Transcript: 2022 Outlook for middle market companies
[2022 CIBC Commercial Outlook]
Dave Donabedian, CFA, Chief Investment Officer CIBC Private Wealth, U.S.]
[Looking back: 2021]
Hello, I'm Dave Donabedian, Chief Investment Officer of CIBC Private Wealth Management in the U.S.. Today we're glad to be sharing our 2022 Outlook for commercial clients. To kick things off, I'll present our analysis of expectations for the economy and financial markets. Then to help put some of these themes into a real-world context, we have 2 leaders from our commercial lines of business to share their insights.
With us today are Bob Frentzel, Managing director and co-head of CIBC U.S. Commercial Banking, and Karen Case, Managing Director and President of US commercial real estate.
[Themes for 2022]
[ A look back: Market scorecard 2021: A year full of surprises and profits. Total returns as of December 31, 2021. Stocks: Trailing 1 year: US 28.7%, Developed International 11.5%, Emerging Markets -2.5%. Trailing 3-year: US 26.1, Developed International 13.5%, Emerging Markets 10.9%. Trailing 5-year: US 18.5%, Developed International: 9.5% Emerging Markets 9.9%. Bonds: Trailing 1-year: Long-Term Treasuries -4.6%, Intermediate GovtCorp -1.4%, Corporate High-Yield 5.3%. Trailing 3-year: Long-Term Treasuries 8.8%, Intermediate GovtCorp: 3.9%, Corporate High-Yield 8.8%. Trailing 5-year: Long-Term Treasuries 6.5%, Intermediate GovtCorp: 2.9%, Corporate High-Yield: 6.3%. Commodities: Trailing 1-year: Bloomberg Commodity Index: 27.1%, Oil (Brent): 65.6%, Gold: -4.3%. Trailing 3-year: Bloomberg Commodity Index: 9.9%, Oil (Brent): 15.4%, Gold 11.0%. Trailing 5-year Bloomberg Commodity Index: 3.7%, Oil (Brent) 8.4%, Gold: 8.4%]
Now let's get started. We'll begin with a quick look back at financial market results from last year. If you scan down the trailing one your column here, you'll see that 2021 was a great year for returns in stocks, and most commodities, but not a good year for bonds. The S and P 500 was up almost 29% last year. You have the economy and corporate profits surging, and the government providing trillions in pandemic relief, as the Fed remained highly accommodative. It was the third year in a row of outsized gains in the stock market. In fact, the S and P compounded at a 26% annual rate over the last 3 years.
Looking ahead, let's start with the outlook for the economy. On the whole, we expect another year of above average growth in the U.S.. Now, you might wonder why we would expect that with this short-term disruption caused by the COVID Omicron surge. But the answer really lies with the consumer, and consumer spending is about two thirds of all the economic activity in our country.
[U.S. economy — growth: Outlook mixed, but tailwinds win out. The U.S. consumer is flush. Wealth surges with stocks and housing. Household net worth and % of disposable incomes line graph with percentage of disposable income going up to a disposable income of 775 entering 2021. And the job market is strong. Unemployment percentage rate line graph from 2016-2021. Unemployment rate from 2016 to 2019 is steady at 3.9-4%, then spikes up to 12% in 2019 and then stabilizing back to around 5% entering into 2021.]
As you can see on the top of this slide, household wealth has soared to new heights, on the strength of higher stock prices, on higher home prices, and a couple of trillion in extra savings left over from those pandemic relief checks. And the job market is strong. During 2021, the unemployment rate fell from 6.7% in January all the way down to 3.9% in December. So, we're well on the way to a full employment economy. The housing market is strong, and business investment is picking up after a year of sharply improved profitability.
So, we don't think growth will be a problem this year. We think though that inflation will be. You can see on this slide, the red line shows that we finished the year with a consumer price index up right around 7%. That's a 40-year high for the inflation rate. Now, some of the factors causing this big increase should calm down as the year progresses. Namely, some of the supply chain disruptions and product shortages that have been experienced.
[US economy — inflation: Inflated expectations may become reality. After a quiet decade, Inflation has surged. Consumer Price Index, annual % change line graph, which includes: Headline CPI and Core CPI. From 2011-2019 headline CPI has dipped from 3.5% to a low of -0.5, then gradually trending upwards to a high of 7% in 2021. Core CPR from 2011-2020 is steady starting from 2% and spiking upwards to a high of around 5%. ]
But, we're more focused and concerned on some of the factors that can cause a more persistent pattern of rising prices. Things like hyper growth of the money supply, wages rising faster than productivity, and sharply rising costs for home purchases and rentals. So when we put all of these factors together, we do think that 7% headline rate of inflation will trend lower as the year progresses. But, we think the inflation is going to settle in at a rate well above the Fed's 2% target. Probably something more in the 3 to 4% range. And that's well above the Fed's own forecast. And that, of course, immediately raises the question about what they might do about stubbornly high rates of inflation.
