A Look Ahead: 2022 and Beyond

 

March 3, 2022

Bill Carter, CFP®, CLU®, ChFC®
Chairman and CEO, Carter Financial Management

We are only two months into 2022 but there is already so much to discuss about our economy and national/world events that could affect your finances. In this white paper, I will hit on the key things I think will be relevant for you and your money this year, and in years to come. In preparation for writing this paper, I have poured through stacks and stacks of reading material, which makes for a messy home office. Key themes for my comments will include the potential financial impact of legislation, our domestic economy, world events, taxes, and the ever-present COVID-19. We will discuss Federal Reserve policies and potential interest rate increases, addressing whether inflation is permanent or transitory. We will also discuss China, Russia, climate change, cryptocurrency, and a market outlook for 2022. There is so much more I could cover, but unfortunately, even in a white paper, it is simply impossible to talk about every topic of interest.

I believe Fed actions will have more impact on our economy than any other single driver, except possibly additional legislation that may be passed by Congress.

Inflation

For the last two years, the most frequently discussed subject has been COVID-19. With the newest Omicron variant and its continued mutations, COVID-19 will continue to be a widely discussed topic for the foreseeable future. But in recent months, another hot topic has emerged – inflation, which may soon overshadow discussions about COVID-19.

In 2021, the fourth-quarter inflation rate was 6.9%, resulting in an annual inflation rate of 6.7%. In January of 2022, the inflation rate had risen to 7.5%. That is the highest rate since February 1982. The big question around inflation is whether it is transitory, as we initially thought, or whether we are looking at a new, lasting, higher level of inflation. I do not believe this inflation is transitory, but I do think it can be moderated by the Fed. It is unknown how much pain the economy will have to endure to bring inflation under control.

For the last 10 years, inflation has averaged 2.4%. The Federal Reserve’s long-term target for inflation has been 2%, which was expected to produce a healthy and stable economy. When COVID-19 initially struck and the economy went into a panic, the Fed lowered the federal funds rate to near zero and indicated a willingness to accept a higher rate of inflation to prevent another recession. They have also adopted a policy in which the rate of inflation can now exceed 2%. The Fed will accept a higher inflation rate because it is believed to make up for the shortfalls we experienced in recent years, but I do not think last year’s inflation rate of 6.7% or the January 2022 rate of 7.5% is what the Fed had in mind.

To better understand inflation, let us briefly consider the law of supply and demand. This was my first subject of study in economics at Texas A&M. In the simplest terms, the law of supply and demand is a theory that explains the interaction between the sellers of a resource and the buyers for that resource. The theory defines the relationship between the price of a given product and the willingness of people to either buy or sell it. It is the main model of price determination used in economic theory. The two laws interact to determine the actual market price and volume of goods we trade on the open market. If demand exceeds supply, prices will increase. As prices increase, sellers supply more, and consumers demand less. When supply builds, prices decrease, and demand grows. This is simplistic; more factors can impact inflation, but understanding this basic concept can be very helpful when considering the complexity of our economy.

My first experience with supply and demand was when I was eleven years old. We lived twelve miles outside of Decatur, and I rode the bus to school. Most of the kids in the bus line were, like us, relatively poor. But there was one family that was poorer than any of us. The family was extremely nice and the kids well-behaved; they were just extremely poor and always wore hand-me-down clothing. One day, they got on the bus wearing brand new clothes. They looked great. This was a substantial change to what I usually saw, and I was curious how they could afford those clothes, especially in the middle of the semester. Most of us got new clothes at the beginning of a new school year. Finally, my curiosity exceeded my manners and I approached one of the boys and said, “I am really impressed with the new clothes. You guys look great. I was just wondering how you were able to buy those during the middle of the semester?” He lit up and said, “Dad bought a bunch of pigs and we just sold them, so we were all treated with new clothes.” Well, that got me excited. As soon as I got home, I ran to the dairy barn and said “Dad, Dad, we need to buy pigs”. Dad was amused with my excitement and asked why we should buy pigs. I explained about my friend and his family. Dad said “Bill, if we had sold pigs this year, we would have made money. But since so much money was made this year, everyone will plan to buy pigs to sell next year. With this increased supply of pigs in the marketplace, prices will decrease, and people may lose money.” And that is exactly what happened. Just as Dad predicted, many people bought pigs to put on the market the following year. And as Dad also predicted, because of the increased supply, prices would fall, resulting in losses for many. That was my first real “life lesson” in economics and the theory of supply and demand.

