This week, CIO Tom Weary, CFA®️, reviews economic performance from the past year and identifies potential headwinds for 2022.


Hi, I’m Tom Weary here at Reilly Financial Advisors with your Weekly Market Update. Well, as the year winds down, it’s a good time to look at what drove results in 2021 as well as looking ahead to some of the potential headwinds we might face in 2022. As I have often said in both 2020 and 2021, the pandemic drives the investment narrative, and I fear that it shall continue to do so in 2022. Even now we are seeing all-time record numbers of daily new COVID cases given the recent surge due to the virulent Omicron variant.  Analysts fear that this latest surge will slow economic growth early in the new year. Yet, what has been really remarkable is how resilient The U.S. economy has proven to be, thanks to the almighty American consumer. And that is where I would like to begin this week.

The American consumer drives not only the U.S. economy, with consumption representing 70% of Gross Domestic Product, but also to some extent the global economy as other countries export goods to meet our demands. As you can see in this first chart, after taking a big hit early in the pandemic, personal consumption adjusted for inflation has returned to its long-term trend in recent months. But the patterns in spending have been altered by the pandemic. Given that many services are delivered in person, consumers shifted many of their purchases to goods, as we can see in this second chart.  With the purchases of physical goods skyrocketing while the supply of goods was constrained due to pandemic related production and shipping challenges, the price of goods moved sharply higher, as we can see in this next chart of the Fed’s preferred measure of inflation.  Even though recent measures of inflation have hit their highest level in 40 years, when we take a step back and look at the longer term, the inflation picture isn’t so frightening. This last chart looks at core PCE inflation over the past 20 years, showing that cumulative inflation is still below the Fed’s long term target.  We are only now recovering from the deflationary impact of the Great Financial Crisis in 2008.

But how did the American consumer manage to spend furiously in the midst of a global pandemic? It turns out that we had a little help from Uncle Sam. This first chart shows both the hit that regular income took due to the pandemic as well as the extra help from government transfers in the form of enhanced unemployment benefits and direct stimulus payments. The U.S. government was literally shoveling money into consumers pockets in the hopes of avoiding a depression. It turns out that Americans could not spend all of the largesse. This next chart shows an enormous spike in the savings rate due to all the stimulus payments. Now that the stimulus payments have ended, that savings rate has returned to normal levels. And yet as this last chart illustrates, all of those fiscal transfers led to enormous household savings, approaching nearly $2.5 trillion.  That is an awful lot of dry gunpowder that will either be spent or invested someday.

Contrary to Milton Friedman’s dictum that inflation is always and everywhere a monetary phenomenon, one could make the argument that the inflation we have seen recently was driven more by an overly generous fiscal policy. We are unlikely to see fiscal policy to be nearly as stimulative in future years. Direct payments to consumers have ceased.  While the Biden administration was able to push through a bipartisan infrastructure bill, it only amounted to $1.8 trillion which will be spread over the next decade. The prospects for the build back better spending bill aren’t looking great and even then funds would be spent over the next 10 years. None of this is nearly as stimulative as what we saw during the early days of the pandemic. The slowdown in fiscal policy is likely to be a headwind for the economy.

Monetary policy is also likely to become a headwind for the economy and financial markets. The Federal Reserve has already begun to taper their bond purchases, which will see excess liquidity dry up.  By their own reckoning, the Fed will increase the Federal Funds Rate three times in 2022 and another three times in 2023.  Given that the rate currently stands at zero, this may not prove to be too much of a challenge to stock prices, yet if there is one thing that Wall Street enjoys and will sorely miss is free money.

Economic growth is also likely to slow in 2022, although it is likely to remain above trend as it comes off torrid growth of the past two years. The economy rebounded strongly from the pandemic plunge aided by enormous monetary and fiscal stimulus, posting growth rates not seen in a generation. U.S. economic growth will likely be relatively strong next year, while reverting back to its long term trend as the year progresses.  Slowing economic growth may become a headwind to corporate profit growth, even as companies face ongoing cost pressures from materials, labor and logistics.

And current valuation levels present yet another headwind for financial markets. Bond yields are extremely low, meaning that bond prices are very high. A more hawkish Fed creates a challenge to these high bond prices, meaning that fixed income returns face a huge hurdle in coming years.  With bond yields so low, stocks trading at around 21 times forward earnings may seem reasonable.  But it is difficult to make the argument that they are cheap. We probably should not count on P/E expansion helping us from here.  Diversification has not been of much assistance recently, with bonds, gold, emerging market stocks and even hedge funds showing negative returns in 2021.  Investing is going to become even more challenging.

So, what does it all mean? With the S&P 500 index returning around 30% in 2021 following over 18% in 2020 and over 31% in 2019, and facing a number of headwinds that I just discussed, we should all probably restrain our expectations for 2022.  There is a saying in this business that trees don’t grow to the sky, meaning that these extraordinary levels of returns cannot continue forever. And yet, none of us knows what the future holds. It is probably best to stick to our investment discipline and avoid making any bold bets which could go horribly wrong. With 2022 likely to be an interesting year, we will follow the data closely and keep you updated on how things unfold. All of us here at RFA wish you a very happy and healthy New Year. So please, sit back, relax, enjoy your New Year’s celebration, and join us next year for the next Weekly Market Update.

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