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2022: Slower. But still pretty fast.
- After a 2021 dominated by upside risks — to growth, inflation, interest rates and investment returns — we see a more balanced outlook heading into 2022.
- Global economic growth and inflation are set to slow next year from their fastest rates in decades, but will likely remain relatively high.
- Many factors that propelled the economy forward in 2021 will fade in 2022, but some key risks holding us back will remain.
- As companies’ profit growth decelerates, we expect returns on risk assets like stocks to come in closer to their long-term averages after three years of stellar returns.
- Don’t laugh: The global goods shortage is transitory and should fade by the second half of 2022. If central banks are forced to tighten, it will likely be due to a labor shortage in the services sector.
- We expect short-term interest rates to increase by somewhat less than the market has currently priced in, but longer-term rates should rise even if inflation abates.
We're slowing down . . .
2021 was a year of historically strong growth, fueled by a combination of unprecedented fiscal and monetary stimulus and a once-in-a-century global economic reopening. Growth was suppressed mainly by the unexpected surge in COVID-19 over the summer that interrupted the global recovery and exacerbated issues with products reaching consumers. Most factors that contributed positively to growth will fade in 2022, but strong consumer demand and the inflation it helped create remain as we head into a new year.
Despite being accompanied by some negative side effects, the fastest economic growth in decades helped propel equity markets to their third straight year of well-above-average returns. Vaccinations and fiscal stimulus helped companies achieve historically high earnings growth, which was helped by inevitably flattering comparisons to conditions in 2020. That will not be the case next year, when global earnings growth will slow from greater than 50% to a mid-single digit increase.
While new spending out of Washington, D.C., is earning lots of press coverage, far more government assistance will roll off this year than roll on. Expiring stimulus will dwarf any increase in discretionary spending for infrastructure, child care or a variety of other programs. And the fact that much of the new spending will be offset by higher revenues further reduces its immediate economic impact.
Monetary policy has managed to keep financial conditions loose throughout the recovery, but central banks have already begun to wind down their liquidity provisions as they weigh when and whether to begin tightening policy outright through interest rate hikes. To the extent that equity, credit and real estate markets have benefited from extraordinarily easy monetary policy — and they have — they’ll find it less helpful in 2022.
. . . But still moving pretty fast
Despite fading stimulus and continued supply/ demand imbalances, we retain a positive outlook for growth and investment returns for several reasons. First, private sector balance sheets are uncommonly strong. Figure 1 tells us a story of not only where U.S. consumers — as always, the lynchpin for global growth — have been, but also where they might be going. Household net worth has hit new all-time highs thanks to higher savings and rising asset prices, and the trillions now sitting in cash should continue to fuel high spending growth well into 2022. These measures are far better predictors of economic behavior than consumer sentiment opinion polls, which have become too skewed by political party identification to use for economic forecasting.
The positive demand shock of 2021 has receded, but it has not gone away entirely. The hole left by expiring stimulus is being filled by robust wage growth in a prematurely tight labor market. For the first time in recent memory, workers have a clear upper hand over employers in negotiations over terms of employment. We think the economic benefits of this realignment outweigh the potential costs for now.
Meanwhile, the supply/demand imbalance in the global market for goods should begin to fix itself. Global manufacturing output and trade are already at all-time highs, but production can rise further to catch up with demand and help businesses replenish depleted inventories. More countries will be able to fully reopen as their populations are vaccinated against COVID-19, and global consumers will resume activities in areas like leisure and travel that have yet to see full recoveries.
There are encouraging signs of reacceleration in China and other Asian economies after a recent series of lockdowns, with Japan likely in store for better growth after a recent Delta-induced contraction. More countries returning to normal can help stimulate both global supply and global demand. As factories return to full production capacity across East and Southeast Asia, supply chain stress will ease. At the same time, higher consumer spending in reopening countries will lift overall growth in the region and around the world.
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. We can’t foresee anything happening in 2022 to match the explosive demand growth generated by the global reopening, but the economy still has clear pillars of support and is gathering new momentum as vaccine doses are administered across the world. Financial markets will likely take notice.
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.
“Transitory” inflation has now become a familiar punchline, but we continue to expect monthly goods price increases — which peaked in the first half of 2021 — to 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.
While we expect supply chain pressures to ease in 2022, we are also concerned that pressures may be shifting to the labor market, particularly for in-person service workers. Job creation was strong across the U.S. and Europe in 2021, but employment remains well below prior peaks even as GDP has returned to its 4Q 2019 level. Over 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. Where have these workers gone, and are they coming back?