An example of supply and demand that is all too familiar to Texans is the price of petroleum. Low energy prices coupled with oil and gas regulation over the last few years caused producers to slow production. This has resulted in a leveling, or decrease, in supply. This will be exacerbated as COVID-19 mandates are lifted and people resume life at a prior pace, resulting in a scenario where demand continues to exceed the supply of oil and gas. With supply staying level or decreasing and demand increasing, prices naturally rise. The invasion of Ukraine is already having a negative effect as supply fears push oil prices higher. We will continue to face increasing energy prices for some time. And it is not just the prices at the pump that increase; when petroleum prices increase over an extended period, many products are affected. Keep in mind how many products contain petroleum hydrocarbons – the list goes beyond gasoline and distillates, such as diesel fuel, heating oil, and jet fuel. Petrochemical feedstocks, waxes, lubricating oils, asphalt, aspirin, CDs and DVDs, chewing gum, clothing, dentures, cosmetics, rugs, and shampoo are all impacted by petroleum pricing; in fact, there are over 6000 items that use raw petroleum. You can see how rising oil prices will have an impact on inflation.

Housing is another area impacted by increasing prices. This is another example of supply and demand at work, as we have seen substantial population growth in the DFW market, coupled with fewer homeowners being willing to list their homes during pandemic times. Following the Texas recession in the late 1980s, Dallas and state leaders decided they needed to diversify the economy. Their efforts have been wildly successful. Businesses have been attracted to DFW, and employees of those businesses all need places to live. Consequently, we have demand exceeding supply. I suspect many of you received the same letter I did, asking whether I want to sell my house. I get 2-3 calls per day making the same inquiry. If home builders continue to build at a faster pace, eventually there will be a surplus of houses and prices will level out, maybe even decline – but not anytime soon. The increase in home prices reached an all-time national high of 18.8% in 2021.

A rising wage rate is the inflation driver that causes me the greatest concern. I don’t disagree with wage increases, but these increases are not transitory increases. Once an employee’s wage is raised, it is permanent. With the current shortage of workers that so many businesses are facing, salaries will likely continue to increase. While housing or energy costs ebb and flow as supply and demand change, permanent salary increases can have a much bigger impact on long-term inflation. They also drive additional price increases as business owners offset their new, higher labor costs.

We cannot discuss the U.S. economy without considering potential Fed actions that will receive much press, not just during the coming month, but likely all year. I believe Fed actions will have more impact on our economy than any other single driver, except possibly additional legislation that may be passed by Congress.

As the Federal Reserve begins to raise interest rates in 2022, you will hear questions you have not heard for quite a while, such as “Will the Fed be able to achieve a soft landing in the economy?” The Federal Reserve’s challenge is to raise rates in a manner that would create a “soft landing,” which simply means the Fed can slow the rate of inflation without doing too much damage to the economy. A “hard landing” will occur if the Fed’s actions are too aggressive, slowing growth and triggering a recession. Some economists believe the Fed has waited too long and their delayed actions will be “too little, too late.” They believe the inflation genie is already out of the bottle. If the anticipated rate increases do not slow the economy and inflation continues at a high rate, the Fed will likely take much more aggressive actions. Obviously, current Federal Reserve policies are driven by a desire to slow the economy enough to ease inflation pressures without creating a recession.

Some of you will remember that in the late 1970s inflation had become a major economic problem. In August 1979, Paul Voelker was confirmed as Chairman of the Federal Reserve. Under Voelker’s leadership, the Fed made a major change to focus on money supply and allow interest rates to float. This was different from the previous Fed model. Voelker said in a news conference that the Fed would no longer dictate the level of long-term interest rates in the U.S. Instead, the market would dictate interest rate levels. Only by allowing free movement of money would we expect to see interest rates at levels necessary to decrease inflationary growth. The biggest question at the time was whether Voelker would have the courage to remain steady and maintain this policy; he knew it would be painful. The prime rate soared to 21.5%; long-term treasury bonds jumped to 15.25%. For those of you who were around at that time, you may remember money market funds paying 18%. The Fed was called to pursue a policy that superseded political concerns and that over the long-term would dampen the inflationary flames. It worked, but it was difficult. I remember it well. I do not see this scenario repeating itself.

