The economy is slowing, but still moving sums up the current state of affairs. Before we dive into today’s Market Perspective, we want thank you for entrusting us as your wealth advisor and investment manager. We are honored by your choice and remain grateful to be part of your financial success. As the close of 2021 draws near, we share our view on the year and our outlook for 2022.
Turning the page to a new year, 2022 could look quite a bit like 2021 — with some key differences. The positives: the economic reopening should continue and global economic and corporate earnings growth should be above trend. The negatives: Inflationary pressures have increased, interest rates are rising, and fiscal and monetary support are waning. In short, the economy is slowing, but still moving at a pretty good clip. That is to say, the economic cycle isn’t ending, but conditions are getting more difficult and gains may not come so easily.
Looking back to the beginning of 2020, no one ever thought to predict the evolving outcomes that reached every corner of the global population. Hopefully, everyone emerges smarter and more resilient. From our perspective, the pandemic is in the rear-view, though cases and new variants will likely be ongoing. In other words, the world is learning to live with Covid and it is no longer a pandemic. Rather, a way of life that likely presents another new normal. Volatility and the economic recovery remain uneven (globally), and we don’t expect this condition to change any time soon.
The stock market is treading on thin ice heading into the final trading days of 2021. Fear is running high as several key support levels held last week. That suggests we may be making a panic bottom in stocks. If that’s the case, Santa Claus is loading the sled and the traditional year-end rally could start at any moment.
Before we get ahead of ourselves, keep in mind that any key support levels which fail to hold in coming weeks will likely yield more selling, and the possibility of a bear market.
Interest Rate (income) risk not fading any time soon
In the short term, interest rates incrementally rise due to growth expectations and pandemic-related supply and demand issues. Looking further down the road, things keeping rates low remain in place, and for this reason it is our opinion that rates will stay in a range similar to that of recent years. For those depending on income derived from interest sensitive investments, your challenges will likely persist. Working against our thesis of nominal interest rates, massive expenditures coming out of Washington will most assuredly add to supply and demand inflationary pressures.
Whether investing for income, growth, or a combination of the two, diversification and a flexible asset allocation framework is paramount. Additionally, more sophisticated strategies can provide income above that of traditional portfolios. The pandemic, perhaps, taught us to focus on these and other components of our strategies in an effort to build greater flexibility and protection.
Closing 2021 comes with a greater sense of awareness. Nevertheless, the year will go out as one that provided extremely disparate political views, racial tensions, and strong growth fueled by a combination of unprecedented fiscal and monetary stimulus and global economic reopening. The year was bookended with stock market gains while the summer was plagued by an unexpected surge in COVID-19 that rocked the global recovery and exacerbated supply chain issues leaving consumers dismayed. Looking into the new year, we are adjusting our expectations on growth as the aforementioned factors will most certainly fade. On the other hand, consumer demand is intact and inflation, running hot at present, should moderate In the not to distant future as supply is rebuilt.
Looking back, 2021 was replete with bumps and negative side effects. Yet, it provided the fastest economic growth in decades; since 2019, equity markets have delivered well-above-average returns. What drove all this growth? Irrefutably, vaccinations and fiscal stimulus provided many companies with a boost in earnings growth. Compared to conditions in 2020, precipitous growth was nearly a given. Forecasts for 2022 do not provide the same excitement as global earnings growth is expected to slow from greater than 50% to below 10%.
It’s hard to say what garnered the most attention during 2021. Social unrest, January 6 Capitol Riot, Media Wars, Governor Cuomo of NY, Global Chip Shortages, Ransomware Attack against Colonial Pipeline, Tom Brady winning his 7th Super Blow, or a mind-blowing proposal to spend $3.5 Trillion with a price tag of zero. From our point of view, the last one is disconcerting and possibly creates a deleterious outcome.
So, when will this monumental spending out of Washington, D.C. begin to affect the economy? As new debt rolls onto the balance sheet, expiring stimulus should provide a partial offset. However, the fact that much of the new spending is supposed to be paid with higher revenues (taxes) further reduces its immediate economic impact. It is uncertain if tax increases will come to fruition and whether subsequent revenues will be enough. Throughout the pandemic, monetary policy has managed financial conditions reasonably well. Now, liquidity provisions will become less accommodative as central bankers around the world consider interest rate hikes in the near future. Historically low interest rates have benefited equity, credit and real estate markets for several years, particularly 2020 and 2021. We speculate these sectors will find things more challenging in 2022.…But still moving
At this point, you might be asking which direction we are pointed given what might sound like a bifurcated view of the economy. Actually, we are maintaining a positive outlook for growth and investment returns in the new year. Our research provides conclusive evidence that household net worth (recently) reached new all-time highs thanks to stimulus, higher savings and rising asset prices. At this point, trillions of dollars are on the sidelines and pave the way for anticipated spending growth well into 2022. Don’t forget, consumer spending accounts for nearly 70% of GDP. The following pages will breakdown the risks and benefits of our current state and the likely path we take from here.
