Inflation, rising interest rates and coronavirus variants could create volatility in financial markets heading into 2022. But in this episode of Research in Action, Director of Research Matt Peron explains why economic growth could still continue in the new year and what that means for equity investors.

Key Takeaways

• As the global economy continues its post-pandemic recovery, above-average inflation, changes to monetary policy and a number of other variables could combine to create volatility for equity markets in the first half of 2022.
• But we think this volatility will reflect a transition to the mid-part of the economic cycle rather than the end, with more sectors potentially participating in market gains.
• In addition, the shift from growth-at-any-price to growth-at-a-reasonable-price could finally gain traction in markets, benefiting a broader set of stocks.

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Carolyn Bigda: As the year 2021 wraps up, stock markets around the world sit above their pre-pandemic highs. Many households are flush with cash, and interest rates hover near record lows. But is this backdrop all about to change as we head into 2022? And what does that mean for equity investors?

In today’s episode, we’ll take a look at the setup for equity markets as we head into the new year and whether the remarkable rebound that stocks have delivered since the onset of the pandemic can potentially continue. I’m Carolyn Bigda.

Matt Peron: I’m Matt Peron.

Bigda: This is Research in Action.

Matt, I think one of the biggest changes that stock investors are facing in 2022 is higher rates of inflation. In the U.S., the Consumer Price Index, which is a broad measure of price changes in the economy, climbed by an annual rate of 6.2% in October, the highest level in more than three decades. So obviously, we haven’t seen this kind of inflationary environment in a long time. What historically has happened to stock returns when inflation is elevated like it is now?

Peron: Well, Carolyn, the headline is sometimes that inflation is kryptonite to stock multiples, and that’s to a certain extent true when inflation runs out of control for a long time. That’s very bad for equity markets, in general. But if you peel back beyond that sort of punchy headline, if you will, underneath, really, inflation is actually good for equities to a point. And the reason why I say that is because equities get their earnings in nominal dollars, they get it in today’s dollars. So, if there is inflation, you actually have higher earnings.

But if inflation goes too high, then obviously the central bank, the Fed [U.S. Federal Reserve], needs to come in and end the cycle. And by that I mean raise rates aggressively to bring inflation down. And that’s really what equity markets will respond to. They’ll sense a recession coming or a big slowdown coming, and that ultimately will take down equity multiples. So that’s how that dynamic works. So, bottom line is, for 2022, we have to really focus on inflation, but just ensuring that it stays where it is and we don’t have a spiral.

Bigda: So, let’s get a little more specific. What is that point, or sweet spot, in terms of inflation for equities? What does that tend to be?

Peron: Well, I would say it’s hard to put an exact number on it. It’s more of the shape of it: Is it stable? Is it spiraling? [That] is more important than the actual number. That said, I think equity markets would struggle with persistent inflation above 3%, or certainly above 4%, would certainly pressure equity multiples significantly.

Bigda: Okay, so the latest inflation measure was about twice that level, and I know that one of the biggest questions, I guess, going forward is whether inflation will stay at that level or continue to rise from here, or can it moderate? You know, it’s a difficult question to ask, but what is your base case for inflation sort of in the coming months?

Peron: Our base case – and this is informed by our views from our fixed income team – is that inflation will moderate. And I think the equity markets in general are looking through those near-term numbers that you cite and seeing that inflation will likely come down from there, and we generally agree with that. I think the market might be a little bit too complacent about that. I think the Fed was, and they’ve corrected course. But I think, in general, when you look out, inflation we see will moderate to a certain degree.

As a side note, I’m about to publish a paper with a professor, Yosef Bonaparte at CU [University of Colorado] Denver, on the dynamics of transitory inflation. So, we’ve done some work looking at past cycles where inflation has popped up and what’s the decay function of that, of the inflation response, if you will. And so, we’ll be publishing that paper in the coming weeks that tries to get at that question more mathematically.

Bigda: Well, we look forward to reading that paper when it comes out. Can you give us a little preview as to sort of what might be some of the factors that will help moderate inflation in 2022?