The Federal Reserve’s actions and the subsequent success of their policies could have a major impact on corporate earnings and profitability. No one can predict the results of future Fed policies, but one thing I am sure of is that the Fed will raise interest rates until inflation abates. This is a difficult balance to achieve.

International Affairs

Russia is capturing recent headlines. The following is an excerpt that provides excellent insight into Russian President Putin’s current strategy.

“Putin has now taken this approach one step further. He is threatening a far more comprehensive invasion of Ukraine than the annexation of Crimea and the intervention in the Donbas that Russia carried out in 2014, an invasion that would undermine the current order and potentially reassert Russia’s preeminence in what he insists is its “rightful” place on the European continent and in world affairs. He sees this as a good time to act. In his view, the United States is weak, divided, and less able to pursue a coherent foreign policy. His decades in office have made him more cynical about the United States’ staying power. Putin is now dealing with his fifth U.S. President, and he has come to see Washington as an unreliable interlocutor. The new German government is still finding its political feet, Europe overall is focused on its domestic challenges, and the tight energy market gives Russia more leverage over the continent. The Kremlin believes that it can rely on Beijing’s support, just as China supported Russia after the West tried to isolate it in 2014. The Russian president’s behavior is being driven by an interlocking set of foreign policy principles that suggest Moscow will be disruptive in the years to come. Call it “the Putin Doctrine.” The core element of this doctrine is getting the West to treat Russia as if it were the Soviet Union, a power to be respected and feared, with special rights in its neighborhood and a voice in every serious international matter. The doctrine holds that only a few states should have this kind of authority, along with complete sovereignty, and that others must bow to their wishes. It entails defending incumbent authoritarian regimes and undermining democracies. And the doctrine is tied together by Putin’s overarching aim: reversing the consequences of the Soviet collapse, splitting the transatlantic alliance, and renegotiating the geographic settlement that ended the Cold War.” -Angela Stent, “The Putin Doctrine – A Move on Ukraine Has Always Been Part of the Plan”, Foreign Affairs, 1/27/22

As I write this, Russia has 170,000 troops surrounding three different borders and has begun an initial invasion of Ukraine. This invasion of a peaceful, independent nation is tragic. When Putin went to China to seek their economic support, knowing Russia would be facing sanctions, it was obvious at that point they did plan to invade. As this paper is approved by compliance and goes to print, Ukrainians are fighting a very courageous war against the Russian military. Ukrainian President Volodymyr Zelenskyy’s comment “I need ammunition, not a ride” will go down in the history books. I do not see this ending well for the people of Ukraine.

At this stage, I do not see this invasion having a long-term impact on the U.S. economy or U.S. equity markets. We will continue to comment on the situation in the weeks and months to come.

While all of this could have significant political implications, I do not anticipate it will have strong economic implications; the United States is not going to war over Ukraine. The one caveat is a potential disruption of the Russian oil supply. The potential harm to the European economy is real, along with potential damage to the U.S. economy. The following quote explains the possible impact of a Russian disruption on the European oil supply.

“European search efforts began in the fall when the global economic rebound from the COVID-19 pandemic sent gas and electricity prices skyrocketing. Efforts intensified in recent weeks, as Moscow’s escalation with Kyiv left European governments contemplating a once-unthinkable scenario of a conflict interrupting the flows from Russia, which provides about 40% of the 27-country bloc’s natural gas. Few officials expect that to happen. But the scenario is motivating a quest for fallback supplies to cover an economy that cannot otherwise function.” -Drew Hinshaw, Laurence Norman and Bojan Pancevski, “Europe Steps Up Efforts To Secure its Gas Supply”, The Wall Street Journal, 1/27/22

Keep in mind, Russia needs to sell oil at least as much as Europe needs to buy it.

I would also like to mention my concerns about China and the impact China could have on the world economy. As I have said many times in my writings, China is not our friend. A government can do many things when they do not have to answer to an electorate every two to four years. It’s been rumored that China may help with Russian negotiations, but I remain very skeptical. Future letters will address more on China.

