The holidays are the perfect time to reflect on both the year that was and the year to come. Baird recently sat down with our market experts at Strategas and our own financial planning experts to talk inflation, tax changes and potential wealth planning opportunities for 2022.
Market Outlook Takeaways
Market Takeaway No. 1: Inflation on the Rise
When the discussion turns to “rising inflation,” many investors immediately recall the oil shortages, high unemployment and 13% inflation from the 1970s. Given how much stimulus there was during the pandemic, it’s no surprise that inflation is a major concern headed into 2022.
But it’s worth remembering there’s a large middle ground between transitory inflation and what we experienced in the 1970s. We’re somewhere in that middle: Inflation probably won’t be running at close to 7% a year from now like it is today, but it’s likely to be growing much faster than it was before COVID. Investors should expect 2022 inflation rates of 3–4%. There are portions of the labor and housing markets – plus some recent environmental regulations – that will make inflation a little stickier than the Fed had signaled a year ago.
Market Takeaway No. 2: The End of the Ride for Stocks?
After several years of fantastic returns, investors might need to manage their expectations for the stock market going forward. Rising inflation will likely result in tighter monetary policy, including (1) a tapering – if not outright elimination – of the Fed’s bond buying program, and (2) the potential for multiple interest rate hikes. There also will be some fiscal drag next year, which means fiscal and monetary policy, which both were tailwinds for a long time, will likely be headwinds in 2022.
While corporate profits are projected to be up about 9% next year, which would suggest a positive outlook for the S&P 500, equity returns during periods of high inflation tend to be modest. Given all these factors, expectations for single-digit returns for 2022 seem appropriate.
Market Takeaway No. 3: Expect Higher Long-Term Interest Rates
After so many years of low interest rates, it almost became a given that Treasury yields would remain below 2% forever. People forget there are reasons why Treasury yields have been so low – including years of the Fed buying them in bulk. With inflation running at close to 7% and the Fed expected to taper its purchases of Treasurys, it seems reasonable to assume that long-term interest rates will rise. If they rise a lot – say, in the neighborhood of 4% – that could be a big problem for the equity market as a whole. That outcome isn’t likely, but it’s one to keep an eye on.
Market Takeaway No. 4: Added Volatility Due to the Midterms
Historically, the stock market has been more volatile in midterm election years – like 2022 – than in other years for two main reasons:
- Presidents tend to lose seats in their midterm elections. Knowing this, administrations often pursue policies earlier in the year that motivate their base but tend to be anti-growth.
- Investors grapple with the possibility that a new political party could take over in Washington. A shift in power raises all sorts of questions related to the market. For example, if the Republicans take over the House or Senate after the 2022 midterms, will the debt ceiling still get raised in 2023? The potential for a midterm power shift in Congress often creates extra volatility in the equity market.
Note that volatility isn’t necessarily a bad thing: Every time the S&P 500 has declined in a midterm election year, stocks went up – and by an average of more than 31% – one year off the low. In fact, the S&P 500 has not declined in the 12 months following a midterm election since 1946.
Market Takeaway No. 5: Taxes on the Rise
With the White House, House of Representatives, and Senate all under Democratic control, President Biden and party leaders have their sights set on an ambitious fiscal policy agenda. Though the timing and mechanics of this agenda are in flux, given the current deficit concerns and budget rules, any spending increase would need to be offset with individual and corporate tax increases.
The good news for taxpayers is that many of the original tax proposals included in the Build Back Better Plan – higher income tax rates, higher capital gains, higher dividend tax rates, and a lower estate tax exemption – have all been removed. What Congress has done instead is devise a new set of tax increases on a smaller number of taxpayers that will raise the same amount of revenue. Should this framework be maintained as the legislation develops, single taxpayers making $5 million ($10 million for married taxpayers) would be faced with a 5% surtax – a concept we haven’t seen since 1968. If your income is $12.5 million ($25 million for married taxpayers), the surtax would rise to about 8%. Taxpayers in those income tax ranges would be looking at a 31.8% capital gains and dividend tax rate and an income tax rate of about 45%.
Similarly, increases on the corporate tax rate and taxes on multinational income have either been removed from Build Back Better or pushed out to 2023. Removing a corporate tax rate that would have gone into effect on January 1, 2022, added about a 4% earnings benefit to the S&P 500 in 2022. Now the agenda proposes a 15% minimum corporate tax that will only hit between 65 and 80 companies.
Planning Outlook Takeaways
Planning Takeaway No. 1: Follow – But Don’t Overreact
It might be fascinating to follow all the ideas that are being discussed in Washington, but when it comes to thinking about actual legislative proposals, focus on three core principles:
- Try to understand what’s being talked about
- Be ready to react in the event something does happen
- That said, don’t overreact or try to front-run what’s being discussed
If we learned anything this year, it’s that anything can change. A strategy that might seem perfect for a particular situation could end up being totally wrong if a specific law is or isn’t enacted. And even if a law is passed, it takes time to understand how the specifics might affect your circumstances.
Planning Takeaway No. 2: Stay Focused on What’s Important
There’s a lot more to tax planning than reading tea leaves about potential legislation. When done well, tax planning is about re-evaluating your personal circumstances and identifying opportunities that might benefit you.
The end of the year is an especially useful time to reflect on where you’ve been, what you’ve accomplished and where you’re going. As you start looking into 2022, consider the following:
- Are you maximizing your savings?
- Are you taking advantage of any contribution matches your employer might provide?
- Do you have any major expenses on the horizon, and how will you fund those?
- Have you or your family experienced any meaningful changes in 2021?
The birth of a grandchild, a divorce in the family, a career change – all of these are reasons to take a second look at your plans.
Planning Takeaway No. 3: Year-End To-Do’s
Along those same lines, sound financial planning requires annual maintenance. The end of one year and beginning of a new one is a great time to perform some checks that your plans are up-to-date:
- Review the balances on your flexible spending and health savings accounts.
- Review your beneficiary designations on insurance policies, life insurance contracts and retirement accounts.
- Fine-tune your budget over the next six to 12 months, especially if you have a big expense coming.
And to follow up on what our friends at Strategas discussed about inflation – make sure to review your current debt. Despite the prospect of rising interest rates, they are still relatively low, and you might have an opportunity to refinance any debt to more favorable terms.
Between holiday cards and time spent reconnecting with family, the end of the year is a great time to revisit your experiences from 2021. In that same spirit, take some time to consider how those experiences might influence your financial plans for next year and beyond.
The information reflected on this page are Baird expert opinions today and are subject to change. The information provided here has not taken into consideration the investment goals or needs of any specific investor and investors should not make any investment decisions based solely on this information. Past performance is not a guarantee of future results. All investments have some level of risk, and investors have different time horizons, goals and risk tolerances, so speak to your Baird Financial Advisor before taking action.