Peron: So, we look at the response of the various subcomponents of inflation and look at how they’ve responded to impulses in past cycles and then how long they’ve taken to decay back to a more normalized rate. So, really, we don’t see [inflation] getting back to normal until 2023, mid-2023, when you put it all together of how the all the subcomponents will move. Certain things might stay stickier. And I would say that it’s only a guide. We don’t really know; every cycle is different. We could have a wage spiral which would be more persistent, and that would be the one risk that we’d be worried about.

Bigda: So, you mentioned this earlier, which is the Fed response, and that’s another big change that I think is coming for equity investors in 2022 – is the change in monetary policy. Globally, central banks have started talking about scaling back the massive liquidity programs that they introduced during the pandemic. You know, what effect is this shift potentially going to have on equities?

Peron: Yes, certainly a number of changes that that would bring about. First, is we’ll move to a more mid-cycle dynamic. You’ll see the slowing of earnings growth. Already, earnings are set to decelerate to probably up 10% next year, maybe a little stronger than that. So, we’ll see earnings decelerate naturally from the fading stimulus and, of course, pulling some more stimulus potentially would continue that trend. So, we’ll see that mid-cycle from an economic and from an earnings standpoint.

But it’s also negative from a liquidity standpoint. I mean, equities do benefit from increased liquidity, pumping liquidity in. And so, I would see that that’s going to be a headwind for equities. Certainly in the first half of the year, I think equities typically do struggle as there’s a change in policy posture by the central banks. So, I would think we’re going to have some choppy waters ahead in the first half of 2022 before we find our footing again.

Bigda: And does the pace of change in monetary policy have a big impact? Because the Fed has recently said that it might actually speed up the ending of its asset purchase program. Earlier, it had said maybe it would stop in June, now it’s saying maybe a few months earlier. So, do these shifts in timing have an impact on the equity markets as well?

Peron: Yes, they do because the equity markets generally start to price one path of policy and then when you change that, they have to reprice a new path. And we saw that, there was some volatility around that change in approach by the Fed. So, I think that that does matter, and so the markets want stability, and they want to know that there’s a well-defined course in front, and then they’ll price that.

Bigda: So, equity investors might want to prepare themselves for a little more volatility, it sounds like, potentially, in the first half of 2022. Another thing, unfortunately, that we’re still dealing with is the COVID-19 pandemic. We would have probably hoped that it would be done by now, but with the rise of variants such as Omicron it seems to be lingering. You know, how does this complicate the outlook for economic growth next year?

Peron: In terms of the bumpiness of the market that I expect we’ll have first half [of 2022], I think that is going to be more focused on Fed policy and that change that I spoke about, rather than the COVID pandemic, which will keep rearing its head, unfortunately, as you note. But just coming back to that volatility, so typically, around when we look back at prior cycles, you’ll see volatility when, you know, the Fed starts to raise rates. Raising rates doesn’t take effect for two years, so then people realize, okay, this is going to be a more gradual change. And equity markets actually do okay in a rising-rate environment, so long as it’s controlled and messaged properly and it is transparent. Now the sectoral composition, which I’m sure we’ll get into, might change.

In terms of COVID though, yes, as you point out, we thought we’d be done with it by now. It’s going to persist. I think one thing we’re finding, especially with the recent variant news that we went through in late 2021 here, is that the policy prescriptions will be less severe, we hope. We know how to live with it a little bit better, so that will have, hopefully, less impact on the economics and earnings. And so these episodes that we expected to see in 2021 – we said we’d have fits and starts – well, we’ll probably still see that in 2022, except I think there’ll be less severe episodes.

Bigda: Right, now we have more vaccines available, and we have oral therapies that are coming out. So, hopefully, there are ways to manage the impact of these variants as they come about.

Peron: We have a whole range of tools, both on the therapeutic side as well as on the policy side, of how to be more nuanced. Instead of broad measures, we can take more directed measures, you know, maybe work from home for two weeks during the peak of the wave as opposed to shutting down society, etc. So, we’ve got a whole range of tools that we were just discovering in 2021.

Bigda: So, in some ways, it sounds like we are kind of getting back to normal. Where it’s more about Fed policy and economics that are driving markets and not so much the pandemic and these other exogenous shocks, which could be a nice change from what we’ve experienced over the last two years.