To answer this question, we are chiefly concerned with prime-age workers (25 – 54). We know that demographic forces are bringing a larger share of the populations of developed economies into retirement age. A few million people who were working two years ago have simply chosen to retire as scheduled or early if their nest eggs permitted. On the flipside, a larger percentage of younger workers are eschewing additional schooling to take entry level jobs that pay considerably more than they did two years ago. But understanding the drop in employment and, more distressingly, the desire to seek employment among prime-age workers is the key to answering investors’ questions about inflation, interest rates and risk-taking in 2022 (Figure 3).
Let’s start with a sunny prediction. Most working-age people who have left the job market, for whatever reason, since the start of the pandemic will at some point be compelled to return. For many, it will be when their savings wind down or their child care needs are met. Others who have been reluctant to return for fear of contracting COVID-19 continue to find good news on booster efficacy and coming therapeutic treatments. For these reasons and more, labor force participation should increase in 2022.
Now for a more ominous forecast: If workers don’t return quickly enough, the already-tight labor market could get tighter, pushing wage growth even higher. That in itself is not a concern, but if those costs are added to rising raw materials prices and delivery delays, they could threaten businesses’ profit margins and force central banks to preempt an inflationary spiral with tighter monetary policy. This “non-transitory” style of inflation could threaten markets next year.
Central banks are, for now, ably absorbing the pressure in the system…from markets, politicians and armchair economists. Keeping monetary policy easy during a year of high inflation in the service of fostering a faster jobs recovery would, just a few years ago, have been a revolutionary concept. But it seems clear that the pedal-to-the-metal response to the COVID-19 crisis by legislators and central banks helped engineer the strongest bounce back from a severe recession on record.
It now appears, however, that markets do not expect central banks’ newfound dovishness to withstand a second year of elevated inflation. A rate increase from the Bank of England may be imminent, while markets are pricing in Fed rates hikes as early as July. In the case of the Fed, we think markets are being too hasty. The Fed has promised not to even consider raising interest rates until the economy is at full employment, a term around which there is considerable wiggle room. The lesson of the last cycle was that central banks stepped in too quickly and slowed things down too much. We don’t think the Fed will need to be taught that again.
How investors should regard inflation in 2022
To correctly gauge the investment implications of inflation in 2022, we need to know two things: First, how quickly will inflation slow, if it does at all? And second, what will central banks do about it?
We learned in 2021 that a 40-year high for consumer price inflation is just fine for equity markets and pretty benign for bond markets as long as there’s a very dovish central bank at the helm. Assets often seen as inflation hedges like TIPS or gold performed well in some moments, less well in others. But investors in these assets must now consider whether to renew their inflation insurance — with a much higher premium for 2022 (Figure 4) — or turn to a more balanced mix of assets that can reliably perform well when both inflation and growth are above average. We obviously prefer the latter approach, particularly because we expect core inflation to fall back close to 2% in the second half of the year.
Despite high inflation, interest rates were very well behaved throughout most of 2021. This, again, is due to central banks’ willingness to anchor policy rates at zero even as prices ticked up. In fact, because monetary policy is rightly seen as central to the outlook for both rates and inflation, the correlation between the two has been turned on its head. Consider:
- 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.
- Lower inflation takes pressure off the Fed to tighten and lengthens the runway for easy money, which steepens the yield curve with cash rates anchored at zero.
Market returns may be lower in the years ahead, but that doesn’t mean we’re not seeing opportunities.
As inflation eases in 2022, markets should become less concerned with imminent and aggressive rate hikes, and the yield curve should gently steepen. In this scenario, we foresee continued challenges for interest rate sensitive fixed income, but further narrowing of corporate credit spreads. This is why we prefer keeping portfolio duration shorter than normal at this time while maintaining slightly more credit risk. Within equities, global cyclicals and financials tend to perform better when the curve is steepening and the path for growth becomes clearer. And while private assets like real estate can be sensitive to rising rates, they should not be too troubled by moderately higher yields in the context of above-trend economic growth. Finally, real assets can thrive in an environment of good growth and elevated inflation, and those tied to infrastructure can benefit from further investments in green energy and overdue investments by governments and businesses to raise productivity.
Expect more balance heading into 2022
2021 provided close to ideal conditions for economic growth and risk assets like equities, but we see the environment as more balanced heading into 2022. Households are saving less now than they were a year ago and government stimulus is likely tapped out, but underlying fundamentals continue to strengthen, pointing to positive performance from credit markets, infrastructure investments, private real assets and cyclical parts of the global equity market. The major risk to our outlook remains a sudden tightening of financial conditions if central banks are forced to respond to inflation driven by an overly tight labor market. As the global economy continues along its road back to normal and market returns settle back to Earth, now is an opportune time for investors to consider their financial goals and adjust their asset allocation strategies accordingly.
All market and economic data from Bloomberg, FactSet and Morningstar.
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