Stock Market Tailwinds and Headwinds

Over the past few years the stock market, measured by the S&P 500, has been strong with returns of 31.45% in 2019, 18.4% in 2020, and over 25% so far in 2021. We believe that markets generally follow business fundamentals like economic health and corporate earnings growth. Despite the very large disruption of COVID-based restrictions, business and the markets have rebounded, and stocks have followed.

As we look forward, markets will face new tailwinds and headwinds which will influence business fundamentals and the direction of stocks.

Some of the potential tailwinds include:

  • Decelerating inflation
  • Above-average GDP growth
  • Supply constraints easing

Some of the potential headwinds include:

  • COVID and various variants
  • Federal Reserve becoming less accommodating
  • Inflation less transitory than expected

The rising rate of Inflation is a concern for consumers and investors alike. The reason is simple, inflation reduces purchasing power. The chart below shows the US annual inflation rates for the last 10 years with the most recent data from October coming in at 6.2%, which is the highest level in over a decade. 

The Federal Reserve monitors inflation and targets long-term inflation near 2%. If inflation persists above that level, they may adjust monetary policy to slow price growth, which can also slow the economy. With the high level of current inflation, the expectation is that the Federal Reserve will begin to adjust monetary policy to lower the inflation rate. This will likely include reducing or eliminating bond purchases (“tapering”) and ultimately raising short-term interest rates. This shift in Fed policy is seen as a headwind for the market. If inflation begins to normalize, and Fed policy doesn’t impact economic growth substantially, then this shift could continue to be healthy for the US market.

Another headwind in 2021 has been supply disruptions as a result of labor and materials constraints.  Recent labor market trends have continued to improve, however, the supply issues that kept a lid on growth may start to subside and turn into a tailwind in 2022.

As inflation decelerates and supply chain disruptions ease, it should lead to better economic activity. A good way to measure economic activity is the GDP growth rate. Annual GDP growth, which can be seen in the chart below, has snapped back with GDP expected to go from negative 3.5% in 2020 (red circle) to Goldman Sachs forecasted GDP growth of +5.6% in 2021 (light blue circle), which are levels not seen since the 1980s (green circle). The forecasted GDP for the next few years is expected to be above the 72-year average of 3.1%. If we continue to experience higher than average economic growth, businesses within the US economy should continue to thrive. This is the biggest potential tailwind for the markets over the next 3 to 5 years. 

The course of history has shown that there are always tailwinds and headwinds that can impact the future direction of the markets. Based on what we see now, our belief is that trends are still in place for markets to grind higher. Our expectation is inflation will ease but remain above the 2% level.  This likely causes the Federal Reserve to raise rates to control inflation, which historically is a headwind for bond performance. We will continue to evaluate the factors that can influence the tailwinds and headwinds and adjust to capture opportunities that present themselves.