Base-case forecast: Solid, though more muted, gains ahead
Better returns likely in value stocks but keep an eye out for 'The Four Fs.'
As sanguine as our outlook is, we do think the risks ahead are rising and, at a minimum even in our optimistic base case, we expect volatility to increase as those risks are processed by the markets. Though there are plenty of market gremlins out there, we have four in our sights on a near daily basis as we enter the new year. And each represents in some form a potential policy error out of Washington. We call them “The Four Fs.” (Please note I am not picking on Washington here. It’s just that while at times of crisis, the markets often need help to manage through and prevent an implosion, once the private economy is back on track, capital markets really prefer to be left alone.) Our base case assumes that, more or less, the Four Fs don’t materialize, and that the policy backdrop is benign. But we do think at points this year and next, the market will at least worry about one or more of the following.
- Fed policy mistake Though some would say this has already happened—i.e.., the Fed has taken too long to remove its Covid-induced policy stimulus, releasing the inflation genie—we are of the view that, though late, the Fed is probably not too late. By year-end 2021, it seems policymakers figured out they need to get moving, and we expect at least three, if not four, rate hikes this year, followed by four to five next year. This should be enough to withdraw sufficient excess liquidity to tamp down the inflation genie, we hope. The policy mistake we are on the lookout for is that inflation this year, rather than declining modestly off last year’s torrid pace, actually stays at 5% or higher even as the Fed withdraws liquidity. If this happens, the markets will begin to discount a Fed panic, with rate hike moves in 50 basis-point increments instead of the more normal 25 basis points. This matters because a Fed panic could cause an economic pullback or even recession. And should that occur, the stock market engines we are relying on in our forecast—the cyclicals, the financials, the industrials—will see a sharp decline. Not good. In fact, an “F.”
- Fiscal policy mistake We think another cause of the Santa rally we found under the tree was the surprising last-minute collapse of the President Biden’s bloated BBB plan. With labor already in tight supply and fists full of previous fiscal stimulus monies still in consumer’s hands as they head out shopping, the last thing the economy needs right now is more stimulus. So, the collapse of the bill just before Christmas was a welcome relief. Markets will be on guard through the course of this year for any sign that BBB, or some large hunk of it, is, well, back. In the near term, this bugaboo could return via a Biden-Manchin deal, though such a deal likely would be so watered down that the market could probably survive. A bigger issue could be the midterm elections. At the moment, the market is assuming a Republican landslide, ensuring a divided government through 2024. This certainly would eliminate the risk of a big fiscal policy mistake. But should the Democrats rally, and should they look to possibly hold the House and take fuller control of the Senate, look out below. Markets will begin pondering the likelihood of more spending and higher taxes, a double whammy that would drive bond yields higher and earnings lower. “F.”
- Foreign policy mistake Again, some would say this is already in the bag. It does seem that the foreign policy confusion coming out of Washington these days has emboldened our country’s enemies around the world, including the Taliban in Afghanistan, Putin in Russia, and China. Although again not in our base case, the possibility of a shooting war somewhere in the Mideast, Ukraine or even the Taiwan Straits is rising for sure. Our guess is that the Biden administration is aware of these risks and is trying to mitigate them through diplomatic channels, and our base case assumes success. But there is a non-zero probability that a further misstep or miscalculation leads to a further worsening of tensions in one of these global hotspots. The markets don’t like wars. “F.”
- Federalism gone haywire I am using this “F” to encompass a whole grab bag of potential problems at the federal level. First and foremost is excessive regulation by the executive branch, which already has begun but could accelerate following the demise of Biden’s BBB program in Congress. Though regulation of some sort is always needed in a capitalist system, a return to the excessive regulatory environment experienced after the 2008 financial crisis would be market negative at this stage, raising costs and slowing growth. Other potential federalism errors include an attempt by either party to use what little legislative or executive power they have to cram through fundamental changes to our governing process that the other side sees as patently unfair. For instance, if the current rumor holds true that the Democrats will break the filibuster in the Senate, markets will fear that going forward, federal policy is likely to lurch sharply left and right as Senate control shifts left and right with each new election cycle. Markets generally dislike overregulation, and certainly dislike policy uncertainty. Another “F.”
