Recap: Geopolitical tension in Russia and Ukraine has largely overshadowed a series of positive economic data releases, revealing that the U.S. economy has held up quite well amid January's surge in Omicron cases. Retail sales jumped 3.8% during the first month of the year. The overall monthly increase in sales has been the largest since what followed after households last received stimulus checks in March 2021.
Industrial production also climbed higher in January rising 1.4%. The improvement occurred as manufacturing and mining output both rose modestly. The factory sector has continued to be lifted by strong demand, but another drop in auto production during the month is a sign that producers have remained hampered by input shortages as well as transportation and distribution slowdowns.
Consumer spending has been robust, and employers have complained of having difficulty filling open positions. That has led to rising wages, particularly for lower-income workers, which may be contributing to people’s decisions to return to the labor force.
The U.S. economy grew rapidly in the fourth quarter of last year, advancing to a 6.9% annual rate, capping the strongest year of growth in nearly four decades as the country rebounded quickly from the pandemic-induced recession. The gain in GDP reflected solid spending by households, much of it occurring early in the quarter, and companies pushed to rebuild depleted inventories as they tried to overcome persistent supply shortages. Output grew 5.5% in all of 2021 when comparing the fourth quarter to the same period a year earlier.
However, there have been warning signs. First, most of the 4Q growth is owed to companies' restocking rather than people and firms buying new goods and services. Second, two factors that helped drive last year’s expansion – a torrent of cash sent from Congress to households and ultra-low borrowing costs stoked by the Federal Reserve’s loose-money policies - have faded. Households have spent down much of the stimulus money. Third, the Fed reaffirmed its intention to raise interest rates, as early as March, to combat a sharp rise in inflation, which has damaged consumer confidence and outpaced the growth in workers’ wages.
The path of the economy has continued to depend on the course of the virus. Progress on vaccinations and an easing of supply constraints would support continued gains in economic activity and employment as well as a reduction in inflation. Risks to the economic outlook have remained, including from new variants of the virus.
Russia-Ukraine Conflict: Tensions tied to the Russia-Ukraine situation have intensified in recent days as Russia annexed two eastern regions of Ukraine and more broadly invaded Ukraine. Global economic growth and inflation will surely be negatively impacted by this conflict. Oil prices have already moved higher. If energy supplies are impaired this could result in energy shortages, particularly within the European Union. Oil prices have been a key influence for Russia, and current supply/demand dynamics suggest oil prices will move higher, especially with harsh sanctions being imposed on Russia.
Sanctions would also likely place downward pressure on economic growth. With that said, the severity of the sanctions will determine the magnitude as well as the longevity of the hit to Russia's growth prospects in 2022, as well as in years to come. Harsh international sanctions on Russia, have already put severe pressure on the ruble. Along with the ruble, regional Eastern European emerging currencies will also come under pressure.
Inflation: Consumer prices rose 0.6% in January, pushing the year-over-year gain up to 7.5%. Goods inflation has been the biggest driver of sky-high inflation over the past year. There were some tentative signs of easing in some key goods components. With COVID cases on a rapid descent and wage growth running just as hot as inflation, inflation pressures in services have also broadened. With services inflation steadily heating up, it will take a much sharper slowdown in core goods inflation to bring inflation down from its current level.
Inflation should moderate somewhat in the coming months. As total spending growth slows and shifts toward services, goods inflation would likely ease.
Labor Market: U.S. payrolls grew sharply by 467,000 in January, and the jobless rate rose to 4% as the economy weathered the Omicron wave and staffing shortages. There have been numerous signs the labor market has remained tight, from elevated job openings and worker turnover to low numbers of unemployment claims.
Solid employment gains, including surging wage growth and rebounding labor force participation despite the Omicron variant's emergence, have given Fed officials more evidence that the U.S. economy is getting better at dealing with the bumps in the road from the pandemic. It has reinforced the view that the FOMC will initiate a rate hike at its March meeting.
The labor market should bounce back later this year, as the virus subsides. A pickup in labor-force participation should be a key driver behind job growth this year. Workers who were sick will be able to return to their jobs, and employers eager to hire will have fewer disruptions to confront.
Housing Market: The housing market has continued to face a wide array of scarcities, ranging from low inventories of homes for sale to hard-to-find labor and building materials.
Existing home sales bounced up 6.7% during January. Furthermore, while housing starts declined to start the year, building permits have advanced 0.7%. The pickup in permits provides evidence that builders are looking past current supply-side snags.
Mortgage rates have come up significantly since the start of the year, which may be prompting hesitant buyers to get ahead of higher rates and move forward with purchases. The leap in sales has coincided with inventories falling to an all-time low. The historic dearth in supply has pushed prices higher. The intense competition for a shrinking pool of existing homes for sale has been a boon for new residential construction and home builder confidence. Fast-rising prices and climbing mortgage rates have quickly eroded affordability, which may limit home sales in the months ahead.
While the supply of new housing should improve this year, inventories will remain exceptionally lean amid strong demand. This means there will not likely be any significant moderation in home prices this year. The risk to prices has remained heavily weighted toward the upside, as many home buyers are still able to tap savings built up during the pandemic.
Monetary Policy: With inflation well above the Fed’s target, strong hiring gains and consistently high inflation have left the Federal Reserve poised to raise interest rates at its March 15-16 meeting. How much it would raise the fed funds rate is more uncertain. January’s inflation report has kept the door open to a 50 bp rate increase in March. However, if the peak in inflation has occurred before the meeting on March 16th, the FOMC will likely take a more measured approach, opting to raise the fed funds rate by only 25 bps.
