Taxes

DOWNSHIFT IN U.S. GROWTH BUT STILL ABOVE TREND

Jeffrey Roach, PhD, Chief Economist, LPL Financial

We currently expect the U.S. economy to grow 3.7% in 2022. The risks are to the downside since the Fed may err on tightening too fast, the recent commodity spike may trickle down to the U.S. consumer, and supply and demand imbalances may last longer than expected. This forecast is lowered from our previous 4-4.5% range originally published in Outlook 2022: Passing the Baton. The rest of this commentary explains the overall themes supporting the forecast.
 

FROM ONE RISK TO ANOTHER

The U.S. economy grew 5.7% in 2021, exhibiting strength after an unprecedented global pandemic, but as the economy marched into 2022, the COVID-19 Omicron variant squelched some of the rebound in economic activity. Most saw this headwind to be temporary and mostly affecting the first quarter estimates. The LPL growth forecast for 2022 was initially developed in November 2021, and so the reality of a new COVID-19 variant stage was yet to emerge. As the data came out, we saw the need to revise down our forecast for the year. We currently expect the U.S. economy to grow 3.7% in 2022 with risks to the downside for multiple reasons. The rest of this commentary explains the overall themes supporting the forecast. We end this note with risks and alternative scenarios.

FROM SHUTTERED TO UNSHUTTERED

Vaccination rates, COVID-19 cases, and hospitalizations have all improved in recent months and the data proves it. Google mobility trends for everything from theme parks to movie theaters are higher now than last year. Even though remote work seems to be available for many white-collar jobs, Google mobility trends for places of work is also up since December. These stats bode well for consumer spending and business investment, two key components to economic growth and corporate profits.

The speed at which federal, state, and local governments shuttered the economy gave rise to an unprecedented shift away from services spending and into goods spending. Now, the debate is centered on how fast this compositional shift will revert to more normal ratios.

PURCHASING A NEW WASHING MACHINE HAPPENS ONLY SO MANY TIMES

At the height of the pandemic shutdowns, consumers spent discretionary funds on bikes, boats, beds, or books. Few spent on cruises and casinos. Even if people wanted those services, governmental authorities closed those doors.

An unintended consequence of this massive shift in demand from services to goods created immense pressure on suppliers to get products to the market in a timely fashion. The toilet paper and N95 mask shortages of 2020 illustrate fundamental laws of economics. If prices and supply are fixed in the short run and consumer demand spikes, the market will experience shortages. In a freely functioning economy, the simple way to fix a shortage is for suppliers to raise prices and post COVID-19, these fundamental laws still hold true. Much of the lingering inflationary pressures come from these supply and demand imbalances. However, demand for durable goods will likely normalize soon. Most people do not buy a new washing machine on a regular or even semi-regular basis. Outside of the ratio of goods to services spending, suppliers are also dealing with demand that may be sustained longer than anticipated. For example, a new study by Global Industry Analysts report that the N95 mask market will reach $11.8 billion in a few years.1 For our forecast, we expect consumer goods spending to contribute to growth in 2022 but not at the same rate as 2021 (Figure 1).

HOW SOON ARE RATE HIKES COMING?

Lawrence Gillum, CFA, Fixed Income Strategist, LPL Financial

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

STRONG EARNINGS MOMENTUM TO START 2022

Jeff Buchbinder, CFA, Chief Equity Strategist, LPL Financial

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

Corporate America has capped off an outstanding 2021 with an excellent fourth quarter earnings season so far. Entering 2021, the consensus estimate for S&P 500 Index earnings per share (EPS) was less than $170. Now with fourth quarter results mostly in the books, that number is 22% higher at $208. Here we recap another solid fourth quarter earnings season and discuss what the results could mean for earnings growth and stock market performance in 2022.

DELAYED INVESTOR SHIFT FROM MACRO TO MICRO

In our earnings preview on January 10, we noted that we welcomed a shift from the macro to the micro. Well, given the path of inflation, the resulting dramatic shift in Federal Reserve (Fed) rate hike expectations, and the escalating Russia-Ukraine conflict, that shift hasn’t really happened. However, when we turn our attention away from macro headlines to corporate America, we find that companies have again showcased their ability to effectively manage through the pandemic’s challenges, notably supply chain disruptions and labor and materials shortages that have pushed costs higher.

THE VALENTINE’S DAY INDEX

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

Barry Gilbert, PhD, CFA, Asset Allocation Strategist, LPL Financial

With tax season quickly approaching, it’s important to know about the deadlines, new economic relief measures, deductions, and tax brackets. Continue reading for what you need to know about the 2022 tax season.

