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Halves and Half Again — January 1, 2022

Written by Steve Orr, Chief Investment Officer, and Mark Frears, Investment Advisor

index wtd ytd 1-year 3-year 5-year index level
S&P 500 Index 1.25 27.57 29.98 27.23 18.01 4,696.56
Dow Jones Industrial Average 0.15 19.65 22.01 19.57 15.07 35,950.56
Russell 2000 Small Cap 4.14 14.53 13.72 21.63 11.86 2,241.29
NASDAQ Composite 3.13 22.27 23.05 36.43 24.73 15,653.37
MSCI Europe, Australasia & Far East -0.20 9.88 12.82 13.83 9.89 2,295.67
MSCI Emerging Markets -1.09 -4.24 -0.71 10.98 10.37 1,209.88
Barclays U.S. Aggregate Bond Index -0.22 -1.70 -1.50 4.89 3.68 2,356.07
Merrill Lynch Intermediate Municipal 0.03 0.92 0.99 4.31 3.84 320.04

As of market close December 23, 2021. Returns in percent.

Halves & Half Again

For 2022, think in halves of 2021. We are not asking you to use your division tables; just divide by 2 or multiply by 0.5. Half of 2021’s GDP growth, half the earnings growth, half the stock market’s gains. Half again higher interest rates and volatility. Risks to our outlook are virus variants and geopolitical events. 

2022 should see moderating growth ramping down from 2021’s stellar 5%-plus heights. Inflation rates should peak in the first half of the year and finish the year near 3%. The S&P 500’s earnings growth is the one area that should fall more than half, gaining “only” 8%. Revenue growth should show similar gains, above 7%, or half of 2021’s 16% rise. 

Interest rates are finally set to rise, thanks to central banks around the world turning down or off their pandemic support programs. Most, if not all, of the major central banks have announced that rate increases are under consideration. Short-term interest rate futures contracts project the Fed to raise rates at least twice this year and possibly a third time, at the very end of the year. Three-quarter point increases should place the Fed Funds overnight rate at 0.75%. Longer-term interest rates should finally respond to stabilizing economic growth, inflation, and monetary conditions. The ten-year Treasury should settle above 2%, and the thirty-year closer to 2.5%. 


The $20 trillion question in 2022 and beyond is how quickly the economy will slow to its pre-pandemic 2% pace. Unprecedented fiscal and monetary stimulus accelerated the 2020 recovery from virus shutdowns. 2021 saw the recovery turn to expansion with the GDP growing well above trend. Central banks and the virus may set the boundaries of possible growth this year and next. After inflation, our economy has averaged real growth of 2.5% since 1980 and 1.4% since 2009. Considering our aging demographics and high national debt, long-term trend projections still hover around 2% growth.  

Does the Fed raise rates too quickly this year and slow the economy into recession? Does the global economy reopen faster than expected as new virus strains fail to materialize? The Fed’s prior actions show that “taking away the punchbowl” of easy monetary conditions is a valid fear. Vaccines and herd immunity could finally slow COVID variants and allow the world to move toward some “new normal.” 

Last year’s 5%-plus growth should slow by half this year to near 3%. This would still be double the growth rate over the last decade and above trend. We would like to ramp back down to 1.4% trend growth as slowly as possible. A decade of above-trend growth would establish Millennials and Gen Z into productive careers and family formation. Central banks tightening financial conditions by raising interest rates too quickly and/or removing other market supports would ramp the economy down below trend and invite a recession. 


Since 1900 the average expansion cycle has lasted 48 months, and recent expansions have reached 100 months. Our memories of April 2020 are still very fresh, and it’s hard to believe that 20 months have passed. But at 20 months, this business expansion is just gathering its legs. Most expansions see the fastest rise in the early months as pent-up demand pushes growth. The very compressed recession of March to April 2020 led to a very fast rebound, peaking with the 12.2% annualized GDP growth in the second quarter of last year. We are now riding down the ramp to long-term trend growth. What will the ramp look like this year? 

