The 2020 economic recession driven by the Covid-19 pandemic and nearly worldwide disruption of business activity was short in comparison to previous recessions. In the span of only two months in 2020, the gross domestic product (GDP) of the U.S. plummeted, recovered, and then expanded dramatically into 2021. What makes this recovery so atypical is the speed at which the global economy went through a complete business cycle of expansion, peak, contraction, and trough. The average economical cycle in the U.S. since 1950 has lasted roughly 5.5 years. Completing an entire business cycle in just a few months has placed undue stress on developed economies in a variety of ways. Despite the economic recovery, there has been a host of other problems associated with restarting the global economy after a prolonged period of low activity. Most notably, disruption of global supply chains has led to low supply shocks in many industries. These supply shocks are driving inflation, with the Consumer Price Index (CPI) up 6.8% in 2021, including increases of 6.1% in food prices, and 33.3% in energy costs. Despite the supply issues and inflation patterns, there is still significant pent-up demand for housing, and Americans (on average) are still in a good cash position with nearly 2 trillion in short-term deposits, and strong asset returns from 2021.

Last year, in our 2021 outlook, we expected solid returns as the global market entered the expansion phase of the business cycle, with less focus on growth-oriented companies and more towards value and cyclical equities:

“Arrow has a positive outlook for economic and corporate earnings growth in 2020, with a continued low interest environment that favors equity over bonds. We do think there is some short-term risks however, with the logistical requirements of vaccine distribution becoming an obstacle to economic growth through the summer of 2021. Moreover, we think the market environment will favor a light rotation away from growth stocks towards value and cyclical equities, and from large cap to the extended market. We don’t expect this rotation to be long-lasting, or a hindrance to the growth of large tech companies, but these value-rich sectors are primed for increased investment as the world economy recovers from lockdowns.”

With the S&P 500 posted gains of 26.9% in 2021 and the Dow Jones 18.7%, both outperformed the technology and growth oriented NASDAQ for only the 6th time in history. Arrow increased allocations in many portfolios in value and dividend funds ETF’s early in the year (SCHD, SCHV, NOBL among others) based on these expectations. However, we maintain that growth-oriented tech companies are still the best place to look for long-term growth, even if short-term patterns are less favorable.

Consumer spending and inflation

We’ve learned from the Delta and Omicron variants that Covid isn’t going anywhere, and most countries have relaxed many restrictions and lockdowns that tended to inhibit economic growth. The Omicron variant does have the ability to further worsen supply chain issues because of its high transmissibility keeping workers in quarantine, and temporarily closing labor-short businesses. However, if the pandemic impact wanes in early 2022, improved global supply chains and factory reopening’s have the potential to ease inflation. Consumer spending drives 70% of the U.S. real GDP; and there remains pent-up demand and large amount of free cash for most Americans, so the consumer spending trajectory is strong. However, there has been a decoupling of normal patterns, as during the pandemic, spending on goods has outpaced services. The downside is that the prices of many goods (food, apparel etc.) has lagged inflation. So there still might be some headwinds in early 2022, before supply chains can fully recover. Inflation remains higher among “core goods” compared to “core services”, which means the overall impact of inflation has remained narrow, despite the large 6.8% in CPI.

Will a volatile labor market impact corporate earnings?

Growth in labor force participation remains low, and according to the U.S. Census Bureau, 2.5 million people are reluctant to enter the workforce because of Covid and nearly 3 million have decided to retire early. However, there still strong growth in nonfarm payrolls, with elevated levels of job openings that will likely decline as people re-enter the workforce. Worker shortages have strengthened wages, with growth of nearly 4% in most industries.

 Source: Charles Schwab, Bloomberg, Bureau of Labor Statistics 11/1/21

Increased wages do have the potential to drive inflation, as higher incomes support consumer spending, leading to a complex interaction of wages and prices, forcing companies to pass along higher costs—which puts more upward pressure on wages. This puts a lot of power back to workers to wait for higher paying jobs, but from an investment viewpoint, could lower corporate earnings. Labor market issues are going to be further complicated as baby boomers continue to retire, reinforcing low participation and pushing wages upwards.

The interaction of inflation with labor participation and upward growth in wages is the primary reason that Arrow expects growth to be lower in 2022 than in 2021. However, we still think pent-up demand, free cash, and easement of supply chain issues will still produce market growth.

Sustainable Investing in Climate, Infrastructure, and Robotics

The publication of a new Intergovernmental panel on climate change report in 2021 and the long-awaited United Nations Climate Change Conference in Scotland have placed a new level of importance on global policy shifts related to sustainable energy. The economic recovery from the Covid recession and high corporate earnings have produced strong cash positions among many companies (see Fig below), providing much needed capital for expenditure on these items. These positions when combined with global support by governments and the public for sustainable infrastructure, energy efficient utilities, and green technology could provide the perfect conditions for large investment in sustainable energy. These capital investments will help private industry fuel growth to reach the “net zero” target carbon emissions by 2050, which requires significant support from utilities and the automotive sector.

Source: Goldman Sachs Capex Tracker as of October 2021.

Upward pressure on wages and a weak labor market (as noted above) could also spur capital investment in more automation and robotics, particularly to replace labor (i.e., jobs) with automated equipment processing and manufacturing. Continued focus on new technology and automation will allow companies to increase productivity without spending resources on competing for employees in a difficult job market.

For investors, Arrow thinks the sustainable energy and technology, automation and robotics, and physical infrastructure are primed sectors for growth in 2022 and 2023.

 Are stocks “expensive”?

Global markets demonstrated resilience and profitability in 2021, even as the threats from inflation and the covid pandemic generated much uncertainty. Earnings of S&P 500 companies was massive in 2021, fueling the high returns. Year over year change in the S&P 500 tends to track earnings growth well, and in that sense the performance in 2021 was in line with the earnings. This is the primary reason why investors should be wary of people claiming for imminent market crashes due to a “bubble”. Corporate earnings are still strong and that is a primary predictor of how the market will grow.

Many valuation metrics (such a forward Price to Earnings ratio, P/E, or Price to Book, P/B, Market Cap/GDP, among others) still suggest the valuation of the market is near an all-time high. This means that most stocks are “expensive” in a general sense, so investors should understand that growth in 2022 might not be able to reach levels from 2021. The good news is there is still considerable room for growth when you consider the valuation of stocks from a lens that considers both bond yields (interest rates) and inflation. Stocks are not expensive when compared relative to bond prices, or after-inflation bond yields. For example, the Russel 3000 index is near its all-time high Price to Earnings Ratio (P/E), but near the bottom of its historical ratio when compared to after-inflation bond yields.

Conclusion (Arrow market outlook for 2022)

Consumer spending and inflation patterns, labor market issues, and the relative valuation of stock to bonds suggest there is still growth potential for the global equity market in 2022. Growth is expected from pent-up demand, strong personal and corporate cash positions, and capital expenditure in innovative sectors. However, headwinds such as weak labor force participation, continued supply chain shocks, and expected corporate earnings suggest the growth will not be as strong as 2021.