Welcome to 2022. In this edition: 1) Company Announcements, 2) Timely and useful information, as we have presented in Januarys past, 3) A deep dive into our own 2021 capital markets forecasts and our views on 2022.
In addition to her role as Chief Operating Officer, effective January 1st, Ms. Jennifer A. LaDuca is now PIM’s Chief Compliance Officer. In the near future we will be sharing with you the details of certain operations/ compliance initiatives that are nearing completion.
New Year Information and Reminders
Changes to RMD
Beginning at age 72 (previously, age 70 ½), the IRS requires retirement account owners to take distributions of a certain minimum amount from their retirement accounts and pay the commensurate federal income tax. This is generally referred to as Required Minimum Distribution (RMD). RMD does not apply to Roth IRA accounts.
RMD is calculated using the value of your retirement account on the last day of the previous year, divided by the number of years the IRS assumes you have remaining to live. These divisors are found on the IRS life expectancy tables. For the first time since 2002, the IRS has updated the life expectancy tables, which now reflect an assumption that we’ll all live just a bit longer. The result is that this year and going forward RMD will be lower than it would have been without the change.
For example, under the previous life expectancy tables, a 73-year-old person with a December 31, 2021 IRA account value of $500,000 would have had 2022 RMD of $20,242.92, based upon a divisor of 24.7. Under the new, 2022 life expectancy divisor of 26.5, the same person will have an RMD of $18,867.92.
Of course, if you are subject to RMD, you may set your distribution amount to any level you wish, so long as you at least satisfy the RMD. For those whose income needs are met entirely by taking only the minimum required, this will be welcome news, as it could result in lower taxable income.
2022 Retirement Plan Contribution Limits
The maximum employee contribution to a 401(k) or 403(b) for 2022 has increased from $19,500 to $20,500. The maximum that may be contributed by the employee and employer combined is $61,000, up $3,000 over 2021. The additional “catch-up” contribution that can be made by those age 50 and over remains the same, $6,500.
The annual contribution limit to IRA accounts remains unchanged, at $6,000. The additional “catch-up” contribution for those age 50 and older also remains unchanged, at $1,000. There have been slight increases to the income phase-out ranges that determine eligibility to make tax-deductible traditional IRA contributions. The deductibility of IRA contributions depends, in-part, upon participation in an employer retirement plan. If married, deductibility considers whether one, both or neither spouse participates in such a plan.
The income phase-out ranges for Roth IRA contributions for 2022 have increased. For single persons, the phase-out range is $129,000-$144,000. Below $129k, a full contribution is allowed. After $144k no contribution is allowed. Within the boundaries, a partial contribution is allowed. For married filing jointly, the phase-out range is $204,000 to $214,000.
If you wish to make an IRA contribution for 2021 (Traditional or Roth), you may still do so, as long as your contribution is deposited or post-marked by April 15th, 2022.
The Year Before, and the Year Ahead
It is customary for investment firms to make grand predictions about the market at the beginning of a new year. It is far less common for prognosticators to analyze their own forecasts after the fact, unless they got everything right, which is great for marketing. We prefer to share the good, the bad and everything in between.
Our 2021 forecast was that the S&P 500 would struggle to stay above 4300. This was correct for nearly ¾ of the year. Then, positive earnings beyond our assumptions (83% of firms exceeded earnings expectations), elevated the market to 4740 at year-end. Additional unanticipated factors helped to move the S&P higher than we expected.
- Retail investors bought more equities (stocks), in dollar terms, in 2021 than in the previous 19 years combined, according to Bank of America Merrill Lynch.
- US Consumers spent much more than anticipated. It was thought that the household savings rate would remain elevated (~10%), as is typical after an economic shock. That rate today is 6.9%, lower than the pre-pandemic savings rate of 7.8%. A lower consumer savings rate means more spending, promoting a faster growing economy and increased corporate profits.
- Mega-cap technology firms continued to beat expectations. Just five companies account for 50% of S&P 500 returns since April, while the average stock in the S&P 500 was down 11% from its 2021 peak. This is truly remarkable.
