Economic Outlook – January 2022

1/20/2022 2:00:00 PM

Bell Bank News

Observations for the Coming Year

Happy new year, everyone! The annual review and outlook article is our longest feature each year, and this one is no exception. I understand that reader interest is inversely proportional to the length of an article – which is why we like to keep them as short as possible. In this case, I hope you’ll humor me for a bit longer as we begin with a topic we feel will be meaningfully influential for future investment returns. After that, we will provide last year’s market wrap-up – in which case your time might be used more effectively elsewhere. 

In 1980, inflation as measured by the consumer price index (CPI) hit a quarterly, annualized high of 14.8%. It spent the next three years declining below 3% per annum, where it has remained most of the time since. Yes, there have been periods when inflation migrated above 4% per annum for several years, but it didn’t stay there. We don’t expect it to stick this time, either. There are three very strong forces suggesting the current 7% annualized inflation rate will migrate lower over the next few years: demographics, globalization and technology. 

I wanted to touch on inflation, since it’s certainly on consumers’ minds. However, I won’t expand on it right now. Instead, let’s move to our next salient theme: the Fed. The Federal Reserve Board has made liberal use of both its interest rate policy and a tool called quantitative easing to stimulate the economy, beginning with the financial crisis in 2007 and again in 2020 in the wake of the pandemic. Except for 2016 to early 2020, the Fed Fund rate has been near zero. Consistent with the idea that every solution creates a new set of problems, this is no exception. What started out as well-intended economic stimulation ended up as a form of income inequality, inflation and elevated asset valuations. Again, these are topics of interest – but I won’t expand on them right now. 

Here is the final set up… Our information sources provide return history for the Dow Jones Industrial average going back to 1900 (before I was born!), while S&P500 return information goes back to 1928 (still before I was born). Putting both of these indexes in the same time frame starting January 1, 1928, the annualized returns would be 9.74% for the S&P500 and 7.9% for the Dow.

Using December 31, 2008, as the first time we know of the Fed implementing a zero interest rate policy (officially known as ZIRP), the annualized return on the Dow since then was 14.35%, and the S&P 500 return was 15.96%. Our thesis proposes that generous monetary policies from the Fed supported these outsized returns. In the case of the Dow, annualized returns were double the long-term average. We expect such generous Fed support to wane moving forward. Some of the Fed activity of getting money into the economy will be replaced by fiscal policy from Washington, D.C. – notably the Build Back Better spending plan being negotiated in Congress. Please note, we are not predicting some sort of market or economic meltdown. After all, regular readers know there are two potential outcomes from a prediction: lucky or wrong.

What is the point of all this? Returns are not likely to be in the mid-teens as they have been over the last 13 years. We believe there is an inflection point when the market will migrate more toward its historical nature, with returns in the mid- to high single digits. To that end, the information we want to showcase is our Capital Market Outlook for various market sectors in the coming 10 years. This information is updated annually and incorporates economists’ projections, long-term market averages and our own outlook. It is then weighted among each set of data, resulting in our baseline estimate as source data for developing strategy, constructing portfolios, planning and helping clients set and meet expectations.


Timing is always a challenge and never a good investment strategy – but the shift in Fed policy is an important signal suggesting moderation in future multiple expansions, in contrast to what happened to the stock market action over the last decade.

One thing we see over the coming five to 10 years is that dividend income from stocks will likely make up a larger portion of returns than it has in the last 10 years.

It doesn’t end with the stock market, however. Federal Reserve Board actions also impact fixed income (bond) investments. Investors might be cheering higher interest rates for their ability to generate more income in the form of higher yields, but this only applies to future bond purchases. For bonds already held in a portfolio, rising interest rates mean the value of existing holdings declines. The amount of volatility is a function of the average maturity of a fixed income portfolio. For an equal rise in interest rates across the maturity spectrum, short-term investments will retain more value than long-term investments. Saying this a different way, short-term investments will lose less market value than longer-term investments. For example, if interest rates rise half a percent, the market value of a 10-year U.S. Treasury bond would decline 4.4%, but a 2-year U.S. Treasury bond would only decline 0.96%. There are situations where the yield curve does not change universally across the maturity range. The yield curve can flatten or invert (where short-term yields are higher than long-term yields). In these environments, it is tricky to find the right spot to invest. Monitoring this and other potential developments are all part our investment process. 

