Recap: The U.S. economy has continued to grow and add jobs at a strong pace, making steady progress towards the Federal Reserve's goal of maximum employment. But supply constraints—both bottlenecks and labor shortages—have had a larger and more persistent effect on the economy than anticipated. Due to the collision between those supply constraints and strong demand, inflation pressures have become more widespread and may last longer into 2022 than first thought. The economic recovery should continue but the risk that supply constraints may limit job gains and economic growth has increased, and inflation could complicate the Federal Reserve’s management of monetary policy in 2022.
The Delta variant and supply chain problems threw the economy off its strong growth track in the third quarter of 2021 but could return to that path in the fourth quarter, as society continues to learn how to manage and adapt to the disease and ever-improving treatments reduce the likelihood of death and hospitalization. GDP is expected to resume its robust growth not only in the fourth quarter of 2021 but also in the first half of 2022, 4Q GDP will be reported 1/27.
In terms of the job market, conditions are as tight or tighter than they were pre-COVID, even though the unemployment rate is more than a percentage point higher. There has been ample data showing labor demand is strong. Job openings have remained at a record level. New businesses are starting up at a much higher pace than they did from 2017 to 2019. People are quitting jobs, either to take new ones or because they are confident that they can find new ones, likewise at a record rate. The improvement expected in managing COVID should drive demand higher but also provide a boost to labor supply as those who have been on the sidelines return to a job market that keeps improving.
Inflation has escalated substantially this year, along with a significant rise in inflation expectations. Despite the highest wage gains in years, inflation in 2021 has wiped out any real wage increase for the average worker. Upward price pressures, no longer concentrated in a few categories, appear to have broadened. There has been a notable increase in the prices of energy, food, goods, and services, as well as the cost of owning a home.
These pressures are related to both supply constraints and strong demand. Wages have continued to grow quickly and on a more sustained basis than they have in more than 20 years, most recently reflected in a striking increase in the employment cost index. Wages and employment costs have been widespread across industries and among businesses of varied sizes. Crucial to the path of inflation will be whether the input cost increases are consistently reflected in final goods prices consumers pay.
The last few months saw energy join the list of supply-side impediments impacting the global economy. An energy supply crunch in China and Europe sent natural gas and coal prices skyrocketing, with knock-on effects to North American natural gas and world oil prices. The jump in oil and gas prices has contributed to consumer price indexes hitting multi-decade highs in November.
The Omicron variant has circled the globe, closed borders, and sparked new restrictions on economic activity. Yet central banks, instead of loosening monetary policy to prop up their economies as they did at the start of the pandemic, have moved to unwind stimulus, and raise interest rates. Central bank officials worry that rather than simply threatening to curtail economic growth, a surge in Covid-19 cases could also prolong high inflation.
Monetary Policy: An acceleration and broadening of inflationary pressures, together with signs of an ever-tighter labor market have reshaped the Federal Reserve’s economic outlook and policy planning. Fed officials could face two opposite risks. One would be tightening monetary policy, causing the economy to slow on top of a sharp drop in the rate of inflation next year. The other would keep inflation higher, and households and businesses would come to expect prices to keep rising, leading to a wage-price spiral.
Consequently, they have set the stage for a series of interest rate increases beginning in the second quarter of 2022, completing a major policy pivot showing much greater concern for inflation to stay high. They have approved plans that will more quickly scale back their Covid-19 pandemic stimulus efforts, ending a program of asset purchases by March instead of by June. That would open the door for them to start raising rates at their second scheduled meeting in mid-March of 2022.
Fiscal Policy: President Biden recently signed the Infrastructure Investment and Jobs Act into law. The legislation authorizes about $1 trillion in spending, of which $550 billion is "new" spending above previously authorized levels, over the next 10 years on "hard" infrastructure.
Separately, on November 19, the House of Representatives passed the Build Back Better (BBB) Act, which contains many "soft" infrastructure initiatives such as paid family leave, green energy initiatives, childcare subsidies, universal pre-K, housing, and health care, etc.