We watch the Leading Economic Indicators index and housing starts for clues to the big picture. “On the ground” activity reports come from the ISM and Markit Purchasing Manager surveys. The Leading Index has risen every month since May of 2020 and November’s increase of 1.1% was the most in six months. Falling jobless claims are one of the largest contributors and are recently at record-setting lows. The ratio of coincident and lagging indicators and leading indicators suggest the economy is on strong footing heading into the new year. 

Housing starts are at their highest level since 2007 but still below their peak that year. Single-family starts and permits peaked last fall but remain near record levels. The NAHB/Wells Fargo index of next six months sales remains very high at 84, just below its November 2020 record of 89. Affordability is a serious issue, and housing could be impacted if interest rates move higher later in the year. 

Purchasing Manager indices cover a wide range of business health indicators. Our favorite is the “gap between new orders and inventories” indices. When the gap between the two is greater than 10, stocks tend to do well over the next 12 months. The gap sat at 16 in July and 4 in November. Orders remain strong, and despite supply chain problems, inventories are finally starting to catch up. 

Retail sales were beneficiary of all the stimulus thrown at the economy. Through November of last year sales were running nearly 20% above their pre-pandemic level. Yes, some of that rise is due to inflation, but the net gains are still impressive. Stimulus support is now fading, and we expect retail sales will drift lower this year. Much of the gain in sales was in goods, as a good portion of pandemic spending focused on home improvements and autos. If COVID fades, there will be another reopening of sorts in the services industries of travel and dining out. This will shift retail sales from big-ticket items to more everyday pre-pandemic patterns. Together, housing and retail sales account for about three-quarters of GDP. Both should grow at a slower pace this year now that much of the reopening demand has been satisfied. We expect GDP to average 3.5% this year. The first quarter should show a mild rebound from December’s omicron ouch, and if vaccines and the new therapeutic pills get the upper hand, a steady 2.5% should prevail by year-end. 

Retail sales and overall consumer spending depend on consumer sentiment and growing wallets. Consumer sentiment regarding the economy remains upbeat but below highs of early 2021. Worries over inflation and the administration’s policies are pulling down the readings. Wages have been growing above 4% over the last year. The greatest gains have come in hourly wages, a rare improvement for a group that has seen nearly zero wage gains in the last decade. The work force, unfortunately, is shrinking, thanks to Boomer retirements and folks taking a different view, or location, on their career. Falling supply of any good should raise its price and we had graphic examples of that economic law last autumn. Both contracts for Deere and Kellogg’s Frosted Flakes hourly workers largely followed the workers’ demands. Included in both for the first time in many years were cost-of-living increases tied to inflation. Higher wages are here to stay.


Wage increases will be necessary, as inflation is not going away anytime soon. Supply shock inflation from recessions is a feature of early-stage expansions. During recessions, factories slow or shut down production, and once demand turns, distributors are frantic to fill shelves. One could say 2020 to 2021 is a supply shock on steroids. Factories not only shut down, but so did the trucking lines, the ports, and, in many cases, the entire country. We acknowledge that we thought by Halloween, most supply chains would be unsnarled. And we thought we were bravely going many months further into 2021 than our peers. We are all wrong. How long will ports and deliveries be messed up? A lack of truck drivers and rail employees is likely to be a permanent feature, not a temporary bug. We do not have an answer, but are encouraged by the fact that many auto plants in the U.S. appear headed back to normal schedules. We are wary of the fact that west coast longshoremen are due for contract negotiations soon. 

What about after the supply shock? The rate of inflation should be peaking in the next few months. Base effects are the term used by economists when comparing a monthly change from the previous year’s same month. The first three months of 2021 had pre-pandemic level inflation rates of 1.6% and below. The effects of direct stimulus payments from the American Rescue Plan helped to push inflation to an average rate of 5.5% for the balance of the year. November’s year-over-year increase of 6.2% marked a 39-year high. Starting in the second quarter, the year-over-year base will rise and reduce the rate of change. Indeed, in some categories inflation could turn briefly negative, or deflationary. Auto prices would be an example. After a large (20% for some models) jump last year, price increases could flatten as supplies improve. For most other goods and services prices will not be returning to their pre-pandemic levels. The rate of inflation will slow starting in the middle of the year, finishing near 3%, or half its 2021 peak. 