Cryptocurrency

Outside of the domestic economy and worldwide political affairs, cryptocurrency is another area that has attracted investor interest. When cryptocurrency first came on the scene, many thought it was simply a fad. It has, however, caught on quickly, reaching just over $68,000 PER BITCOIN before retreating to half of that value just recently. Raymond James and many other broker/dealers are taking a very conservative approach regarding investing in crypto. It is still an unregulated market. Cryptocurrency is not just Bitcoin, there are thousands of coins and many exchanges on which to trade those coins. Think of multiple New York Stock Exchanges all trading many of the same coins, as well as their proprietary coins. It is truly the wild west. If you would like to learn about the origins of bitcoin, I would refer you to a book, ‘Digital Gold’ by Nathaniel Popper. The name of the book explains its premise. Even though people think of cryptocurrency as currency, it is much less stable. If you were a landlord, you would likely not take bitcoin from a tenant. A $1,000 rent payment today could turn into $500 tomorrow, it is just too volatile. It behaves more like a ‘hard asset,’ however silly that sounds, and it is being used more as an investment than cash. I think you will see substantial growth in this area over the next few years. To give a full explanation of cryptocurrency is beyond the scope of this whitepaper, but it is something you should pay attention to. You may be asking the question “How can I invest in cryptocurrency?” It is getting easier to buy actual coins through apps on your phone, which is the way that most people buy and sell, but beware, the amount of information required is very much like opening an account at a brokerage firm. Presently, there are a few ways to invest through traditional markets, such as exchange-traded funds and mutual funds. You can also get indirect exposure through crypto futures contracts; however, this is not regulated currently. It is extremely volatile and not for the weak of heart. It is certainly not for someone whose primary objective is principal conservation. Regarding cryptocurrency, we would say “buyer beware.”

Climate

Another item to put on your watchlist for 2022 is climate. Climate change is and will continue to be intensely covered in the press. Important to note are the floods in Germany and wildfires in the western U.S. In 2021, all of us in Texas experienced one of the harshest February winters we have seen, followed by one of the warmest winters on record the following December. Growing up on a dairy farm in Decatur, Texas, I was taught to be observant about the weather. Dad taught me to pay attention to rain clouds, severe directional storms, and extreme weather events. I have been a believer in climate change for many years and this is simply from observation. I am much less sure of what is causing the weather to change. Is it hydrocarbon emissions or is it a natural phase we are experiencing in the weather cycle? I have read multiple articles on both sides of this argument and both present compelling reasoning and substantial evidence. If I were to guess, I would say it was a combination of both. Until now weather has not had a great impact on the global economy, although it’s had a substantial impact on certain local economies here and in select markets overseas. If the current climate trends continue, the weather will play a greater role in economic and market forecasts.

Taxes and Legislative Action

I have saved your favorite subject for last – TAXES. During the fall of 2021 and into January 2022, we heard much about expected significant increases in both corporate and personal taxes for households earning over $400K. In addition, substantial changes in estate taxes were also being proposed. In 2022, an individual can leave $12.06 million to heirs and pay no federal estate or gift tax, while a married couple can shield $24.12 million. The exemptions that were proposed were much lower. These tax increases were being pushed because the amount of money that was going to be spent in the $3.5 trillion “Build Back Better” bill had to come from somewhere. The sentiment was to tax the wealthy, with “wealthy” defined as households earning over $400k/year. The first $1.2 trillion infrastructure bill passed, but the larger $3.5 trillion “Build Back Better” bill did not pass the Senate. During negotiations, the price was lowered to approximately $2.2 trillion. The bill passed the House in November of 2021 but failed to pass in the Senate because Senator Joe Manchin believed the bill was still too large and lacked sufficient accountability. Senator Manchin and Senator Kyrsten Sinema both declared they would not vote for the proposed bill, essentially killing it. There has been much speculation that the Democrats would break the bill down into smaller sections for reintroduction in 2022. I still think this may be a possibility, but with inflation increasing, it is going to be difficult to get spending bills passed by Congress. I think we will see some tax increases, primarily on personal income tax rates, but not to the extent of last fall’s speculation.