Peron: It is a nice change to talk about plain-old boring economics and Fed policy and cycles again, yes.

Bigda: I think one thing, though, that is still lingering from the pandemic is the impact on supply chains. COVID outbreaks have certainly exacerbated the supply chain problems that we’ve all been suffering through over the past year. I mean some retailers were warning that if you didn’t get Christmas shopping done in October, you might not have anything to put under the tree. Do we think these issues are going to persist for much longer into 2022, or are those problems starting to work themselves out?

Peron: So, it’s generally stabilizing, and I think starting to work things out. So, our base cases is it gets better in Q1 and then more or less resolves in Q2 of 2022. So, we’re seeing that to a certain extent, the early signs of that, I should say.

Now the shift might take a new tone to it, and which is to say, okay, what happens when people start canceling their double orders? And last time in the Japanese earthquake, when we had a similar supply chain disruption, it wasn’t very pretty. So, we have to be careful on both sides of this. Okay now, we know how to, we know what it looks like in terms of the disruption. How does the resolution look like, and how does it resolve? How do we have a soft landing from this crisis, so to speak? So, you know, we’re mindful of that looking ahead to that next chapter, knowing that we’re not out of the woods yet on the actual supply chain.

Bigda: So, if I’m hearing you correctly, is one of the risks then that we have an oversupply of inventories in 2022, as manufacturing catches up?

Peron: Yes, you could have that, and you could see orders evaporate. But there’s enough demand that, you know, we should be okay. But there could be some volatility around that, especially in some parts of the supply chain where you see acute double ordering. So, we’re mindful of the risks on both sides of this episode, if you will, and that could cause some volatility, as well. So, for a number of reasons, I think the first half of next year, you know, treading water would be a good outcome, maybe a little correction. And then, but hopefully, I think it’s a good setup for smoother sailing in the back half of 2022.

Bigda: So, speaking of demand, I think one of the most interesting byproducts of the pandemic has been the excess savings that households globally have accumulated, whether as a result of government stimulus programs or economic lockdowns that essentially made it impossible to continue with normal spending patterns. Are those reserves, or excess savings, are they enough to help consumers overlook higher prices at the checkout counter? Are they enough to help fuel economic growth further in 2022?

Peron: I don’t think that the price increases we’ve seen so far will derail the economic recovery, but with the emphasis on so far. So, we do need to see the rate of inflation settle back down. Consumers, as you note, can handle this through the build-up in their savings rate and their balance sheets are in very good shape, so they can absorb it; they’re also getting raises. We just don’t want this to start a spiral where, okay, prices are higher, so they need higher wages, etc. That’s toxic if it continues. So we want to be mindful of that. If it settles down now, which is our base case, then it should be manageable next year.

Bigda: I guess one thing is, consumer spending makes up a big part of U.S. GDP [gross domestic product]. And so, is it going to be vibrant enough in 2022 to sort of continue this next leg of the economic recovery?

Peron: Yes, we see a very strong consumer. So yes, we believe that it will continue. Spending will continue at a pretty robust rate, so I wouldn’t worry about the demand side as much at this point. But, you know, prices could be a problem if they continue, as I mentioned, so we’re watching that. But I think right now, the consumer – with their strong balance sheet, their high savings rate -they’re in the position to spend, they have a lot of pent-up demand to spend. And one thing that’s interesting is, we’re seeing the unemployment rate fall through the various measures: unemployment claims and job openings, etc. So, that backdrop looks set to continue, and job gains are usually a very strong precursor for consumer spending.

Bigda: And those job gains are another reason why the Fed is considering tightening its monetary policy, so it all kind of goes hand-in-hand with each other.

Peron: It does and that means we’re hoping and banking on the Fed, no pun intended, to give the so-called soft landing for the economy to bring the plane down on the runway very gently.

Bigda: If we take the net of all these factors that we’ve just talked about – and there’s a lot going on in the economy right now – what’s sort of the overall outlook for economic growth in 2022? And what does that mean for stock markets?

Peron: So, the economic growth backdrop is pretty strong. I mean, the issue is whether it’s too strong. And so certainly, we will see nominal GDP be quite robust next year if all these risk cases can be avoided, such as too high inflation or some pandemic-related issue or something like that. So, the backdrop is quite strong for continued economic growth.