As mentioned, stimulus is expiring which presents a threat to spending. The counterbalance is robust wage growth in a highly competitive and tight labor market. Workers have a decisively upper hand over employers; improving earned income and lifestyle. This shift has economic benefits, and is unequivocally positive, for now.
Shifting our focus to the supply/demand crisis in the global market should abate as global manufacturing output and trade continue at all-time highs. Capacity, however, provides the opportunity to catch up with demand and help businesses around the world replenish depleted inventories. Additionally, global consumers are expected to resume activities in areas like leisure and travel that have yet to see full recoveries. In fact, the gap between goods and services is nearly 20%, further supporting our expectation of consumers vacationing via cruise lines and air travel.
More countries are reopening and returning to normal. This in itself is stimulative; helping ease the pressures of supply chain stress. Simultaneously, higher consumer spending in these regions will add to the recovery.
As 2022 approaches, the world economy shows signs of heating up. Data releases are once again surprising on the upside. Global manufacturing activity has reaccelerated, and unemployment rates continue to fall quickly in countries that are further along in their recoveries.
A high pressure (economic) system
For the first time in decades, investors find themselves in a high-pressure economic system. Inflation is running high in developed economies, while unemployment continues to trend lower and wage growth is accelerating. Global production, orders and shipments are at or near all-time highs, but so are input costs and delivery delays. Despite this, we do not think inflation should be investors’ main focus as they consider adjusting their portfolios heading into 2022.
Back in the early days of America’s Great Recession, the word transitory became the new vogue as Ben Bernanke, Federal Reserve Chair, gave it a thorough workout. This hackneyed expression has returned. The latest victim of the fashionable word is inflation. And yes, monthly goods price increases — which peaked in the first half of 2021 — should moderate as supply increases and consumer preferences shift. U.S. personal spending is well above its pre-pandemic trend, but the mix of that spending remains skewed toward goods over services (Figure 2). Even a partial reversion to January 2020 conditions would have a disinflationary effect, as service prices have not been under nearly as much pressure as goods prices.
Of particular interest in a high-pressure economy is supply chain demand. Expected to ease in 2022, these pressures may not fully cooperate. Instead of going away, it may be more of a shift to the labor market, creating another set of challenges. To better illustrate this point, consider job creation across the U.S. and Europe in 2021; a strong trend yet employment remains well below expected levels. Roughly 10 million jobs sat open in the U.S. as recently as September, and employment is still down four million from its December 2019 peak. Did these workers vanish, or do they plan on coming back?
A few million people who were working two years ago have simply chosen to retire as planned or early. With a growing number of workers reaching retirement age, this dynamic will continue placing pressure on filling vacancies across nearly every industry. Further complicating things are younger workers choosing to forego additional schooling to take entry level jobs that pay considerably more than they did two years ago. If you followed the math, several million workers are potentially needed but they are not coming back as quickly as they left. All of this is the key to answering questions about inflation, interest rates and risk-taking in 2022. Solving this conundrum requires more of a “wait and see” approach. The question is, how long will it take and how much time do we have?
On the one hand, most working- age people who have left the job market since the start of the pandemic will eventually return; savings will be exhausted, child care is readily available, fear of contracting COVID-19, or they simply want to be around their peers.
On the other hand, things could be much worse. If workers don’t return quickly enough, wage growth could accelerate, adding costs already rising raw materials prices and delivery delays. These unintended forces could threaten businesses’ profit margins and force central banks to act in an effort to prevent a resulting inflationary spiral. This would likely mean tighter monetary policy, raising interest rates or reserve requirements. Should this set of conditions become a reality, markets will be threatened in 2022.