[ Monetary policy. Hawlish-ish pivot. Fed projects very low policy rates into 2024. Line graph of: Fed funds target after inflation of Actual and Projected. Actual rate from 1971 starts from -1% and dips to a low of -5% where it peaks to a high of 10% in 1981, dipping down to -5% in 2021. Projected rates represented in red triangles in 2021 start from -5% upwards to 0 in 3 years. ]
And that leads to where we're going next. What we're looking at here is a slide of the federal funds rate. This is the Fed's key primary policy interest rate. And it's adjusted by the rate of inflation. So, it's the so-called real Fed funds rate. You can see from the gray line that it's in deeply negative territory. This is indicative of the Fed's current highly stimulative policy. But then, using the Fed's own forecast, you can see from the red triangle is that the real Fed funds rate is expected to go up, but it's still only expected to get up to zero 3 years from now.
Now, I hope this forecast is right, because it would be very bullish for financial assets. But I fear that it's somewhat unrealistic. And because of stubbornly high inflation, the Fed is likely to need to raise rates faster and further than what is currently expected. So, we first see 3 25-basis point rate hikes this year at least. It'll probably end up being more than that. And as a result, should come with it a rise of bond yields across the maturity spectrum.
So now, what about the stock market?
[US equities. Corporate earnings. Corporate earnings outlook: Growth, but much slower than last year. S and P 500 earnings growth: After the boom comes normalization. A line graph includes year-over year earnings growth from 2021 and 2022, quarter by quarter alongside a calculated year for each.]
Well, let's focus on the 2 most important factors, corporate profits, and valuation. Here we're taking a look at the earnings story. We're looking at earnings growth rates for each of the quarters last year, and projections for 2022. And it's kind of a bad news, good news story. The bad news is that profits this year are likely to grow much more slowly than last year. If you look at the 2 red bars here, profits boomed 46% last year, unsustainable, but are expected to grow just around 9% this year. Now the good news is, profits are in fact going to grow, not decline. In the context of history, 9% earnings growth is actually pretty respectable.
[US equities – Multiple contraction. S and P 500 TTM P/E with long-term average in a line graph. ]
Well, now let's look at the valuation scoring. This chart shows the historical price to earnings, or P/E ratio for the U.S. stock market. This is really the most common measure of valuing stocks. And you'll note that the most recent reading is above the historic average valuation. And it should be. Because we're in a period of historically low interest rates. But, you'll also note that that P/E ratio has come down a lot in recent months, and that's simply because earnings grew faster than stock prices.
So, we put all these factors together, and conclude that this level of stock market valuation is full. Not necessarily overpriced, but certainly not cheap either. And it may be that if bond yields rise, as we expect, this PE multiple will need to contract a bit. That's another reason why even though we think the bull market will survive 2022, there is somewhat of a lid on how high the stock market can go this year.
[ Investment themes:
Yet another COVID surge may disrupt the economy in the early weeks of 2022. However, we expect solid growth for the year as a whole.
Inflation, running at a 40-year high, will be the key economic issues for the year. Our expectation is that the Federal Reserve (Fed) will need to act more aggressively to arrest stubbornly high price pressures.
Bond yield will probably adjust higher by 0.5% - 0.75% over the course of the year, triggered by inflationary pressures and cessation of the Fed’s bond purchase program.
The equity bull market is expected to continue in 2022, paced by economic and profit growth. However, both those factors should see slower advances compared to last year. Absolute valuation are stretched, and our interest rate forecast suggests slight multiple compression. We are left with a mid- to high-single-digit forecast for S&P 500 total returns.
The Fed’s policy pivot, fluctuating COVID trends, and multiple tense geopolitical issues suggest higher stock market volatility this year. Remember: it is not uncommon to have at least one 10% correction in the equity market annually.]
So, before we bring in Karen and Bob, let me quickly recap our key investment themes for the year. First, the Omicron variant surge is getting the economy off to a slower start here in the early weeks of 2022. But we expect solid growth for the year as a whole. We think the inflation outlook is more challenging. Inflation will be persistently high, and the Fed will probably need to act more aggressively to counteract it. And as a result of that, bond yields are likely to move higher, a trend we've already seen emerge here in weeks.
Because the economy's likely to grow, and earnings are likely to grow, we think the equity bull market will continue. But a starting point of relatively full valuations and rising interest rate trend will moderate the upside potential. So, we see the S and P 500 rising mid to high single digits this year. That's still better than the expected returns from bonds and cash, but a much smaller gain than what has been enjoyed in recent years.