So then, for equity markets, equity markets generally follow earnings. Nominal earnings will be strong we think, ultimately, but as I mentioned earlier, I think there’s going to be a shape to that, which is to say that the first half of next year might be bumpier than the second half, is the way I see it. It’s always hard to make such precise forecasts, but I would say that just, I think we need to consolidate gains here. We’re shifting to that mid-cycle, so that’s why I think we’ll consolidate for a while, get used to what the path of inflation looks like, the path of Fed funds [rate]. Assuming all is well, then, we’ll have some catch-up to do to catch up to earnings, which should have grown nicely, given the backdrop of economic growth.

Bigda: So, with that in mind, you know especially as we kind of enter into this mid-cycle part of the market cycle, what areas of the economy then tend to do well in that environment? You know, especially if the Fed is starting to raise rates and all these things that you’ve talked about, are there certain parts that tend to outperform or do better than others?

Peron: So, Carolyn, I think that the theme of next year is going to be the shift into mid-cycle and all that comes with that, which comes to your question of, okay, so what’s that look like? What are the contours of that in the equity markets? I would say it’s going to bring a more quality and growth-at-a-reasonable-price type of dynamic to the market with, you know, perhaps more participation among other sectors. Here, in late 2021, the market got quite narrow recently, with just some small sub-sectors leading, and I think that as we come to mid-cycle, there should be a broadening out. Valuation will matter again; not that it will necessarily be deep value, but more of good growth, quality growth with robust earnings to underpin that, what’s called GARP, growth at a reasonable price. So, I think we’ll see that type of character in the market next year.

Bigda: And what about this battle between value and growth stocks? For so long, we’ve talked about how value stocks are ready to come back, but they just haven’t been able to outperform growth. Growth has sort of been the shining star, especially through the pandemic. Is there potential for that balance to shift in favor of value stocks next year?

Peron: Yes, I think it’ll even out a little bit more, as I mentioned earlier, because we’ll see more participation. Every time value stocks started going in 2021 – as I mentioned, the fits and the starts, right – well, we’d run into a fit. So, I think, hopefully, if there are fewer fits, we’ll see more participation from value. Whether it’ll be value-led completely, I don’t know. I would think that sort of middle ground, of growth at a reasonable price, will be the style that investors would return to in 2022. It’s a middle ground between that value/growth dichotomy that we saw really kind of be almost bipolar last year.

Bigda: And is it possible to find these types of stocks, these GARP stocks as you refer to them, is it possible to find them throughout all the sectors in the market, or is it just certain sectors where you tend to find more of those opportunities today?

Peron: Yes, I think you tend to find them in more sectors, which is why I think there’ll be broader participation, rather than just hyper-growth, which is only down to one or two sectors, right: tech and you know, some areas of e-commerce, etc. So, that’s the premise of my call for a broader market and a “GARPier” market.

Bigda: What about geographically? U.S. stocks in 2021 were very strong, other areas of the world have also seen gains, but maybe not as much. Do you see some sort of evening out there going into next year?

Peron: Yes, I think typically, you know, in a broader market, you will see participation from non-U.S. regions. They each have their own challenges right now, which are a bit more acute than what we have in the U.S., where I think, as you noted earlier, we can return to being, you know, green eyeshade accountants and economists, and look at the traditional measures, hopefully, in 2022. They still have some of their unique challenges that are outside of that to deal with, so it’s hard to call them leaders, those regions, but I think there’ll be more even participation next year and increasingly from thereafter.

Bigda: Do the valuations look more attractive in those markets, or does that not matter as much given everything else that’s going on right now?

Peron: The valuations in developed markets outside the U.S. are not as attractive as they seem on the headline number because when you sector-adjust them, the difference isn’t quite that large. But there is a valuation gap that’s legitimate because they have a higher weighting to, you know, lower-multiple sectors. Those lower-multiple sectors should participate in any gains in a rally. So, I think they’re, as I mentioned, they’ll participate in that broadening theme that I spoke about; that’s in developed markets outside the U.S.