Preventing a bad outcome won’t be easy. For now, central banks are navigating current conditions with the appearance of intended outcomes, perhaps engineering the strongest bounce back on record. However, central banks will almost certainly raise rates vs. withstand a second year of elevated inflation. Remember, raising rates is a key element in controlling inflation. In the U.S., the Fed has promised to leave rates low until the economy is at full employment. Should inflation grow stronger, the Fed may have to break that promise to forestall our next recession.
Strategic Investing Amid Inflation in 2022
Inflation was almost nonexistent following the great recession of 2008. The Federal Reserve, as you may recall, set inflation targets that were never hit. We enjoyed a burgeoning economy with no inflation for more than a decade. Many experts speculate why this occurred, but we will save that conversation for another day. Today, we find inflation at every turn, effecting nearly every person. This condition has implications for investors and investment managers. If the current bout of inflation is short-lived, 2022 will most likely feel like 2021 in terms of performance. If inflation becomes more protracted, or turns to hyperinflation, all eyes will be on central banks to pull the right lever. Most of the globe has become very dependent on the Fed and central banks around the world; all seem happy to oblige.
Lessons from 2021: We learned that a 40-year high for consumer price inflation did not harm equity markets. Of course, the deck was stacked in our favor; the Fed Chair is dovish (accommodative), as is the current administration. Monetary policy is very useful and necessary, but eventually the country has to run on its own, and with acceptable levels of debt. Lest we forget their (the Fed) money comes from your money, the tax payer. Depending on how this theme of inflation plays out, allocation adjustments may be required.
We can say without hesitation that high inflation is in place, but interest rates are not responding as you might imagine. Higher inflation raises the risk that the Fed and its peers will have to step in to tighten policy, flattening the yield curve by sending short rates higher and longer-term rates lower. This notion of “steadying the ship” is easier said than done. After a year of persistently rising inflation the Fed has not budged, and we consider this a good thing. Lower inflation takes pressure off the Fed to raise rates and lengthens the runway for a safer landing. This scenario steepens the yield curve. As we move into the new year, our outlook anticipates the latter.
Bottom Line: We are optimistic about 2022 though we expect a noticeable reduction in economic growth as the “reopening” winds down. Inflation should ease as supply/demand normalizes. Our supposition is based on factors that you never hear about in the news. First, long term inflation reduces the value of growth-oriented stocks, thereby making them less attractive. Yet, growth stocks are not selling-off. The U.S. dollar should be weakening in the presence of long-term inflation. Yet, the greenback is continuing its climb. Finally, periods of persistent inflation are usually accompanied by rising gold prices. Yet, continuous gold contracts are not cooperating. Among others, these reasons support our theory of short-lived inflation.
These conditions warrant a slow and steady approach to raising interest rates while simultaneously curtailing fiscal and monetary policy support. Looking back on 2021, economic growth was a slam dunk but the new year may provide fewer rewarding conditions; “reopening an economy” is a once-in-a-century event. Households are saving less now than just a year ago and government stimulus is likely tapped out and, frankly, appears ineffective at this point. Moreover, underlying fundamentals continue to strengthen, highlighting positive performance from credit markets, infrastructure investments, private real assets and cyclical parts of the global equity market.
Our portfolio manager, Roger Fuller adds to the conversation: Continuing the excellent points already discussed, there is a good chance 2022 will provide an event that has not happened in nearly 5 decades, deliver gains in global stocks and losses in global bonds for consecutive years. Throughout this year I have favored equities over fixed income, developing markets over emerging markets, and tightening the reigns on our covered call strategies. Though our outlook is positive for the year, factors such as Central banks pushing too aggressively to fight inflation, delays to the restart, and new vaccine-resistant strains could affect the market. We will keep a close eye on our indicators, adjust as we see appropriate, and continue to stay diversified.
Risks to Our Outlook: Headwinds and geopolitical risks cannot be overlooked but our more immediate concern is the scenario of persistent or hyperinflation, mostly due to tight labor market conditions and overconsumption. Consequently, central banks would be forced to suddenly change course from a “slow and steady” approach to “immediate action”. This creates the potential for an “overshoot”, resulting in some form of recession.
The global economy is making progress along a long road back to normal. Stock market returns have been above average for three consecutive years amid social unrest, a seemingly never-ending pandemic, government intervention and reopening the world economy. Now, we turn the page and look forward to a new year. We believe this will be a time of markets settling back to Earth and a more normalized GDP. For these reasons, our perspective leads us to believe now is an opportune time for investors to consider their financial goals and adjust asset allocation strategies accordingly.