Well, the New Year is upon us and we did get that Santa rally to 4,800 we were calling for in my last memo just three weeks ago—and for the reasons suggested then, that some of the near-term risks the market was fretting over would likely fade. In particular, omicron so far has proven to be highly contagious but not highly deadly. And with Joe Manchin’s steadfast stand against Build Back Better (BBB), markets could breathe a sigh of relief that yet another big round of more spending, taxes and debt might be avoided after all. So, with Santa in the rearview mirror, it’s probably a good time to reassess where we are heading and the potential pitfalls along the way.
As indicated in that Dec. 6 piece, we are holding steadfast to our year-end 2022 target of 5,300 on the S&P 500. At the same time, we are initiating a 2023 year-end target of 5,500. Let’s look into the building blocks of these targets, but first an important caveat: As accurate as last year’s 4,800 target proved to be, at Federated Hermes our market targets are offered to suggest direction and proportionality, not precise accuracy. So, while in each of the last two years our targets of 3,100 and 4,800 implied big double-digit gains ahead, our targets for this year and next suggest harder slogging, with somewhere between low double-digit and high single-digit returns likely over the next 24 months.
The building blocks of our forecast
- Economic growth Owners of companies, i.e., stock investors, are by extension partial owners of the U.S. economy in which those companies participate. On this level, the outlook looks solid. Absent the sharp, artificially induced drop in the economy in 2020 due to the Covid lockdowns, and the artificially sharp bounce back that followed, economic growth has been trending along at a healthy pace since 2016, driven in part by the Trump supply side reforms on taxes and regulation, along with the positive impact of the digitization revolution that the Covid pandemic accelerated. We expect this nominal pace to remain above the long-term average through 2023, running between 6% and 9%, though decelerating quarter by quarter as the sharp post-Covid economic bounce recedes.
- Earnings growth Companies live off nominal GDP, and with nominal GDP in the mid-to-high single digits, earnings growth through 2023 seems likely to exceed consensus forecasts. We expect productivity levels to remain high and growing, given the trends toward increased automation and digitization coming out of the Covid pandemic. And we expect these “multiplier effects” to increasingly be felt among older economy companies, who’ve been making big investments the last several years in just these productivity-enhancing activities. At Federated Hermes, we anticipate overall earnings of the S&P 500 companies to reach $290 by 2024, implying annual growth over the next three years of about 11% on average. Importantly, our base case is that the economy remains on course and is not derailed by a policy error out of Washington. Though we do think the risks of a policy error are rising (see accompanying sidebar), we still think the highest probability outcome is now “steady as she goes.”
- Inflation/Fed policy While the story for the last 20 years has been one of ever-declining inflation, even deflation at times, we are not of the consensus view that sooner or later we are moving back to that world. Something has shifted post-Covid, for good in our view. Across the global economy, a reasonable share of the global workforce seems to have moved on for a variety of reasons, including retirement and shifts back to single wage-earner families. And the global demographics of ever-expanding populations in the emerging world have now begun to reverse, so the global supply of ever-cheaper labor is drying up. In addition, “just in time” global inventory management has been undone by Covid, and the lesson learned from the supply chain disruptions of the last two years has been clear: even though more costly, it’s time to bring the supply chains home. So, another big driver of deflation has now dropped away. Digitization and automation remain the last strong leg in the deflationary stool, but even here, chip shortages are mounting and Moore’s Law (that the speed and capability of computers doubles every two years) itself seems under duress. So, we see inflation staying stubbornly strong ahead, especially now that labor is in tight supply and workers are in a stronger position to demand increased wages. With the Fed until recently considering the shifts noted above as “transitory,” the inflation genie has escaped its bottle. In our base case, we have the Fed playing catch-up, with three to four hikes this year and four or five next year, pushing short yields closer to 2% and perhaps the 10-year Treasury yield to 2.5% this year and 3% next year. This “soft landing” scenario may at times feel bumpy for markets, but we think it's manageable. Indeed, inflation numbers running a little hot, in the 3% range, can be good for nominal earnings and are partly behind our above-consensus call for earnings over the next three years. Importantly, we don’t think the economy is nearly fragile enough to be undone by the rate hikes, off of zero, that we are expecting. Indeed, the components of the U.S. economic engine that are most sensitive to rising rates—inventory financing and consumer spending—seem fairly immune at the moment to hikes. Inventories are far from bloated; in fact, they’re almost non-existent. Likewise, consumer debt has yet to rise substantially.