The BBB legislation now sits in the Senate. The Senate should eventually approve a slimmed-down version of the bill or components of BBB may be approved as separate pieces of legislation. Passage is certainly not guaranteed in an evenly divided Senate.
The BBB could have some positive supply-side effects. Productivity growth could be boosted by the upgrades to infrastructure, and some elements of the BBB legislation, such as more childcare subsidies and universal pre-K, could potentially raise the labor force participation rate which would increase economic output. Other than the BBB, no additional major pieces of fiscal policy legislation are likely to be enacted ahead of the 2022 midterm elections.
U.S. Dollar: Given the faster Fed tapering and faster Fed interest rate hikes, a stronger U.S. dollar through all of 2022 would seem likely. As the Fed and foreign central banks become more active over the next several quarters, monetary policy differences will become increasingly important for currency performance. For example, the European Central Bank (ECB) has expressed less concern about inflation pressures than most other major central banks and has given no indication that policy rates would rise any time soon. This divergence between the outlook for ECB policy and a faster-acting Federal Reserve have underpinned the forecast for a weaker euro relative to the US dollar.
Emerging market currencies have been more sensitive to rising U.S. yields, a pattern likely to repeat itself through 2022. Part of that sensitivity has stemmed from the fact that as yields in the U.S. rise, the need for investors to search for higher returns in the emerging markets may dissipate. In addition, rising U.S. yields have often pressured government financing costs. With some emerging markets already facing precarious public finance positions, elevated financing costs could place additional pressure on debt burdens and fiscal balances. And finally, local political developments may also play into the narrative of emerging currency weakness during 2022. Presidential elections in Brazil and Colombia, as well as the constitutional rewrite in Chile, will weigh on respective currencies, while ongoing concern about policy credibility in Turkey should keep the lira under extreme pressure throughout 2022.
Eurozone: As 2022 gets underway, the region’s growth momentum is expected to moderate, but will not be weakened by historical standards. Real GDP for the euro area is anticipated to grow by over 3% in 2022, putting output only slightly below its pre-pandemic trajectory. With the pent-up gains from reopening mostly exhausted, consumer spending will return to pre-pandemic patterns as demand moves away from goods and into re-opened services. Consumers will remain the key driver of the economy, benefiting from plenty of accumulated savings, the rebound in disposable incomes, and reduced uncertainty.
However, inflation has presented a complication. A mix of transitory and technical factors will continue to affect prices well into 2022, with the headline measure likely to hover above 3% year-over-year initially. These factors included a surge in commodity prices, particularly energy, the impact of supply disruptions, and a reopening-driven rise in the cost of services. As imbalances between supply and demand ease, the rate of price increases should moderate.
The stabilizing economy should allow the European Central Bank (ECB) and national governments to unwind their emergency support programs. The ECB is expected to conclude its pandemic emergency purchase program (PEPP) as scheduled in March 2022.
Monetary policy will continue to work towards achieving inflation targets, but fiscal support will wane. With the pandemic fading, most national governments will dial back their emergency support measures, leading to a notable improvement in budget balances next year. Even though some economic support measures such as furloughs will sunset, robust economic recovery will limit increases in unemployment. Overall, the eurozone recovery will remain on track in 2022 but will need more support from policy than other areas of the world.
Emerging Markets: Pandemic-induced supply-side constraints will continue to weigh on the performance of export-dependent Asian economies. China’s slowdown has been another area of concern for not just Asian economies like Taiwan, Singapore, Vietnam, and the Philippine Islands, but other resource-rich nations such as Chile and Brazil. All these countries have been tightly connected to Beijing in global supply chains.
Higher commodity prices have been a boon for some emerging markets (EMs) and a curse for others. The recent pick-up in commodity prices should bode well for the commodity-dependent Latin American economies. But inflation has continued to rise in most of the emerging world because of higher prices for essentials and demand-supply mismatches on the back of economic re-openings. Exporters and factories have continued struggling with scarce inputs, shipping delays, and chronic port congestion.
Threatened by surging prices and high exchange rate pass-through, a growing number of EMs have tightened monetary policy, risking their embryonic recoveries. Central banks in Brazil, Russia, Mexico, and Chile have already raised policy rates to rein in inflationary pressures, while more countries are likely to follow suit next year.
