2022 Market Outlook

The lack of additional fiscal stimulus and withdrawal of monetary stimulus could cause a serious hangover for a market that is drunk on stimulus.

The S&P 500 capped off a strong year with a Christmas rally to finish 2021 up 27%. Although some of the gains came from earnings growth and easy comparisons against the COVID shutdowns of 2020, much of the gains came from unsustainable PE multiple expansion. The Schiller PE ratio spiked to above 40, levels historically associated with poor subsequent 10-year returns.

With 2021 already in the rearview mirror, what should we expect for 2022? Can such strong market returns continue or are we finally due for poor market returns? It should not surprise you that I think the latter is more likely.

The fantastic returns of the past two years (2020-2021) have been driven by speculative and risk seeking behavior, which was boosted by massive fiscal and monetary stimulus. A quick recap is in order…

Fiscal Stimulus (actions by Congress)

• April 2020: $2.3 trillion CARES Act gave $1,200 per adult and $500 per child to eligible individuals, expanded unemployment benefits, backstopped the Federal Reserve and provided small business loans, assistance for hospitals and state and local governments
• Jan 2021: $0.9 trillion Consolidated Appropriations Act of 2021 gave $600 to individuals, extended enhanced unemployment benefits of $300, another around of PPP loans, funding for K-12
• Mar 2021: $1.9 trillion American Rescue Plan gave $1,400 to eligible individuals, extended unemployment benefits, aided local and state governments, expanded child tax credit of as much as $3,600 per child

Monetary Stimulus (actions by the Federal Reserve)

• March 2020: cut the federal funds rate by 1.5% to 0%-0.25%, purchased treasury and agency securities in amount as needed, introduced a number of facilities to support the flow of credit
• Ongoing: $120 billion in monthly purchases of Treasury and mortgage-backed securities to support economic recovery and keep interest rates low
• The follow chart shows the amazing growth of the Fed balance sheet, the large spike in the spring of 2020 from the initial COVID response and the subsequent gradual climb from continuing monthly purchases.

The major takeaway is that the gains in the US stock market over the past year and a half is inseparable from the massive fiscal and monetary stimulus. However, both of these tailwinds are about to reverse…

2022: Tailwinds Become Headwinds

After enjoying more than 5 trillion dollars of extraordinary fiscal stimulus over the past 18 months, 2022 will be characterized by the lack of stimulus. As reported ad nauseum in the media, attempts to pass additional stimulus by the Democrats ran into gridlock in Congress. Any attempts to pass a scaled-down version in 2022 will likely involve a smaller number than the $2 trillion Democrats were hoping for. The expanded child tax credit could be on the chopping block as it is strongly opposed by Senator Manchin. Another significant difference is this latest round of stimulus is meant to be spent over 10 years whereas the $5 trillion of COVID stimulus was largely spent over a year.  

With inflation now near 7%, the Federal Reserve has rapidly shifted its focus from expanding employment to fighting inflation, which requires raising interest rates. The Fed has already announced that it will reduce its monthly $120 billion of Treasury and mortgage purchases by $30 billion per month, putting it on track to eliminate purchases by April. The Fed has also signaled three interest rate increases in 2022 and another three to four per year in 2023 and 2024.

Taken together, the lack of additional fiscal stimulus and withdrawal of monetary stimulus could cause a serious hangover for a market that is drunk on stimulus. Economic and earnings growth will almost certainly slow in 2022 vs 2021 which does not seem congruent with near record valuations.