Emerging markets, I think, are cheap. Now, again, they have some challenges, but I think there are pockets of emerging markets, in particular, that are interesting, and there are some cheap areas – and some deservedly so – but some have opportunity. So, I think that will be an interesting area to watch in 2022 and 2023.

Bigda: And just briefly, what are some of those opportunities? Is it the fact that they’ll be exporting more of their goods as the economy gets on more solid footing in 2022, or is it other things?

Peron: Well, that’s right. Well, they’ve had some of the tightest lockdowns and restrictions, etc., so that’s one thing. Hopefully, the removal of those restrictions will help. But more importantly, they are exposed from an end market perspective to Europe and to the rest of the globe that is reopening as well. So, they’re a sort of levered beneficiary, if you will, on the recovery.

And then another theme that we’re really excited about is the emerging innovation that we’re seeing in parts of emerging markets. In particular, Southeast Asia is really exciting, some of the things that they’re doing in terms of innovating around health care or innovating around e-commerce. And so, there are a lot of themes there that are presenting opportunity almost regardless of the broader emerging markets as an asset class. We see very interesting pockets of opportunity in emerging markets.

Bigda: Sounds like a good topic for a future podcast where we dive into some of those themes.

Peron: That was a shameless plug there, wasn’t it?

Bigda: But generally, it sounds like more volatility in 2022, but perhaps a bigger opportunity set for new investments. Is that correct?

Peron: I think that’s right. I think a return to traditional cycle dynamics, in particular mid-cycle, which is hopefully healthy and less of the fits and starts. But we do need to get over the hump of the first rate hike from the Fed. Those are typically volatile times in and of themselves, let alone everything else that’s going on. So, once we get over that, I think then we are set for a while into this mid-cycle range, hopefully for a few years.

Bigda: So, to wrap up, let’s maybe take a look back at 2021. In terms of the stock market, what do you think was one of the best success stories this year?

Peron: Well, Carolyn, I would say the biggest success story is that the recovery did unfold. There were probably a little bit more fits than starts than we imagined, in particular the Delta wave in mid-year, which slowed things down. But ironically, that may end up extending the cycle a little bit because it dampened the economy, and the recovery was going robustly; from a personal standpoint, I wish that continued. But actually, from an economic standpoint, it did actually put a damper on the recovery and extend it out a little bit, so there’s some silver lining in that. But I think in general, it was a successful year. We expected continued gains in the market because we knew that we would have robust earnings growth, and that came to pass. And we got it from most sectors, so we broadened out. We still have more work to do in that regard, but the recovery generally happened despite a pretty significant Delta wave, but we were able to work around that and keep the recovery. We didn’t have to stop it [the economy] and end the cycle, which would have been the risks that we were worried about at certain times. So, the fact that we were able to muddle through, and actually quite well from an economic and market standpoint, I think is a big success.

Bigda: What was one of the biggest flops of 2021?

Peron: The biggest flop would probably be the wave of the Delta cases that we had mid-year. Obviously, tragic from a human perspective, but from an economic perspective, too, it certainly cast into doubt, for some time, the pace of growth, and we’re really not out of the woods yet. So, that was probably the biggest concerning issue, and the fact that that might happen again with a new variant is a worrisome development and probably the year’s most notable negative.

Bigda: What about from a sector standpoint? Was there any area of the market that surprised to the downside?

Peron: Yes, I think the most surprising downside was the biotech sector, which really struggled into the end of the year. Now some of that was giveback from robust earlier gains, but it was surprising how soft that sector was at the end of the year. And we have a very positive outlook on the sector, and think it’ll recover, and it will be a great place to be; the pace of innovation, the opportunity set, the appreciation by the average citizen is so much more recognized now. And we just see, really, some tremendous things coming down. So, it’s a bit of a head scratcher as to why that happened, but nonetheless, I wouldn’t – it’s down but not out.

Bigda: Well, here’s hoping that in 2022 we have more good stories than bad. In the meantime, we wish all of you a very happy and healthy holiday season, and we look forward to bringing you more episodes of Research in Action in the new year. I’m Carolyn Bigda.

Peron: I’m Matt Peron.

Bigda: Thanks for listening.

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