Performance in emerging markets has been directly connected to the effectiveness of policymakers in containing the virus and in providing fiscal and monetary stimulus. Broadly speaking, these dynamics have generated the widest gaps among emerging markets.
Fiscal positions in most emerging markets have weakened significantly during the pandemic. It could be challenging for EM governments to rebuild fiscal space without hampering the recovery. Higher-risk borrowers might take comfort in the exceptionally low global interest rate environment; however, sustained inflation could force major EM central banks to tighten aggressively next year, pushing debt-dependent nations into distress. A debt crisis would be catastrophic and could trigger political instability, asset price volatility, and diminished growth.
Outlook: So, what is expected as we just finished 2021 and for all of 2022?
U.S. GDP growth in 2021 is expected to come in at 5.8%. If realized, that would mark the fastest GDP growth since 1984. Looking forward real GDP growth will likely downshift to about 4.5% in 2022, which is still an above-trend rate of growth.
Real disposable personal income soared to record levels in early 2021 on the wings of stimulus checks. As fiscal support waned, traditional sources like wages and salaries have replaced stimulus as the main driver of income growth.
Despite material strides in the labor market recently, the total number of jobs has stayed 3.9 million below its pre-pandemic peak. Demand for labor has rebounded faster than supply, with workers gaining more sway. Prime-age workers’ participation rate has increased as younger workers take advantage of pay bumps in entry-level jobs. But older workers’ participation has remained low, and many of them are unlikely to return to the labor market anytime soon.
Goods inflation drove this year’s historically high inflation, while services inflation has faced near-term pressures from shelter price increases and new demand after Delta-related weakness. Inflation will get worse before it gets better but should subside over the first half of 2022. Still, a return to levels consistent with the Fed's long-run goal of 2% is not likely in 2022.
The Fed will likely start raising interest rates in the second quarter of 2022. Fed rate hikes will not restore clogged supply chains, but they could prevent long-run inflation expectations from becoming unmoored.
The year ahead will see fiscal policy shift from emergency measures to long-term investment. Pandemic support programs have expired, and attention has turned to infrastructure and social spending proposals. Infrastructure investment has found bipartisan support, and its approval will help the transition into less generous but steadier government spending. Ideas for social supports were vast, but only a small subset of programs are likely to be approved.
At this point, it is still too early to know the full extent to which the Omicron variant will change the public health scenario and weigh on economic activity. The Covid virus has been less devastating economically with each subsequent wave to date. But the next few months will be crucial to shaping projections as public health experts learn which aspects of the variant are similar and different from what has been encountered previously.
Market Commentary
Recap: 2021 was another stellar year for equities while most bond sectors turned in negative returns as interest rates began to rise, from what now appears to be more persistent intermediate-term inflation. As has been the story for the past decade, US large-cap equities outpaced both smaller cap domestic stocks, as well as international and emerging market equities. The strength of the record bounce-back in corporate profits, a pickup in corporate stock buybacks, and continued strength in the US dollar were tailwinds pushing returns along.
However, there was a very wide disparity in equity returns across the globe in 2021 as economic performance and central bank policies varied. US economic growth and corporate profits reached multi-decade record levels while the Federal Reserve maintained its highly accommodative policy stance through most of the year. In the US, the S&P 500 posted a 28.7% return while domestic midcaps and small caps as measured by Frank Russell Company returned 22.6% and 14.8% respectively. The MSCI EAFE (European, Australian, and Far East Index) returned 11.3% while the MSCI Emerging Markets Index posted a -2.5% return. The MSCI Europe returned 16.3% while the MSCI Japan posted only a 1.7% return. Among large Emerging Equity markets India posted the highest return at 26.2% while the lowest was posted by China with a -21.7% return.
In the US, double-digit gains were posted by every economic sector. The lowest returns were posted by more defensive “always necessary” sectors like Utilities and Consumer Staples while Energy (54.7%), Real Estate (46.2%), and Financials (35.1%) were the three best performing sectors. In large caps, growth slightly outperformed value with a strong finishing kick to the year while in midcaps and small caps value outperformed growth in each capitalization band by over 10% in 2021.
