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The IBR is a publication of the Indiana Business Research Center at IU's Kelley School of Business.

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Financial markets in 2022: Aggregate demand and inflation

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Associate Clinical Professor of Financial Management, Kelley School of Business, Indianapolis

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James W. & Virginia E. Cozad Chair in Finance, Kelley School of Business, Bloomington

The stock market is at historic highs. As of this writing, the value of all common stock is a little over $48 trillion. That is 32% above where it was just one year ago. Certainly some of this stunning return is due to recovery from the damage done by the pandemic, but not all of it. Over the past five years, we have seen a compound growth rate of 15.9%. This is one of the strongest five-year periods in U.S. financial history. We have had two very different political administrations, a politically divided country, a pandemic, trade wars with many countries and growing inflation, not to mention supply chain bottlenecks, riots and increasing crime—and the stock market keeps adding value. Just five years ago, the market was worth $23 trillion.

What accounts for this creation of wealth and will it continue? We humbly admit that we did not forecast this high of a rate for wealth creation and are not exactly sure why we were wrong. Nevertheless, we have opinions! We believe the following factors were important.

First, the Federal Reserve has kept the money supply growing with a low interest rate policy. The federal funds rate has been kept low and the Federal Reserve has kept up purchases of bonds for its balance sheet. Will this continue? The national forecast says that the Fed will cut back purchases of bonds, so we don’t expect to be in a low interest rate environment for the near future.

Second, aggregate demand has shifted—especially since the end of the pandemic. The ports may be bottled up, but they are processing a record level of cargo. The creation of weath in the stock market and the lack of spending during the pandemic contributed to increased demand for everything. American firms are responding to this demand. The demand for products has put the entire supply chain under pressure and parts are having difficulty responding. Of course, this has resulted in inflation. It is an ongoing debate how much of this inflation is permanent, but recent figures indicate the level of inflation has overshot estimates and sentiment is moving toward inflation being more than just transitory.

Third, federal fiscal policy has added to the aggregate demand. The federal government has run record (or near-record) deficits during both Republican and Democratic administrations. The Biden administration is trying to dramatically increase the size of the federal government and will add significantly to aggregate demand if successful.

Fourth, the American labor force is simply too small to do the job of delivering goods and services that Americans demand. Companies are having difficulty keeping up with demand, with the result that prices are rising as are profits. Shareholders are benefiting at least in the short run. But labor costs are rising fast and this factor could easily be a negative for 2022.

Fifth, trade wars have subsided. While China and the U.S. are at odds politically, the U.S. remains China’s top trading partner with 17.5% of China’s trade in 2020. The U.S. traded more with China than all of the European Union combined. A recent agreeement between the U.S. and China out of the COP26 summit regarding combating climate change may be a first step to further normalization of relations.

With this as a background, we turn to fundamentals, which we hope will give us a sharper forecast for 2022. Stock prices are determined by the future streams of cash flows—driven by earnings—and the valuation of these cash flows (which is the present value using a set of discount rates that reflect risk). Typically, this is summarized by earnings forecasts and a valuation ratio—the price-earnings (P/E) ratio. We call these “fundamentals.”

Positive fundamentals

The positive fundamental factors for stock returns in 2022 include:

  • Earnings growth: Analysts are forecasting earnings will increase 8.6% in 2022 for the S&P 500. Industrials are predicted to grow 36%. Financials is expected to be the worst sector at -8.8% growth (that’s correct, a negative growth). Sectors with above-average expected earnings are energy, consumer discretion and information technology.

  • Revenue growth: Revenues for the S&P 500 are expected to rise 6.9% in 2022. The best sector is consumer discretion with 13.5% growth.

  • Earnings and revenue for 2021: The end of the year is six weeks away at the time of this writing, so much of this is not a forecast, but the S&P 500 earnings are projected to be up 44.6% with revenue up 15.5%. We suspect the supply chain problems will bring down earnings somewhat.

  • Analyst surprises: At this point, 81% of companies have reported earnings higher than analysts have forecast. Analysts tend to be optimistic and this is a strong indicator of earnings strength.

  • IPOs: There have been 250 IPOs that raised $89 billion as of July. In fact, CNBC reported that “for the year-to-date period, the market is already at a record level in terms of funds raised, and it is expected to surpass the full-year all-time high of $97 billion raised in 2000 amid the dot-com boom, according to Renaissance Capital.”1

  • Volatility levels: The VIX index measures volatility in the market by looking at S&P 500 options prices. It was flat and low in 2021 and has come down considerably from the very high numbers in 2020.

Negative fundamentals

The negative fundamental factors for stock returns in 2022 include:

  • Valuation:
    • The current P/E ratio is high. The S&P 500’s current P/E ratio is 29.3, which is significantly above its median value of 14.9.

    • The forward 12-month P/E ratio, defined as current price of the S&P 500 over forecast earnings, is 21.4. This is above the five-year average of 18.4 and the 10-year average of 16.5.

    • The Schiller cyclically adjusted P/E ratio (CAPE) is currently at 39.6, which is one of its highest measurements since the 19th century. The latter part of the 1999 internet bubble had a Shiller P/E ratio of about 43, but that is the only time this ratio has been higher. The average for over 100 years has been about 16. In 2022, we expect most companies to continue to produce positive earnings over the coming year, which should help bring the Schiller P/E ratio measure for the market back into line, but there is little room for valuation to grow.

  • Inflation is surging: Led by energy prices, inflation is currently running about 6%. The key question is how much is permanent? A permanent or volatile inflation rate can choke off aggregate demand and make corporate investment risky.

  • U.S. energy policy: Energy prices are up 30% over last year. Heating oil is expected to rise 43%. The continuing effort by the White House to reduce energy production is adding to inflation and threatens to increase the problems of supply.

  • Pressure on interest rates:
    • The projected budget deficit for 2021 by the Congressional Budget Office is $2.3 trillion. This means that federal expenditures were $2.3 trillion more than federal revenue. This is about $900 billion less than 2020, but triple the deficit in 2019. The deficit is about 10.3% of gross domestic product (GDP), well above the 50-year average of 3.3% and the largest deficit since 1945 (excluding the 14.9% in 2020).

    • The deficit has caused the largest expansion of federal debt since World War II. The total debt (held by the public) is $23 trillion, which is 102% of GDP. This ratio was 76% in 2018. Increasing the average interest rate by 1% will trigger an additional $140 billion in federal spending.

    • The U.S. still faces a huge funding deficit in Social Security and Medicare payments. The present value shortfall is about $62 trillion. This is equivalent to $206,000 per person or $825,000 per U.S. household. These problems are not insurmountable, but they do require common sense and bipartisan leadership—something that appears to be in short supply in Washington, D.C.

    • Since Labor Day, the financial market prediction for Fed action has shifted from no change in rates expected in 2022 to a 70% chance of two hikes by the December 2022 meeting.


Looking forward to 2022, the positives probably outweigh the negatives for the market. Earnings are strong and likely to stay strong, but valuation is high. Inflation is likely to increase interest rates, which will cut valuation ratios.

In this environment, we expect that the return to equities will be positive but again below the 7% average return over the past 50 years, and there is a significant chance of a negative return. Value stocks are likely to outperform growth stocks given the high P/E ratios. Also, we think that the 10-year U.S. Treasury rate is likely to be well above the current 1.6%.


  1. Yun Li, “IPOs are on track for a record year as companies cash in on sky-high stock prices,” CNBC, July 26, 2021, www.cnbc.com/2021/07/26/ipos-are-on-track-for-a-record-year-as-companies-cash-in-on-sky-high-stock-prices.html