Dave Donabedian (07:12):
And, it's likely to come with more volatility. Last year we only had one 5% drawdown in the market. Now let's get in on the ground perspective from Karen Case and Bob Frentzel. [transition to video feed - Bob Frentzel and Karen Case] So, I emphasize the risks around high inflation. And in a survey of the CIBC conducted with the business journals, the rising cost of doing business was cited as the top concern from business executives. So Karen, let's start with you. How does this apply to commercial real estate? What are driving costs across your industry today, and as we look ahead to the rest of the year?
Karen Case (07:46):
Well, thank you for your insightful presentation earlier, Dave. Appreciate your thoughts on that. I think the better question might be, what isn't driving costs up today? Wages, materials, and especially the availability of both of those are the challenges seen in all businesses. Overall construction costs are coming in 15% higher than budgeted even six months ago. And then the question is, one, whether rents will move up at the same pace, and two, is that the end of the increase?
Karen Case (08:22):
Because throwing money at it doesn't necessarily solve the problem when it comes to availability. And in fact, in some cases we're seeing national home builders, for example, are slowing their sales efforts intentionally, because of the uncertainty of delivery dates, and the uncertainty of cost at the end of the day is certainly a factor.
Karen Case (08:44):
For example, I don't want to, as a home builder, sell you a house for $100 a year out when I don't know, one, if I can deliver that house in a year from now, and two, what my cost will be. If I charge you $100 but my cost ultimately is $120, probably not a good idea. Multifamily developers are ordering appliances 18 months in advance, hoping they'll show up in time, instead of a more typical four months. And then having to deal with off-site storage, and insurance costs, and so forth. There's so much uncertainty.
Karen Case (09:23):
Another place is precast for industrial projects, now has to be ordered a year out. That's insane and unprecedented. The positive is the vast liquidity in the marketplace, which I'll talk about in a few minutes.
Dave Donabedian (09:37):
All right, thank you. So Bob, what are you seeing across the general commercial and industrial landscape?
Bob Frentzel (09:42):
Well, consistent with what Karen's saying, there's a tremendous amount of liquidity in the market. And this is one of the first times where we've seen demand really outstrip the supply. As a result of that, our clients, be at the auto, commodity, labor, transportation have been able to pass along those costs. And what they can't make up in volume, they're making up in price. So, our clients are at least able to pass along those costs at this point in time.
Bob Frentzel (10:11):
The question is, how long is that going to last? We're working with clients and doing various modeling as far as how to help them build their inventories. Obviously, they're looking at their supply chain and trying to figure out how they can source or on-shore more readily, so they can get the products to market. But again, those most people feel will subside relative to supply chain and some of the products. We talk about the auto chips and things like that.
Bob Frentzel (10:39):
Labor's the other element. And certainly those costs are more permanent. And at this point, it's not about what it's going to cost to get somebody, it's just getting somebody in the seat. And so, that's where we'll see that will abate a little bit on the labor cost. But it's certainly rippling through all of our industry sectors that we work with.
Dave Donabedian (11:03):
Absolutely. So, Bob, you touched on workforce challenges there briefly. Let's go a little further there. Workforce challenges have dominated the headlines. In our CIBC business journal surveys, participants voiced a lot of concern around being able to find and keep good employees. The so-called labor shortage. So Bob, can you shed some light on the headwinds that employers are facing with regard to talent acquisition and development?
Bob Frentzel (11:32):
Sure. We're certainly, the health and safety of our employees is paramount. And the COVID variant has created some challenges as far as where people will work. But as things hopefully will moderate, the two areas that our clients are seeing the biggest challenges is on low skill levels seasonal workers. And then the skilled workers with five to 10 years of experience.
Bob Frentzel (11:59):
So, if we look at the low scale, we've had some clients actually this holiday selling season, where they could not get their products out the door. It was a combination of they typically will hire seasonal workers that come in, they'll help with the packaging, and scanning, and getting them out the door, and they just couldn't find the normal unskilled labor that they normally would have. And so, it really impacted their ability to hit the targets that they had, and the orders that they had. There's not a lot that you can do to automate in those seasonal situations. So, that's going to be an interesting dynamic to see where those workers will come from. And again, that'll go back to some of the things in Washington relative to immigration, and other ways that we might be able to fill those positions.
Bob Frentzel (12:52):
Then you go to the skilled workers, and certainly Karen and I in the professional services space and banking, we've got a number of very talented individuals. And much like banking, you've got the consulting firms, the law firms, and others where they've got a lot of work, but they don't have enough people to do it. And in their business it's, again, very dependent upon individuals. And so, you're seeing an uptick in people moving, because there's a significant increase and a potential increase in salary increases. The question is the sustainability of that.
Dave Donabedian (13:31):
Absolutely. So Karen, what about on the commercial real estate side? What does the labor issue look like, and how might it unfold in the months ahead?
Karen Case (13:41):
Well, I would say the challenges within commercial real estate are not unlike any of the other industries that Bob talked about, both for skilled and unskilled labor. Whether it be property managers, or workers in stores and restaurants, it's a combination of people being ill, and not able to come into work. If the same as in the hospitals, and the challenges that the airlines are dealing with.
