While  2021 was seen as a year for recovery and rebound, 2022 could build from it to be a year of moderate economic growth, and an overall positive investment outlook, albeit with inflation in the background.

As we move into 2022, we would like to highlight the economic outlook for 2022 in terms of the U.S. Fed’s move on tapering, interest rates and inflation. Robust household income along with the accumulated savings during the pandemic is likely to catalyse increased spending in the new year which could boost overall economic growth. Improved labour market and unemployment numbers show significant strength and will play a key role in economic revival post the pandemic. Most major investment banks predict that 2022 will be the end of the COVID-19 pandemic and see a full economic recovery across the globe and the U.S., and a return to normal economic and market conditions is expected early 2022. 

Faster tapering and earlier interest rate hikes beginning in 2022

The Federal Open Market Committee (FOMC) is doubling the pace of tapering to $30 billion per month from the previous $15 billion per month made in November 2021, thus reducing its $120 billion worth of monthly bond purchases by $30 billion each month. The new pace of tapering will begin in January 2022, and the quantitative easing (bond purchases) program is going to end in March 2022. The Fed chief also suggested its first interest rate hike would be in early 2022 after the end of tapering in March 2022 as decided in the latest FOMC meeting earlier last week. The shift is the latest sign of how inflationary pressure along with signs of tighter labour markets have made the Fed relook its policy plan for 2022.

As shown in the graph below, historically, stocks typically did well in the year leading up to initial rate hikes, and the worst case for the markets was during the “fast” rate hike cycles when the Fed hiked rates at most of the FOMC meets – which will not be the case in 2022 as per data from the latest Fed meet.

Source: Schwab Market Outlook 2022

Increase in federal funds rate  

The Fed emphasised that the earliest the FOMC is likely to start increasing the funds rate (interest rates), is once the tapering is complete in March 2022. On this basis, the FOMC is likely to increase the Federal Funds rate four times in 2022 starting in May next year and go on to a target interest rate range between 1.00-1.25%. The Fed Chair, Powell, also mentioned that the U.S. economy is growing steadily, and rapid progress is being made towards maximum employment, and indicated that the FOMC does not have to wait until the economy reaches full employment in order to start hiking the interest rates. Additionally, JP Morgan’s chief global market strategist predicts that the 10-year U.S. Treasury yields, which is a key growth driver of global borrowing costs, is likely to rise to 2.25% by the end of 2022 from the current 1.5%.

Fed’s tapering and rate hikes

Source: U.S. Federal Reserve, December 2021

Fed tapering is not tightening

The Fed tapering which is reducing the monthly bond purchases is not policy tightening as it is still policy easing albeit at a slower pace. At this new pace of tapering, the FOMC is likely to finish the increase in March 2022 and the Fed’s balance sheet is likely to stabilize from March 2022 onwards.  

Source: U.S. Federal Reserve, December 2021

Inflation remains a focus for investors 

The biggest surprise of 2021 has been the surge in U.S. inflation which will spill over to 2022 as economies reopen. At this point in time, it does not appear that the pandemic is the biggest street fear. However, it may have a large impact if the new variant turns out to be worse than expected. It’s the fear of inflation which continues to be fed by supply shortages, higher labour costs, worker shortages and increased demand that has added investor fear. Added to this was the rise in energy prices and the impact of semiconductor chip shortages, which played upon higher prices for motor vehicles, thus significantly pushing up inflation numbers. Looking at this from the Fed’s perspective, there have been several modest changes post the FOMC’s meeting lately on measures to tackle rising inflation in 2022. The big change however has been to remove “transitory” to describe high inflation. Headline inflation is likely to exceed 7% in the coming months from the current 6.8% seen at the end of 2021. However, the moderating demand and improved supply side of the economy should allow the U.S. inflationary pressures to subside in the second half of 2022.  

Household savings at a record $2.3 trillion

The U.S. households had a record $2.3 trillion in savings during the pandemic – relatively higher to the pre-pandemic levels. This savings rate dropped to pre-pandemic levels of 7.5% of the disposable income and increase in consumption which was reflected in the U.S. retail sales rising to 1.7% in October which was the strongest since March 2021. This data shows an increase in purchasing power which is a boost for the overall economic growth which is likely to continue into 2022.

Greenback to gain strength in 2022

The U.S. dollar has strengthened all through 2021 on investor expectations that the Fed was likely to increase rates sooner than later. The strength in the dollar is likely to gain steam in 2022 as the Fed continues to remain more hawkish, as inflation risks persist into the new year, thus increasing the interest rates – which is positive for the greenback.

Equities are likely to generate higher returns over bonds in 2022

Equity markets are likely to be supported by the above trend of economic growth, growth in corporate earnings and the central banks move to gradually remove accommodation. The above growth trend and higher long-term interest rates are likely to favor cyclical and value stocks over growth stocks in a rising interest rate environment.

Conclusion

The U.S. economy is poised for another year of above-trend growth–  but it may be at a slower pace than what we saw in 2021. The pandemic has clearly illustrated that the market can look beyond the challenging times considering the current supply chain disruptions and the rising energy costs witnessed in 2021 which seems mostly impermanent. All in all, the U.S. economy is likely to deliver 4% GDP growth in 2022 according to most economists. There is a possibility that investors are likely to witness a significant rally in equity markets if the COVID-19 fears prove to be unfounded, and the new vaccines and therapeutics would likely result in strong cyclical recovery along with release of pent-up demand from consumers.  

To conclude, on the investment side equity markets are to remain more selective in 2022 with a greater focus towards valuations and strong fundamentals. We will look into the sectors and themes which will be positive for the year in our next report in January 2022. Until then stay invested.