Can stocks post double-digit returns for the fourth year in a row? We think it is possible, albeit at the low end of the double digits. At the time of this writing, the S&P 500 sits less than one-half of a percent below its all-time high and has tested that level three times. If omicron peaks and wanes in the next two months, the major indices should be able to push higher. The most recent closing high was on December 10th. Counting from March 2020, that would make the current Bull cycle only 627 days. This is less than half the median length of the 14 Bulls since 1945. 

The economy in the fourth quarter of 2021 started strong and faded a bit in December with the omicron wave. That may affect fourth-quarter earnings results, but improving activity thanks to immunity, boosters, and new therapeutics should make full-year estimates of 8% earnings growth attainable. Valuations appear full at 22 times the projected earnings, but we would remind readers that stripping out the mega-cap FAANG stocks reveals a reasonable 18x to 19x earnings for the remaining 500 stocks (the S&P 500 currently has 505 members). Only 12 stocks, the FAANG group and several energy names, accounted for 13% of the S&P 500’s 24% gain through late December. Exactly 100 S&P 500 members have negative returns for 2021 as of this writing, and the percentage of members above their 50-day moving average sits at a neutral 56%. The stage is set for a broader rally if risks remain low. 

Omicron, inflation, the Fed, and D.C. drama take their share of the blame in dampening investor sentiment over the last few weeks. Worries over the above pushed volatility higher and sentiment into Bearish territory. Sentiment has an impressive track record: it has reached these depressed levels only about one-quarter of time since 1994, and stocks averaged double-digit gains in the year that followed these readings. 

Sentiment also drives short-term volatility. When volatility readings on S&P 500 futures spike above 29, as they did in early December, markets tend to get bumpy several months later. We are not forecasters but know that humans and history tend to repeat themselves. Mid-term election years and the third year in a Bull tend to see drawdowns early and then again in the middle of the year. In these cases, the drawdowns are larger than recent experience, which should cause some interesting headlines. The third year of a Bull usually ends with positive returns for stocks. Over many years, stocks average at least 2 declines of 10% or greater during the year, and a return to this pattern would not surprise us. 

Geopolitical events can temporarily sidetrack markets, and there are plenty on the concern list as we start the year. Putin will keep the pressure on Ukraine for the foreseeable future. The Communist Party has its hands full in China, managing the deflating real estate bubble. At nearly one-third of the Emerging Markets index, China will continue to influence EM returns. Congress will take up some version of the Build Back Better bill later this month and tax law changes could be included. 

In summary, we expect stocks to stick to their historical pattern at this stage of the Bull: more volatile than the last two years, especially in the summer, but ultimately finishing higher. If the S&P 500’s earnings of $206 per share in 2021 can grow 8% in 2022, earnings would finish the year near $223. A P/E ratio of 23.3 times earnings generates an index level of 5,200 or a healthy 11% return. 

Interest Rates

It is a new world for interest rates in 2022. Central banks around the world have announced or are considering plans to raise rates. The Fed is no exception. This will have an impact on short-term borrowing rates for commercial clients, as well as sending the message that inflation is the Fed’s focus.
Longer-term interest rates, think 10 years and longer, are a function of inflation expectations, demand for credit and supply of debt. Supply chain disruptions are the current focus and are causing inflationary trends in the short term. Expectations are for normalization of distribution channels by 2H 2022, moderating increasing costs for goods and services.  

The two-year breakeven rate shows expectations for inflation over the next two years. Current levels show a rate of 3.1%, up from 2.0% in December 2020, and down from a high of 3.5% in mid-November. Inflation expected in 5 years is 2.20%, well below today’s level. Both indicators show a moderate increase in rates, but not runaway inflation.  