U.S. Treasury Inflation Protected Securities (TIPS) are often a hot topic in times of rising interest rates as a way to protect fixed income value – but as of January 10, the Bloomberg TIPS Index is already down 2.17% for the year compared to the Bloomberg Aggregate Index, which is down 1.62%. When rates are rising, there is nowhere to hide. Along the spectrum of meeting long-term investment objectives, minimizing losses during periods like this contributes to maximizing longer-range investment goals.

Our short-term liquidity bond strategy became very popular during the last few years of near-zero short-term interest rates. We invest in 1- to 3-year securities as a way to capture incremental yield while remaining short in the maturity spectrum. The yield has been better than remaining in cash deposits, and its return has been doing very well compared to popular benchmarks listed above – but even that strategy has been impacted by rising interest rates and is down 0.15% year to date. 

As investors, we always want to make progress toward goals, but every now and then, there are obstacles that require perseverance, discipline and patience. Now might be one of those times. We see stable market fundamentals with continued corporate earnings growth, but price/earnings (P/E) multiples are currently elevated. Keep in mind, we are looking at the prospect of diminished returns compared to the last 10 years, something in the range of single digits – not a wholesale market selloff for the year. 

Observations About the Economy

It’s not what you know that gets you in trouble; it’s what you know for sure that just isn’t true. 

The story goes that supply constraints and bottlenecks were to blame for low inventory, bare shelves and rising prices. What if we theorized instead that supply constraints were really a symptom of increased demand? April 2020 marked the first date for a series of individual stimulus checks, totaling $3,200 over about a year’s time, sent to over 100 million people in the U.S. That amounts to the potential for $3.2 trillion of additional consumption or investment that would not ordinarily have been available. If we extrapolate the linear progression of normal consumer behavior, we see that current annual consumption would be around $15.5 trillion. It is actually $16.4 trillion. That’s nearly $1 trillion of additional consumer demand that disrupted an otherwise orderly progression of normal supply chain growth. 

We don’t see this repeated in the coming year. Labor shortages and interruptions contribute to supply chain challenges in nearly all areas of employment these days. The graph below shows the spike in savings consistent with stimulus checks in April 2020 ($1,400 stimulus checks), Dec 2021 ($600 stimulus checks) and March 2021 ($1,200 stimulus checks). Most of the pent-up savings have now been spent or invested. Sure, not all of the money saved was stimulus money – but there were noticeable jumps consistent with the timing of the federal checks.

Economic Outlook Graph

Source: Bureau of Economic Analysis

The Federal Reserve is on the cusp of transitioning from quantitative easing (QE) to quantitative tightening (QT), while also raising short-term interest rates in an effort to combat inflation. Regular readers may recall earlier monthly outlook comments about inflation being the check and balance against excess monetary policy. Well, here it is. Just like the Fed waited too long to curtail its excess policy, there is a risk that the Fed also decelerates too fast and breaks something else in the process. This is especially the case with all the political pressure placed on a Federal Reserve that is supposed to be independent of political influence. The current majority party in Congress is getting a tongue-lashing from constituents feeling the pressure of higher inflation. As we’ve pointed out, the seeds for inflation have been sown over several years of economic factors and policies. Wages are rising, but not as fast as inflation – and consumers see themselves going backwards.

Observations About the Stock Market

For the full year 2021, the S&P 500 had a return of 28.68%. The S&P 495 (all except the top five stocks) had a return of 19.55%. With nearly one third of the return resting with five companies, the market is considered lacking in breadth. As investors, we keep a list of what we call market rules, or more accurately, market wisdom. One of our points of wisdom says markets are strongest when they are broad across many sectors and styles and are weakest when they are narrow. This is looking like a narrow market. 

The Russell 2000 Growth Index had a return of 2.82% in 2021. The Russell 2000 Value had a return of 28.21%. Value materially outperformed growth in this index last year. In the prior year of 2020, it was nearly the opposite, with the Russell 2000 Growth return at 34.61% and Russell 2000 Value return at 4.60%. This is a great example of why it is so important to avoid chasing returns.

The P/E ratio of the S&P 500 is 25.8. It was higher a couple of months ago. The last time it was hovering above this range was at the peak of the tech stock bubble in the early 2000s. Something in the range of 16 to 17 times is closer to the longer-term average. There are a couple ways that P/E ratios could moderate. The market can tread water over time while corporate earnings rise, the market could sell off, or corporate earnings could come in higher than expected.