Market volatility in the US continued to come down from the extreme volatility brought on by the onset of the pandemic in the first quarter of 2020. Lower volatility is associated with greater investor confidence and higher market prices. While overall that was true, there were several events during the year (e.g., the emergence of the Delta and Omicron COVID-19 variants) that spooked investors, caused short-term spikes in volatility, creating conditions for a retreat in market prices. In hindsight, these dips turned out to be short-term buying opportunities as the underlying strength of the US economy and strong corporate profits dominated temporary headline-grabbing events.
Outlook
As has been the case for almost two years, the course and trajectory of the pandemic continue to be a major influencer of worldwide economic behavior. As infections, hospitalizations, and deaths increase restrictions and lockdowns soon follow. That rapid and unplanned curtailment of “normal” economic behavior (like travel, leisure, dining) had immediate and often sudden impacts on business in those industries (e.g., airline flight cancellations) and the industries in the supply chain feeding those industries. It impacts the bond market and level of market interest rates as well. As was stated earlier, these sudden changes have precipitated stock market volatility which has represented buying opportunities. These declines in the market have been accompanied by short-term dips in interest rates as confidence temporarily erodes for growth prospects.
The important backdrop however to the global stock rally has been driven by strong, above-trend economic growth and record levels of corporate per-share earnings growth. It is expected that corporate earnings growth will continue to be strong in 2022 but just not at 2021 levels. This is because earnings growth in 2022 will be compared to earnings in 2021 and those comparisons while attractive, will be lower and maybe only half or less than what was achieved in 2021 vs. 2020. With that said, it will be no surprise if US equity performance comes in lower than in 2021 if for no other reason corporate profits will decline. 2023 should offer more of the same in terms of lower equity returns and lower corporate earnings growth on the heels of slowing economic growth.
There appears ample difference of opinion of what will happen in the bond market in 2022 and beyond. What does appear certain is that the US dollar will remain strong relative to foreign currencies given both relative economic performances, the anticipated rise in interest rates, and the potential rise of the entire yield curve. This strength will continue to attract foreign capital seeking safe and rising yields. What remains a quandary, however, is why the bond market in 2021 as a whole appeared unconvinced that inflation poses a structural or more permanent problem for investors. Long-term interest rates have remained low though they fluctuated between about 1.2%-1.7% for the benchmark 10-year US Treasury. This may change but bears close watching as the Federal Reserve shifts monetary policy to a less accommodative stance in 2022.
There remains a litany of other factors that will have their impact on earnings, stock, and bond prices that cannot be forecast but must be considered. First is what will the Federal Reserve do with interest rates? They have signaled their bond-buying program will end in March which should take some of the downward pressure off long-term interest and mortgage rates. Since their policy decisions are data-dependent, what if inflation continues to run “hotter” than they expect? Will they feel compelled to have a 50-bps hike in 2022 rather than only 25 bps increases or could there be four hikes next year rather than three? This kind of surprise for the market could prove disruptive though the Fed would signal their inflation concern in advance so as not to shock impact investor psychology.
And there are other influential issues including the gradual healing of supply chain issues, the absence of new stimulus money into household bank accounts as savings are drawn down, the 2022 mid-term elections, and the rate of wage increases drawing people back into the workforce, etc. Needless to say, there are plenty of potential influences that will have a bearing on how the stock and bond markets perform.
As much as we try to resume normal life, the data does suggest vaccines, treatments, and our collective experience have helped us develop a better working knowledge about how to manage our way through life with the virus in our communities. 2022 should in theory be a period when we can put all this to work in more effective ways than was possible just 12 months ago.
Sources: Department of Labor, Department of Commerce, Morningstar, Bloomberg, Standard & Poor’s/Case-Shiller, European Commission, European Central Bank
Disclosures:
Past performance quoted is past performance and is not a guarantee of future results. Portfolio diversification does not guarantee investment returns and does not eliminate the risk of loss. The opinions and estimates put forth constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.
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