WHICH REGION WILL GET THE GOLD IN 2022?

Jeff Buchbinder, CFA, Equity Strategist, LPL Financial

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

Scott Brown, CMT, Technical Market Strategist, LPL Financial

The near-10% correction in the S&P 500 Index and even larger drawdown in the Nasdaq have

gotten a lot of attention this year. What hasn’t gotten as much attention—and maybe surprising to

some—is the relative resilience in equity markets outside the U.S. In our special Winter Olympics

edition of the Weekly Market Commentary, we hand out medals to the U.S., developed

international, and emerging markets. Who do we think will get the gold? Read on to find out.

U.S. HAS BEEN SKIING UPHILL

It’s been a rough start to the year for U.S. stocks with some stiff headwinds. The path of the

S&P 500 in January looked like something Mikaela Shiffrin might ski on given the steepness of

the decline with twists and turns. Fears that the Federal Reserve (Fed) might be behind the

curve in its inflation battle got most of the blame for the market selloff, while a few high-profile

earnings misses—Meta (Facebook) being the latest—have added to investors’ anxiety levels.

Meanwhile, the international equity markets have held up relatively well. The S&P 500 Index is

down 5.6% year to date, outrun by the 3.8% and 0.9% declines in the MSCI EAFE Index

(developed international equities) and the MSCI Emerging Markets (EM) Index. To assess

which regional market might come out on top at the end of the 2022 competition, we take a

look at global fundamentals, valuations, and technicals.

ECONOMIC GROWTH LIKELY TO BE A CLOSE RACE

Starting with economic growth outlooks, emerging markets may produce the fastest gross

domestic product (GDP) growth in 2022, but it could be a close finish [Figure 1].

If you’ve spent more than five minutes on a kid’s television network, you’ve seen just how inundated young kids are with commercials for everything from the latest gadget, to some dreadful snack that features something gooey and/or messy. It’s also safe to bet that many of these kids run to their parents, wanting to buy some or all of these items.

SUSTAINABLE INVESTING YEAR IN REVIEW

Jason Hoody, CFA, Head of Investment Manager Research & Sustainable Investing Research, LPL Financial

Sustainable investing hit several milestones in 2021, but continued to attract its critics. Below we look at how sustainable investing fits within the broader concept of sustainability, its growth during 2021, and an implementation framework that has been helpful for many. A well diversified sustainable investing portfolio doesn’t mean that an investor has to make a choice between achieving market-like returns and being an aware social and environmental steward.

Market volatility has been the dominant story for many investors in early 2022, but even as we focus on near term events it’s important to continue to track important market trends. Sustainable investing has become a significant theme in how many investors choose to direct some or all of their capital, choosing to emphasize businesses that show they’re in it for the long term. The space has been evolving as it continues to meet its critics and address the challenges that come with growth, with several important developments in 2021.

What is Sustainability?

The concept of sustainability can easily get bogged down in confusing definitions and minutia. Most simply, sustainability is humanity meeting its current needs without overburdening the natural environment or future generations. Environmental sustainability refers to maintaining the balance of natural systems and that natural resources are consumed at a rate that can be replenished. Social sustainability refers to a minimum standard of basic necessities and that human rights is afforded to all people. As shown below, sustainability includes action by individuals, companies, governments, and increasingly investors.

POTENTIAL CATALYSTS FOR A TURNAROUND

Jeff Buchbinder, CFA, Equity Strategist, LPL Financial

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

After a tough start for stocks in 2022, investors are looking for reasons to expect a rebound. After more than doubling off the pandemic lows in March 2020, without anything more than a 5% pullback in 2021, stocks probably needed a break. That doesn’t, however, make this dip feel much more comfortable. Here we cite some reasons we don’t expect this selloff to go a lot further, though a 10% drawdown in the S&P 500 seems reasonable to expect.

TOUGH START TO THE YEAR

It’s been a rough few weeks for the stock market. Fears of rising rates and the Federal Reserve pulling back its stimulus more aggressively than previously anticipated to fight high inflation have caused most of the market jitters, though earnings season—albeit in the very early stages—hasn’t helped either.

The pain has been particularly acute for the many growth stocks that make up the Nasdaq Composite, which has corrected 14% from its November 2021 high. This is the third worst start to a year ever for the Nasdaq (down 10% year to date), though it was positive the rest of the month the last five times it was down 5% or more year to date through January 20 (thank you to our friends at Bespoke Investment Group for that nugget).

Small caps have been hit even harder, with the Russell 2000 Index nearly in bear market territory with its 18% decline since November 8, 2021—though the higher quality S&P 600 small cap index has fared better in losing 12% during this period.