The market cap of the top five S&P 500 stocks (Microsoft, Apple, Facebook, Amazon, Google) is $9.6 trillion. The market cap of the entire Russell 2000 index is $3.37 trillion.

It is often said the stock market is a leading indicator of the economy, and a stable stock market suggests a stable economy. There is an argument to be made that the proliferation of passive investment (aka investing in an index) has migrated the stock market to a lagging indicator. The stock market is no longer dominated by a bunch of investment professionals looking at future earnings prospects. It is now dominated by money flows into low-cost, passive options, and it is only after the economy changes that investors might alter those money flows. 

There is a risk to the stock market if the Federal Reserve’s approach toward inflation is either too aggressive or too conservative. The Fed is threading a narrow channel between these two themes. Recognizing that it will bounce off one guardrail or the other is one of the reasons we anticipate a bit more volatility in stocks this year.

Observations About the Bond Market

The biggest bond buyer, the Federal Reserve, is leaving the market. The Fed, which had been purchasing $120 billion in bonds a month, is expected to nearly exit this policy by mid-year. Bonds are a defensive asset class, traditionally insulating portfolios from the volatility that originates with more risky allocations such as stocks while contributing some cash flow for investors. The low interest rate environment has made bond income a challenge, but bonds’ characteristics of lower volatility are still relevant. However, 2021 was not kind to those allocating a portion of their portfolio to bonds. Even though absolute interest rate levels are currently low, they were even lower at the beginning of 2021. Earlier, we learned that rising interest rates erode the value of fixed income investments – and this was the case in 2021. Popular fixed income benchmarks like the Bloomberg Aggregate Index lost 1.54% in 2021. The Bloomberg Long Treasury Index lost 4.65%. Bell’s fixed income allocations did better, losing in the range of 1%. 

We expect 2022 to remain challenging for fixed income allocations. The environment is facing inflation, Federal Reserve fund rate increases and the pullback of quantitative easing measures, all at the same time. This translates to more volatility. Even so, we anticipate that our fixed income strategy approach will end up better than popular benchmarks in 2022. 

In spite of the low interest rate environment, there is still strong demand for bonds. In addition to being a portfolio’s “shock absorber,” fixed income is heavily used by insurance companies, pension funds, retirement plans and many other investors. The market is calling for material increases in rates, but we would not be surprised to see some yield curve flattening and more resilience in the bond market than is currently anticipated. Yes, the real rate of return (the return after accounting for inflation) looks dismal right now, posting negative real yields – but even prior to the telegraphed shift in Fed policy, real returns were challenged. That didn’t keep investors in other developed countries from purchasing debt at interest rates even lower than those in the U.S. In some cases, those rates were negative even before accounting for inflation. Even today, Germany and Switzerland still have negative 10-year government bond yields. Investors purchasing these bonds and holding them to maturity are guaranteed a loss!

Make no mistake about it. Managing bonds in a rising interest rate environment is very difficult.

Observations About Housing

Housing prices have been rising, making home affordability difficult even in this low interest rate environment. Rising prices are consistent, in part, with relocation trends that were already in place but accelerated by the pandemic, work from home and lifestyle changes. Our most recent data suggests that demand for homes continues to outstrip supply. This means we expect demand for housing to continue to support current prices. 

Portfolio Strategy

We have outlined various market conditions in this overview. In the normal course of our investment approach, we try to determine if these conditions are expected to be cyclical (occurring over a relatively short period of time) or secular (occurring over a longer period of time). To the extent we expect them to be secular, we incorporate the theme into an overall portfolio strategy aiming to maximize return and minimize risk within the tolerance of each asset class. Cyclical themes tend to be “noise.” They need to be filtered out to avoid responding to fads and then winding up on the wrong side of chasing returns. 

This is all a fancy way of saying that our underlying investment models reflect steps in the direction of long-term themes, so our clients don’t have to make adjustments at the margin in their accounts. This is not intended to be full auto-pilot. It is best to have an annual update meeting regarding your investment objectives and to review progress toward long-term investment goals to determine if everything is progressing as intended.

Thank you for your business and confidence in Bell. Here’s to a great 2022!

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