Our bond market forecast proved to be more accurate. We thought that the benchmark 10-year Treasury would finish the year with a yield between 1.5% and 1.6%. It closed out the year with a yield of 1.51%, after starting the year at 0.93% and making a brief burst to 1.78% in the first quarter. Our premise was based on continued Federal Reserve involvement in the Treasury market along with increased demand from foreign investors, domestic banks, and pension funds. For institutional investors, US Treasuries are still attractive relative to alternatives.
In 2021 we increased our allocation to TIAA Real Estate and increased our exposure to REIT (Real Estate Investment Trusts) in our Schwab allocations. Both decisions were driven by an expectation that the sector would rebound as the economy reopened and interest rates remained low. This was handsomely rewarded as TIAA Real Estate appreciated by 17% and Real Estate sector of the S&P was up by 41%.
We believed that inflation would spike as the economy emerged from lockdowns, then fall back towards the ~2% pre-pandemic trend. Inflation certainly did spike, and COVID variants kept it elevated. COVID variants made a challenging inflation situation worse as consumers adjusted their behavior to public health concerns and continued to spend money on goods rather than services. Consumer spending on goods during the pandemic is nothing short of amazing. From the end of the financial crisis in 2009 to the end of 2019, consumer goods spending increased by 48% (seasonally adjusted annual rate). From April of 2020 to December of 2021 consumer goods spending increased by 46%. The amount of growth in consumer goods spending that took a decade to build was nearly repeated in less than two years. This record demand, combined with labor shortages and supply bottlenecks, pushed inflation to multi-decade highs.
Ironically, Fed Chairman Powell has cast aside the term “transitory” and thereby made inflation transitory. Since Powell’s last testimony before congress in November, when he signaled unease with current price levels, inflation expectations (5-year break-evens) have fallen from 3.2% to 2.6%. The Fed’s intent to quickly end stimulus efforts and raise rates in 2022 seems to have convinced the market that inflation will moderate. Wage growth, a key contributor to inflation, appears to be concentrated in low-wage/low-skill positions and not the overall workforce. Supply chain bottlenecks are easing for both the manufacture and shipping of goods according to many measures. Omicron will no doubt prevent these pressures from easing quickly, especially as China holds strong to its zero tolerance COVID policy.
In summary, our forecast for US large company stocks was correct for most of the year, then was overtaken on the upside by positive earnings. Our forecast for the fixed income market was correct. Our assumptions about inflation were off the mark. Or, rather, we had the timing wrong. Our view that inflation is transitory is generally correct. Our assumptions about the duration of inflation were not.
The S&P 500 hit 70 new all-time highs in 2021, despite record valuations and a myriad of challenges and uncertainty. We thought now would be a good time to step back and view the markets through the lens of the longer-term business cycle. We turn to Howard Marks, CFA, the famous investor, and partner of Oaktree Capital Management, for insight. In early 2008, he had this to say about the bull market:
“For a bullish phase to hold sway, the environment has to be characterized by greed, optimism, exuberance, confidence, credulity, daring, risk tolerance and aggressiveness. But these traits will not govern the market forever. Eventually they will give way to fear, pessimism, prudence, skepticism, risk aversion and reticence... Busts are the products of booms, and I’m convinced it’s usually more correct to attribute a bust to the excesses of the proceeding boom than to the specific event that sets off the correction (“Now what?” January 2008).
To lessen the economic impact of public health policies needed to fight the pandemic, global policy makers, via stimulus programs, unleased the confidence, optimism and exuberance referenced in the quote above. The first quarter of 2021 saw significant interest in risky investment strategies that tend to symbolize exuberance over reason. Here are a few examples of investment themes that peaked in March:
- “MEME” trading, or retail traders banning together to manipulate the market.
- SPACs, blank-check companies designed to bring private firms public, flourished on the most dubious of premises.
- New technology firms with little or no profits specializing in artificial intelligence, robotics, and next generation internet.
In early 2021, investors were busy making the “this time is different” arguments that rarely hold water for long. Many of these speculative areas are now down approximately 50% or more from their peaks.
We’ve discussed at length the importance of stimulus measures to the health of the economy and capital markets through the worst of the pandemic period. The economic stimulus party is winding down. The Fed is expected to end their bond buying program in March and raise short-term interest rates three times in 2022. Hopes for further stimulus from the Federal Government in the form of the Build Back Better Act appear to be dead. Mid-term elections, if history is a guide, should produce a divided government unwilling to pass major legislation. The aforementioned will likely produce an economic environment in which capital markets are forced to stand on their own.