I was a strong supporter of the $1.2 Trillion infrastructure bill that did pass. If you travel on the interstates in Texas or even in your local communities, you know our infrastructure needs improvement. Our domestic airports can also benefit from modernization. Many U.S. airports are in poor condition compared to some of the newer, more modernized international airports. Some of the infrastructure money is geared toward upgrading our airports, which will be economically beneficial. As this bill creates jobs, a further tightened labor pool is unlikely to help improve inflation any time soon.

The positive and the negative outlooks will be engaged in a tug of war for the foreseeable future. My market outlook for 2022 is positive despite all the unknowns.

Market Outlook

The positive and the negative outlooks will be engaged in a tug of war for the foreseeable future. A worldwide pandemic, a shortage of workers, growing inflation, clogged global supply chains, high energy prices, and problems with both China and Russia lead to a lot of potential negatives for the 2022 outlook. On the positive side, the economy is growing strongly as evidenced by GDP numbers increasing 5.7% in 2021. It appears the negative effect of the pandemic should ease from the peak soon. We will continue to see strong consumer spending as people return to work, travel, eat out at restaurants and continue to spend their accumulated cash on consumer goods and services. The Federal Reserve will attempt to rein in inflation, but it will be tricky to produce a “soft landing.”

Equity and bond markets will most likely be a rollercoaster ride for 2022. You have experienced these vacillations in the markets before, and as I have said over the years, corrections are normal and healthy for equity markets. This year may be a little different; in addition to the ups and downs, there will be a few jerks along the way which will be unpredictable and uncomfortable. Supply chain problems should continue to ease throughout 2022, and demand for goods and services should continue to expand and drive economic growth. In addition, Congress typically increases spending in election years, which provides a positive tailwind for both the economy and the markets. We will continue to follow this closely.

My market outlook for 2022 is positive despite all the unknowns relayed above. However, my forecasts, like everyone else’s, are nothing more than an educated guess. That is truer this year than in previous years. Last year, large cap growth stocks and U.S. stocks were the strongest performers. I talked to many money managers who believe those sectors could once again lead the market, but they do not foresee double-digit returns. In fact, while they may expect positive returns, managers say they would be very happy with positive single digit returns. If you are looking for bargains, two sectors you may want to discuss with your planner are small cap stocks and emerging market stocks.

While I doubt the Fed will be able to fully achieve a “soft landing,” I think, overall, economic growth will remain strong enough to drive improved corporate earnings. I will caution that you may not see those returns until the fourth quarter or even as late as December 2022. As I have indicated, expect a rocky ride.

There are three important caveats to consider. First, another COVID-19 variant could emerge and be severe enough to cause a devasting impact on the global economy. Second, the Russian invasion of Ukraine could result in a long-term oil shortage for western Europe, with a ripple effect throughout the globe. And finally, if the Fed gets it wrong and raises interest rates too quickly or too high, it could severely hamper economic growth, which would have negative implications for equity markets.

So, my advice for the year is not to panic, as we may very well experience more volatility than we have in several years. These down-market conditions may provide an opportunity to add to existing portfolios or to open new positions. I think there will be several buying opportunities that may arise in 2022, so I suggest you discuss with your planner what investments may be best for your personal goals and objectives.

We have several educational events planned for 2022 which we hope will help you navigate these volatile times. We hope after three years that we will be able to have the Carter Investment Conference in-person this fall. We will also continue our monthly Carter Advantage Education Series webinars, and probably host some surprise speakers during the year. I will continue to write on the progress of events in my letters and hopefully, we will once again be able to see you during in-person meetings at our office.

As 2021 is now behind us, let me once again thank all of you for your continued support during what has certainly been one of the most difficult times our country has ever faced. Our country has suffered the effects of a serious pandemic, but we have endured.

It is going to be an interesting year ahead and we will continue sending out updates. As always, feel free to call your advisor with any questions.

All of us at Carter Financial hope you have a profitable, happy, and healthy 2022.

“One death is too many, but to put that number into a little bit of perspective, according to the World Health Organization, in the United States alone for the 2019-2020 season, there have been at least 15 million flu illnesses, 140,000 hospitalizations and 8,200 deaths. Imagine if everyone with an internet connection followed the spread of this annual flu, case by case, hour by hour.”

Brian S. Wesbury & Robert Stein, CFA; First Trust economists