The Fed, as part of the process to reduce stimulus to the economy and focus on inflation, is pulling back from purchasing Treasury bonds and mortgage bonds. This will have a two-fold impact, reducing stimulus cash injected into the market and no longer being a significant buyer of debt securities. Looking at the supply-demand picture, who will step into buy these bonds? What impact will that have on rates?

The Fed, Bank of Japan, and European Central Bank have announced that they will only stop buying new bonds. All will still reinvest maturing bonds back into Treasuries and mortgages and will not sell their existing portfolio. 
That is an important point, as the private sector will be able to absorb this capacity. U.S. rates are still attractive from a global perspective, and with a strong economy plus a strong dollar, buyers will come. Based on projections, the private sector will have to purchase fewer bonds in the next three years than they did in the 2018 to 2020 period. Therefore, expect rates to only rise modestly, but the focus will be on the Fed and how well they are managing inflation.

Corporate bond spreads to Treasury bonds are still low across the spectrum. Five-year AA and BBB are both up only seven basis points year-over-year. In the face of higher wages and some supply constraints, the underlying strong economy is helping companies to maintain earnings. They also have more pricing power, given the current environment, and expect to pass that along to consumers. High yield borrowers also are seeing near record-low spreads, making borrowing relatively cheap, even as yields rise slightly. 

Mortgage bonds should start to see higher returns if the long end of the curve heads higher. Prepayments have slowed down in the past two months, as there is not as much advantage for the consumer to refinance. Good demand from financial institutions will absorb the additional capacity from reduced Fed purchases.

In the municipal space, there has been a lot of wait-and-see, as all eyes are on Washington D.C. Build Back Better stimulus would potentially supply funding to municipalities for infrastructure, with debt issued on the front end. The timing and scope of that legislation is less than clear. In addition, potential tax hikes could make municipal bonds more attractive to investors, but this also is uncertain.      


Since the early 2000s, institutional investors have viewed commodities as a hedge against rising inflation. We are not certain of this correlation. Generally, commodity price spikes in recovery/expansions are due to low inventories pitted against a rapid increase in demand. OPEC is back in the price-setting driver’s seat. The Biden administration has curbed leasing on federal lands, limiting domestic exploration. We expect OPEC will gradually increase production this year, monitoring global demand post-virus. 

Natural gas has joined crude oil as a geopolitical weapon in Europe. The Nord Stream 2 pipeline is nearly complete, but Europe may be having second thoughts. Last fall Putin did not send the usual pre-winter amounts to build inventories. Europe is starting the year very short on gas. A sharp cold spell could close factories and dampen the earnings outlook. 


2022 should see greater volatility and, after a bumpy road, positive returns. 2021 marked a third consecutive year for double-digit stock returns. A fourth year is not out of the norm. The long-term Bull cycles in the 1980s and 1990s included five straight double-digit years. But markets do not move in straight lines, and double-digit return years often have one or more double digit declines during the year. Consistent with economy and earnings growing above trend, the continuing Bull cycle argues for drawdowns to be a time to add to positions. 

Higher interest rates may give some bond holders pause, but increased income and more “elbow room” for the Fed to maneuver charts a better course than zero-bound rates. Commodities are our main concern for growth. Any uptick in virus strains will curb mobility, cutting earnings. Tough weather this quarter can strain already low natural gas inventories and in turn strain pocketbooks. 

We enter the year with green indicators for the economy, reasonable valuations for most stocks, and favorably low sentiment. Our hope is that you and yours will stay healthy and patient through the market’s ups and downs. 


Steve Orr is the Executive Vice President and Chief Investment Officer for Texas Capital Bank Private Wealth Advisors. He holds a Bachelor of Arts in Economics from The University of Texas at Austin, a Master of Business Administration in Finance from Texas State University, and a Juris Doctor in Securities from St. Mary's University School of Law. Follow him on Twitter here. Mark Frears is an Investment Advisor at Texas Capital Bank Private Wealth Advisors. He holds a Bachelor of Science from The University of Washington, and an MBA from University of Texas - Dallas.

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