When building an outlook for capital markets, a good place to start is the level of growth expected in the overall economy. The final figures are not yet available, but the Federal Reserve expects 5.5% GDP growth in 2021 followed by deceleration to 4% in 2022. This forecast assumed the Build Back Better Act would pass, which seems unlikely today. Moody’s Analytics, a firm with a strong track record making forecasts, sees 5.2% in 2021 followed by 2.2% this year. We can safely assume that economic growth will slow on a year over year basis, as you only get to re-open the economy once. Further, we know that the Fed will at least try to raise short-term interest rates to quell any remaining inflationary fears. This should produce an environment where borrowing costs increase while the economy slows. That combination is a rare occurrence that is typically only seen at the end of a business cycle.
There is still fuel left in the economic tank thanks to pandemic policy largess. Corporate America is sitting on a record pile of cash ($3 trillion, according to some measures). This cash will find its way to investors through stock buybacks, which are expected to top a record $1 trillion in 2022, as well as increased dividends. Earnings growth for the S&P 500 should normalize to 5-10% according to participant companies’ own estimates. Mid-single digit growth is still a strong number, though not near the 38% year over year experienced in the 3rd quarter of ‘21. Consumers still hold record levels of wealth. Total US household wealth has increased by $26 trillion since the end of 2019 according to Federal Reserve data, though most of this growth is held by the wealthiest 1% of households.
Our models suggest high single-digit S&P 500 growth. Corporate stock buy backs alone should account for 3-5% growth and earnings for another 5-10%, if the multiple remains constant (i.e. the price to earnings ratio, currently 24). The biggest surprise of 2021 was the investment activity of retail investors, so this group deserves additional attention. Housing is the largest asset for American consumers and may dictate retail investor risk appetite.
The housing market has historically been an excellent “window” into the state of the economy, pun intended. There is a correlation between home appreciation and retail investor participation in the market. Home prices have been on an absolute tear since April of 2020. Housing affordability measures (median income to median prices) are at an all-time low, even taking out the housing bubble years. Yet, home buyers have been able to hold their noses and buy up to this point, aided by low mortgage costs and optimism.
As the Federal Reserve backs away from stimulus and raises rates the cost of home loans should modestly increase. For the average home buyer this should matter a great deal. Wages have not kept pace with home price appreciation, but low borrowing costs have served to make up the difference. If this variable is reversed home price appreciation should moderate. This is enough reason for mild caution, but nothing more at this point. It appears that the tailwind of retail investor participation in the markets has eased, but not yet reversed. It is unlikely that small investors will be able to match the equity buying spree of 2021, but we do not anticipate that this group will be net sellers of equities in the coming year.
In this environment, the best equity investment strategy is to seek out companies with the ability to grow faster than a slowing economy, with strong balance sheets to negate the effects of higher borrowing costs. This is referred to generally as “quality growth”. The most speculative areas of the market should be avoided. Although valuations are one of the worse timing signals in markets, foreign equities have more appreciation potential than domestic, with growth-oriented European and Japanese equities standing out.
Certain areas of the S&P 500 have gone through a period of “greed, optimism, exuberance, confidence, credulity, daring, risk tolerance and aggressiveness”. Thus far, the correction in these areas has been contained and offset by the success of large-cap technology firms, which carry a far higher weighting in the index. Positive market sentiment will need to persist, and the Federal Reserve will need to be cautious with their interest rate plans for the market to maintain its upward trajectory. We don’t believe that now is the time for the fear, pessimism, prudence, skepticism, and risk aversion referenced in the Marks quote, but we are getting closer to the end of the business cycle. We can’t predict these variables with certainty. We can only prepare and remain vigilant.
We enter 2022 with modest optimism for investment markets and cautious optimism that the Omicron variant will be less destructive and manageable, if not containable. We stand ready to serve PIM’s valued clients with investment management, retirement planning, and general financial counsel, as we have been for well over 30 years.
If there is anything you need from us, please do not hesitate to reach out. In the meantime, we will be in touch with each of you to schedule a call, video, or in-person meeting, as appropriate.
Our very best wishes for a happy, peaceful, and prosperous 2022.