- Valuations The fourth building block to our forecast is valuations. With the Fed pinning short rates at zero and pressuring longer bond yields ever lower, stock market valuations have quite fairly expanded. As we begin 2022, the S&P is trading at 21x the consensus earnings numbers for 2022. This is a high level historically but, in our view, a fair one given where the 10-year yield is trading. But if we are right, and the yield creeps higher as inflation remains stubbornly elevated, we expect the stock market’s valuation to compress correspondingly, perhaps to the 19x level. Nineteen times forward earnings would still be historically high, but not out of line in a soft landing scenario with solid economic growth and inflation stabilizing in the 3% range. This multiple, combined with our $290 earnings forecast for 2024, gives us our 5,500 target on the S&P by the end of 2023.
So, when you stack it all up, our base case for strong though decelerating nominal GDP growth and with it, earnings growth, along with compressing S&P valuations, suggest attractive, though no longer spectacular, stock returns ahead. And a lot of that could be front loaded, with 10-11% returns this year followed by another 4-5% in 2023.
Where to put your money in this environment
At Federated Hermes, we are holding strong to our 500 basis-point overweight to stocks versus bonds, which represents 50% of maximum bullishness in our most referenced asset allocation model. This is a bit less enthusiastic perhaps than the heady days of 2020 and early 2021 when our recommended overweight to stocks reached 60% of max but is still quite positive. Indeed, though we anticipate more muted equity gains ahead, bonds could struggle to even produce a positive outcome as rates rise. And our average forecasted equity returns for the next two years of 7.5% is certainly enough to outpace the negative effect of inflation, especially if it diminishes toward our 3% target.
But here’s the real punch line. With earnings growth strong but valuations compressing, the real action is likely to be under the surface of the market. There, investors accustomed to simply plowing their money into the market index could be surprised perhaps to find a large number of stocks that could post very strong double-digit returns. Indeed, the market indexes are bifurcated, with a small number of mega-cap, high-growth companies sporting spectacular valuations, and a large number of “old economy” companies trading at low double-digits or even single digits. This gap probably makes sense given what’s in the rearview mirror. With rates low and the digitization revolution accelerated by the pandemic, high-growth companies with very strong fundamentals fairly deserved the rich valuations investors awarded them. And older economy companies—think energy stocks, banks, industrials, materials—deserved low valuations. With the nominal economy and their earnings growing slowly, and even declining sharply during the lockdowns, these stocks were left out of the party. Deservedly.
We think the environment ahead, however, is likely to shift this dynamic. Growth companies’ valuations are the ones most likely to be driven downward in reaction to rising bond yields, as they were the ones that rose most strongly when yields were low. And the old economy companies are not only sporting low valuations, they also are seeing accelerated nominal earnings growth as the cyclical tilt of their businesses supports sales and margin expansion. And many of them, such as banks and financials, actually benefit from rising yields.
So, cheer up and enjoy the new year. Though overall stock market returns ahead are unlikely to match the terrific numbers we’ve experienced in 2020 and 2021, they’re still likely to be positive and better than inflation. And under the surface, there are many stocks, particularly in the value indexes, that should do a lot better than that.