WHAT MIGHT GET THIS MARKET TURNED AROUND

So what might turn this market around? Stabilization in interest rates would help. The 10-year Treasury yield’s inability to break through 1.9% last week and subsequent dip below 1.8% is a good start. Stock valuations are interest rate sensitive and harder to justify if bond yields go much higher (the price-to-earnings ratio for the S&P 500 using the 2022 consensus estimate for earnings per share is currently a touch below 20).

On inflation, clearly a key risk for markets right now, the data likely won’t change much in January when it’s reported in February. However, we could soon see more evidence of easing supply chain bottlenecks and more people jumping into the workforce as COVID-19 disruptions hopefully fade (there are a near-record 10.5 million open jobs in the U.S. now compared to less than 7 million pre-pandemic in December of 2019). When the market begins to gain more confidence that inflation will start coming down, hopefully as winter turns to spring, inflation may turn from stock market detractor to a contributor. A Fed meeting this week without any negative surprises would also help. Stable or lower oil prices would help as well.

What about earnings as a potential catalyst? As we suggested in our 2022 Outlook: Passing the Baton, earnings growth would likely be the primary source of stock market gains this year. The downward pressure on stock valuations from higher interest rates makes that more likely.

In Figure 1 we have decomposed annual returns for the S&P 500 into earnings growth, valuation changes, and dividend yield. During 2019 and 2020, when the S&P 500 returned 24.7% annualized (55.7% cumulative), increases in valuations drove much of the gains. That changed last year when earnings rose an estimated 50% and valuations contracted. We expect 2022 to look more like the mid-cycle mid-2000s or mid-2010s with more modest returns, more contributions from earnings growth and dividends, and little, if any, contribution from valuation.
 

DON’T EXPECT THE FED TO END THIS BULL ANYTIME SOON

Jeff Buchbinder, CFA, Chief Equity Strategist, LPL Financial

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

The Federal Reserve (Fed) has engineered a massive hawkish shift, causing a bit more stock market volatility recently. But how worried should investors be? Here we take a look back at historical performance for stocks before, after, and much after initial Fed rate hikes to help reassure any nervous investors out there. We also take a quick look at what the Fed pivot could mean for growth/value and large cap/small cap trends given the maturing business cycle.

MASSIVE HAWKISH SHIFT

With the recent pivot by Jay Powell and Company at the Fed, rate hikes have been getting a lot of attention. And rightly so, given the bond market has gone from pricing in one 2022 rate hike just a few months ago to now pricing in three to four. That’s one of the most dramatic hawkish shifts by the Fed in a short period of time that we’ve ever seen, so some market jitters are not surprising.

HOW MUCH SHOULD WE WORRY?

A look back at history may help calm some investors’ jitters around the start of Fed rate hikes. As we wrote in our Outlook 2022: Passing the Baton, stocks tend to do well leading up to initial Fed rate hikes. There we highlighted the average 15% gain during the 12 months ahead of the initial hike of an economic cycle, including gains in all nine cases back more than 60 years. This makes sense given it takes a strengthening economy to create the job gains and inflation the Fed needs to see to take away the punchbowl. We see the first rate hike coming in either March or May, and with the S&P 500 Index up nearly 20% since March of 2021, and more than 10% since May 2021, those gains may already have occurred.

Looking beyond the initial hike, on our LPL Research blog last week we looked at how stocks performed during various periods after the Fed starts to hike rates. The story is similar, with the S&P 500 up an average of 7.5% six months later and 10.8% over the next 12 months historically. Stock were up all eight times one year after those initial hikes going back to the early 1980s. So based on history, the start of a rate hiking campaign by the Fed should not be too worrisome for investors.

LOOKING OUT LONGER TERM

But what does the hike mean further out, say 2023 and beyond? In Outlook 2022, we noted that initial Fed rate hikes can help us mark where the economy is in its cycle. The start of rate hikes typically happens in the early-to-middle stages of the cycle, where stocks historically see solid gains as we are forecasting for 2022.

But we can extend this exercise further and look at how stocks have done from the initial rate hike of a cycle until the end of the accompanying bull market, as we have done in [Figure 1]. Those first rate hikes have been followed by an average gain of 67% before the subsequent bull market peak. For those keeping score at home, that would take the S&P 500 to over 7,700 (no, that is not a forecast) before the next 20% or more decline.

On average, after rate hikes start, bull markets have run for about three to four years (or 40 more months) before peaking, with the longest in the late 1990s at six years (72 months) between the 1994 hike and the bull market top in March of 2000.