Karen Case (14:11):
And then, it's the issue around flexibility and remote work for those of us in office situations. The flexibility that we are having to offer to workers to attract them, to retain them. And yet, I know many of us, probably those of a certain age, worry that with everybody working from home on a consistent basis, that we will lose a lot of that corporate culture. And if you don't have the culture, people aren't as likely to stay.
Karen Case (14:45):
The last thing on the construction side, one of the things that I'm hearing from some of our clients, is that in that sector, really the talent is aging out. That there aren't as many people that want to get into the construction business. The workforce there is aging, and there is a shortage from that perspective too. Having nothing to do with COVID, or the wage increases that we're seeing across the board.
Dave Donabedian (15:19):
Thank you, Karen. So, we've identified a wide range of challenges, labor shortages, cost pressures, COVID. And yet we see from our survey and others that business confidence actually remains pretty high. So, Karen, let's start with you. Why are real estate professionals and institutional investors positive of what lies ahead for their business, and the overall economy?
Karen Case (15:45):
Well, I think that the institutional investors are out there fast and furious, both domestic and international investors looking for a safe haven. And that's not new. They've been coming to the US for real estate investment for decades. But there is, I think, some concern about the equity markets, and the continued robust activity that we'll see there. Always real estate investors have liked the tangibility of real estate.
Karen Case (16:20):
And what we're seeing though is that all of the equity, and there are billions of dollars coming into real estate right now, is going into really to asset classes, industrial and multi family. And when you've got all that money chasing only to asset classes, because obviously there's uncertainty around the office sector, the hotel sector, and retail, that prices are being driven up. And we laugh among ourselves whether price and value are the same thing. But, the yields that the investors are willing to take despite an increasing interest rate environment, yields are 4%, 3%, or even less in some cases. But, we feel comfortable with continuing to lend in this space because of the significant equity that's being put in.
Karen Case (17:25):
But what we're seeing, the last thing I'll mention is, what we're seeing is that the runoff, the loan repayments that are coming fast and furious because of these property sales that are taking place at such high dollars, are really overtaking how we used to get repaid. I would say historically 75% of our loans would get repaid through refinancing. But today, it's through sales. And so, if your house is worth $100, and somebody comes and offers you $200, you may not have been a seller, all of a sudden you're a seller. And we'll see what happens over the long term as yield expectations go up, and what the property performance looks like as a result of the high prices paid.
Dave Donabedian (18:15):
So Bob, we've identified that business owners and executives across industries are pretty optimistic about the outlook. What do you think is driving that, and what types of opportunities are companies seeing for 2022?
Bob Frentzel (18:28):
Well, I think a lot of the information you shared in your opening remarks relative to liquidity and the market, the strength of the consumer, and the amount of liquidity that's out in the marketplace, with the savings that accumulate... And not only in the consumer side, it's also with our corporations and our companies. The PPP loans that were brought in in 2020 were very helpful to fortify the balance sheet.
Bob Frentzel (18:55):
And now they're looking to deploy. Now it's looking at investing in equipment, investing in real estate, and then trying to figure out how to take advantage of this significant demand. This is a very unique situation for clients, where they were typically concerned about how could they ultimately supply, or meet the... get more sales? Well, now they have more sales than they know what to do with. They just can't supply.
Bob Frentzel (19:25):
So, they're trying to figure out strategic ways, or creative ways to meet the supply, changing some of their supply chain. And ultimately, because that demand is so strong, they're very optimistic about being able to find ways to meet that demand. It's giving us opportunities to have conversation with clients about increasing lines of credit, or for them to build their inventories to have ample inventory levels, as well as invest in equipment, as we talk about the labor challenges.
Bob Frentzel (19:56):
Unfortunately, one of the consequences of that is, a lot of individuals or corporations are going to be looking to reduce the labor component of their business. And that's investing in different ways that they can streamline the manufacturing process. But in general, it's all about liquidity, and the ability to sort of take advantage of the demand that's out there.
Dave Donabedian (20:18):
Karen, Bob, thanks for a great conversation. I think there were a lot of takeaways and insights for business leaders. Karen, what can someone do to get in touch with us if they'd like to discuss any of these topics further?
Bob Frentzel (20:30):
Well as always, Dave, clients can reach out to their RM at any time. And if you're not yet a client and don't have a relationship with CIBC, you're welcome to reach out to Bob or to me directly. And we'll provide our contact information at the end of this video.
Dave Donabedian (20:47):
Great. Thanks, Karen. Thanks, Bob. And thanks to all of you for your time and attention. [slide: Dave Donabedian, Bob Frentzel and Karen Case CIBC titles and contact information] [slide: disclosure text] [slide: CIBC logo] [end]