The FOMC will also likely hike rates by 25 bps at the May 4 and June 15 policy meetings. The Committee will likely take a breather on raising the fed funds rate at the July 27 meeting, but it may use this meeting to announce the start of shrinking its balance sheet, which is another form of monetary policy tightening. Another 25 bp rate hike is expected at the September 21 meeting before the Committee pauses again at the November 2 meeting ahead of the midterm elections. One more 25 bp increase in 2022 could well happen on December 14.
A more gradual pace of rate hikes in the second half of the year could occur due to deceleration in spending and slowing in the rate of inflation, as well as by the Fed balance sheet runoff getting up to full speed.
Fiscal Policy: Federal fiscal policy developments were a key driver of the U.S. economic outlook in 2021, but as 2022 has begun, fiscal policy has quietly taken a back seat. Most of the pandemic-related fiscal policy support has run its course, and Democrats' Build Back Better plan appeared unlikely to become law anytime soon. Congress increased the debt ceiling in December by $2.5 trillion, which should give enough borrowing room to last through all of 2022. No new federal fiscal policy measures would likely become law in 2022.
U.S. Dollar: While the U.S. dollar has started 2022 on an underwhelming note, and a temporary pause in the dollar's uptrend could be possible during the first quarter of this year, fundamentals should prove favorable for the U.S. dollar over the longer term. The crisis in Ukraine has only strengthened the dollar in a safe haven trade in the short term. Once the Federal Reserve begins raising interest rates in March, or shortly thereafter, the relative attractiveness of the U.S. dollar should improve and should support the currency going forward.
In addition, the U.S. economy should be a relative outperformer in terms of growth prospects. Economies across the G10 have lagged behind the United States, while most developing economies have struggled to gather or maintain momentum since the start of the pandemic. Market participants should begin focusing on country-specific fundamentals and investors will again divert capital back toward U.S. dollar-denominated assets, which should be supportive of the dollar over time.
Eurozone: Eurozone economic growth softened around the turn of the year, and although consumer fundamentals should support continued expansion, GDP growth should be slower in 2022 than in 2021. The economic impact of the crisis in Ukraine is a still an unknown given the wide dispersion in possible outcomes.
In contrast, CPI inflation has remained elevated, with January's 5.1% year-over-year increase the largest on record. While much of the increase has been driven by energy, price pressures have become more broad-based, and neither headline nor core inflation has likely peaked. The crisis in Ukraine has only added to those woes.
The ECB has appeared to be laying the groundwork for an eventual rate increase. In March, the ECB should signal €40B per month of bond purchases during Q2-2022, should signal €20B per month of purchases during Q3-2022, and should indicate an intent to end bond purchases in September.
Beyond March, the ECB would start raising its deposit rate shortly after completing its net bond purchases. Specifically, an initial 25 basis point deposit rate hike in December 2022, and another 25 basis point hike in March 2023. Beyond that, hikes in June, September, and December of 2023 are expected.
China: China's economy has struggled with many issues over the past few years. Structural imbalances in such an over-leveraged economy and an aging population have stunted growth prospects, while recent regulatory adjustments and authorities' commitment to the "zero-COVID" policy has decelerated growth. Despite these challenges, the Chinese economy has experienced sequential growth of 1.6% and year-over-year growth of 4% in Q4-2021. While the economy still slowed from the prior quarter, the upside surprise means China's economy grew 8.1% in 2021, one of the fastest annual growth rates in years. Going forward, China's growth prospects will continue to dwindle amid the structural issues mentioned as well as lockdown protocols to prevent the spread of COVID.
To that point, Chinese authorities have locked down multiple cities over the past few weeks to contain locally transmitted Omicron cases. As a result, local ports and shipping capabilities have been interrupted, which is likely to weigh on China's export sector throughout Q1-2022. In addition, consumer activity should come under pressure in the first quarter and China's economy will likely get off to a rocky start in 2022.
Outlook: U.S. economic output is expected to grow modestly this year, slower than last year and even slower because of the impact of the war in Europe. Americans still have higher savings compared to before the pandemic, and jobs are plentiful. The biggest challenge for the economy right now is not demand, but supply. While U.S. producers are making more goods and services than they did before the pandemic, they are doing so with fewer workers.
While the effects of the Omicron variant may fade in the coming months, the illness is for now restraining the economic recovery. Demand for products and services from companies has been solid, if not strong, but supplies - whether of goods or workers - have been running tight. Those shortages are stoking inflation.
In addition to weak income growth acting as a headwind in January, the weakness in spending at the end of the year will set the first quarter up for a fairly challenging time. US GDP growth in 1Q22 is expected to be only about a 1% annual rate. That would mark the weakest quarter of growth since the recovery began in mid-2020. The pandemic, along with declining help from fiscal and monetary policy, would keep growth in check.
After the dislocations in the first quarter, growth should rebound in subsequent quarters with full-year growth still coming in above trend. The inventory surge in Q1 may have been unintended, but 2022 should be a year-long restocking effort, in the wake of the supply chain crisis, to result in a trend rise in inventories over the longer haul.
Sources: Department of Commerce, Department of Labor, Morningstar, Bloomberg, European Central Bank, Peoples Bank of China
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