Base-case forecast: Solid, though more muted, gains ahead

Well, the New Year is upon us and we did get that Santa rally to 4,800 we were calling for in my last memo just three weeks ago-and for the reasons suggested then, that some of the near-term risks the market was fretting over would likely fade. In particular, omicron so far has proven to be highly contagious but not highly deadly. And with Joe Manchin's steadfast stand against Build Back Better (BBB), markets could breathe a sigh of relief that yet another big round of more spending, taxes and debt might be avoided after all. So, with Santa in the rearview mirror, it's probably a good time to reassess where we are heading and the potential pitfalls along the way.

As indicated in that 6 piece, we are holding steadfast to our year-end 2022 target of 5,300 on the 500. At the same time, we are initiating a 2023 year-end target of 5,500. Let's look into the building blocks of these targets, but first an important caveat: As accurate as last year's 4,800 target proved to be, at Federated Hermes our market targets are offered to suggest direction and proportionality, not precise accuracy. So, while in each of the last two years our targets of 3,100 and 4,800 implied big double-digit gains ahead, our targets for this year and next suggest harder slogging, with somewhere between low double-digit and high single-digit returns likely over the next 24 months.

The building blocks of our forecast

• Economic growth Owners of companies, i.e., stock investors, are by extension partial owners of the economy in which those companies participate. On this level, the outlook looks solid. Absent the sharp, artificially induced drop in the economy in 2020 due to the Covid lockdowns, and the artificially sharp bounce back that followed, economic growth has been trending along at a healthy pace since 2016, driven in part by the Trump supply side reforms on taxes and regulation, along with the positive impact of the digitization revolution that the Covid pandemic accelerated. We expect this nominal pace to remain above the long-term average through 2023, running between 6% and 9%, though decelerating quarter by quarter as the sharp post-Covid economic bounce recedes.
• Earnings growth Companies live off nominal , and with nominal in the mid-to-high single digits, earnings growth through 2023 seems likely to exceed consensus forecasts. We expect productivity levels to remain high and growing, given the trends toward increased automation and digitization coming out of the Covid pandemic. And we expect these "multiplier effects" to increasingly be felt among older economy companies, who've been making big investments the last several years in just these productivity-enhancing activities. At Federated Hermes, we anticipate overall earnings of the 500 companies to reach $290 by 2024, implying annual growth over the next three years of about 11% on average. Importantly, our base case is that the economy remains on course and is not derailed by a policy error out of Washington. Though we do think the risks of a policy error are rising (see accompanying sidebar), we still think the highest probability outcome is now "steady as she goes."
• Inflation/Fed policy While the story for the last 20 years has been one of ever-declining inflation, even deflation at times, we are not of the consensus view that sooner or later we are moving back to that world. Something has shifted post-Covid, for good in our view. Across the global economy, a reasonable share of the global workforce seems to have moved on for a variety of reasons, including retirement and shifts back to single wage-earner families. And the global demographics of ever-expanding populations in the emerging world have now begun to reverse, so the global supply of ever-cheaper labor is drying up. In addition, "just in time" global inventory management has been undone by Covid, and the lesson learned from the supply chain disruptions of the last two years has been clear: even though more costly, it's time to bring the supply chains home. So, another big driver of deflation has now dropped away. Digitization and automation remain the last strong leg in the deflationary stool, but even here, chip shortages are mounting and Moore's Law (that the speed and capability of computers doubles every two years) itself seems under duress. So, we see inflation staying stubbornly strong ahead, especially now that labor is in tight supply and workers are in a stronger position to demand increased wages. With the Fed until recently considering the shifts noted above as "transitory," the inflation genie has escaped its bottle. In our base case, we have the Fed playing catch-up, with three to four hikes this year and four or five next year, pushing short yields closer to 2% and perhaps the 10-year Treasury yield to 2.5% this year and 3% next year. This "soft landing" scenario may at times feel bumpy for markets, but we think it's manageable. Indeed, inflation numbers running a little hot, in the 3% range, can be good for nominal earnings and are partly behind our above-consensus call for earnings over the next three years. Importantly, we don't think the economy is nearly fragile enough to be undone by the rate hikes, off of zero, that we are expecting. Indeed, the components of the economic engine that are most sensitive to rising rates-inventory financing and consumer spending-seem fairly immune at the moment to hikes. Inventories are far from bloated; in fact, they're almost non-existent. Likewise, consumer debt has yet to rise substantially.
• Valuations The fourth building block to our forecast is valuations. With the Fed pinning short rates at zero and pressuring longer bond yields ever lower, stock market valuations have quite fairly expanded. As we begin 2022, the S&P is trading at 21x the consensus earnings numbers for 2022. This is a high level historically but, in our view, a fair one given where the 10-year yield is trading. But if we are right, and the yield creeps higher as inflation remains stubbornly elevated, we expect the stock market's valuation to compress correspondingly, perhaps to the 19x level. Nineteen times forward earnings would still be historically high, but not out of line in a soft landing scenario with solid economic growth and inflation stabilizing in the 3% range. This multiple, combined with our $290 earnings forecast for 2024, gives us our 5,500 target on the by the end of 2023.

So, when you stack it all up, our base case for strong though decelerating nominal growth and with it, earnings growth, along with compressing valuations, suggest attractive, though no longer spectacular, stock returns ahead. And a lot of that could be front loaded, with 10-11% returns this year followed by another 4-5% in 2023.

Where to put your money in this environment

At Federated Hermes, we are holding strong to our 500 basis-point overweight to stocks versus bonds, which represents 50% of maximum bullishness in our most referenced asset allocation model. This is a bit less enthusiastic perhaps than the heady days of 2020 and early 2021 when our recommended overweight to stocks reached 60% of max but is still quite positive. Indeed, though we anticipate more muted equity gains ahead, bonds could struggle to even produce a positive outcome as rates rise. And our average forecasted equity returns for the next two years of 7.5% is certainly enough to outpace the negative effect of inflation, especially if it diminishes toward our 3% target.

But here's the real punch line. With earnings growth strong but valuations compressing, the real action is likely to be under the surface of the market. There, investors accustomed to simply plowing their money into the market index could be surprised perhaps to find a large number of stocks that could post very strong double-digit returns. Indeed, the market indexes are bifurcated, with a small number of mega-cap, high-growth companies sporting spectacular valuations, and a large number of "old economy" companies trading at low double-digits or even single digits. This gap probably makes sense given what's in the rearview mirror. With rates low and the digitization revolution accelerated by the pandemic, high-growth companies with very strong fundamentals fairly deserved the rich valuations investors awarded them. And older economy companies-think energy stocks, banks, industrials, materials-deserved low valuations. With the nominal economy and their earnings growing slowly, and even declining sharply during the lockdowns, these stocks were left out of the party. Deservedly.

We think the environment ahead, however, is likely to shift this dynamic. Growth companies' valuations are the ones most likely to be driven downward in reaction to rising bond yields, as they were the ones that rose most strongly when yields were low. And the old economy companies are not only sporting low valuations, they also are seeing accelerated nominal earnings growth as the cyclical tilt of their businesses supports sales and margin expansion. And many of them, such as banks and financials, actually benefit from rising yields.

So, cheer up and enjoy the new year. Though overall stock market returns ahead are unlikely to match the terrific numbers we've experienced in 2020 and 2021, they're still likely to be positive and better than inflation. And under the surface, there are many stocks, particularly in the value indexes, that should do a lot better than that.