however, is around where this yield adjustment process ends. The bears see no end in sight, with yields extending beyond 2% and eventually, beyond 3%. We don’t see this for a few reasons. The first: the natural anchors of the Fed’s short-term rate, currently pegged at zero, as well as the German government bund rate, currently still less than zero. In both cases, the spread over these and the 10-year Treasury has been historically low, 50 to 100 basis points. But if you look out longer term, this spread could easily get to 200 or even 250 basis points. Beyond that level, the natural forces of yield-curve arbitrage and/or international bond arbitrage kick in, and we think this threat probably holds the 10-year Treasury around 2% for now. We are at 2%, not 2.5%, because of another factor always present: the Fed. It has the ability to challenge a move above 2% for sure. It could tilt the oversized balance-sheet duration longer, and given its present size, that would have an impressive positive impact on Treasury demand. It’s called “twisting the curve,’’ and though Chair Powell disappointed this week by not bringing it up at his presser, we’d look to him to do so if the bond market rout continues much longer. Mortgage rates have finally begun to back up, and too much of a move higher could threaten the jobs-rich housing economy the Fed needs to meet its employment goals. So, though we think yields could move another 20 to 30 basis points from here, we are getting closer to the end than the beginning of this adjustment. That will help stocks in the back half.
- Taxes Another possible storm cloud that the Biden administration began talking about soon after it had signed off on the $1.9 trillion stimulus bill. If tax hikes are implemented as advertised, it could be a blow to the solar plexus for the U.S. economy. Taxes would be going up for much of the middle class (now defined as “rich” in the popular parlance), for all jobs-producing corporations and for most small businesses. Stock investors would not be spared either, with taxes on capital gains and dividends likely to slow investment and capital formation at the very point when it might be needed most. None of this would be good, and if it does happen like this, we are likely to cut many of our economic and market outlook numbers. However, we think the actual tax increases are not likely to be as gruesome as advertised for political purposes. With the focus on “going large” on stimulus, hitting the economy with the biggest tax hike in history would seem unwise, at least. And real politics then comes into play. In addition to very tight House and even tighter Senate Democratic majorities, moderate Democrats from Blue States will hold more sway than usual in the months ahead, and they are likely to urge, well, moderation. And with difficult 2022 midterms increasingly on the horizon, doing a big tax hike in 2022 might be political suicide. So, we’ll see. But for now, we’re assuming whatever tax hikes we get will be considerably too watered down to impact our outlook substantially.
So, for those focused on every tick of the Treasury bond yield and the short-term reaction of stocks, we’d advise as usual to remain calm and focus on where the puck is heading, not where it is. The focus on 2022 is still not here yet, but within three to four months, it will be all the rage. And when it gets its time in the spotlight, we expect it’s going to look pretty good, indeed. Stay long the bull. It’s got plenty of room to run.