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December 2021

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Fed to cap gains but not wreck market

Over the very long term, earnings are what determine the level of the US stock market. But on a year-to-year basis, the policies of the US Federal Reserve are the most important factor determining returns. That has been well illustrated over recent years. In 2018, earnings growth was strong, but the Fed was raising rates and shrinking its balance sheet. The S&P 500 fell slightly that year. In 2020, the first pandemic year, earnings shrank, but thanks to very accommodative monetary policies from the Fed, the S&P 500 had a good year.

We are expecting a below average performance from the S&P 500 in 2022, because policymakers at the Fed are going to be gradually reducing monetary stimulus. We have set a year-end target for the S&P 500 of 4,850, up 3% from present levels. We are not predicting US stocks to finish in the red, because the Fed’s plans for tightening are modest. There is general agreement that the Fed needs to tighten policy in order to fight inflation. The question is therefore not whether they are going to hike interest rates, but rather how much will policymakers raise rates.

Former Treasury Secretary Lawrence Summers recently said the Fed should hike interest rates four times in 2022 in order to combat inflation. Four rate hikes would likely result in a bear market for stocks on Wall Street. However, Fed officials are not presently showing any inclination for aggressive inflation fighting.