It is often said that economic forecasts exist solely to make astrology look respectable, but since year-ahead predictions are an age old tradition in the financial community we too shall again partake in this annual exercise. Before looking ahead, though, we should first reflect back on what happened during the past twelve months.
At the start of 2021 we were optimistic that the economic rebound would continue in the new year, but cautioned that the ultimate makeup of the recovery would depend heavily on two key issues: government policy and the fight against COVID-19. This was for the most part correct because on the fiscal side of the equation the distribution of an additional economic relief check from the government (on top of what already went out in 2020), and an extension of the federal unemployment insurance boost together helped prop up consumer demand throughout 2022, all while rolling and regionally disparate COVID concerns continued to influence the way Americans spend.
Moreover, due to stronger household balance sheets and improved labor market confidence consumers were both capable and willing to spend last year, but lingering COVID uncertainty has had an impact on exactly how Americans used their disposable income. Traditionally the bulk of consumer spending is on services, but consumption was abnormally concentrated on goods for most of 2021. A slower rebound in services spending was in some ways to be expected since pent up demand is not easily resolved via this form of consumption, e.g. if someone wanted to get a haircut while in lockdown they are not going to go out and get two haircuts to make up for it.
The problem, though, is that the service sector rebound has taken much longer than anticipated because the rise of COVID variants and continued regional differences in activity restrictions have prolonged the economic distortions from this pandemic. For example, with lingering COVID concerns many consumers have been reluctant to return to regularly visiting restaurants, bars, and other typical away-from-home activities, and instead shifted this spending to where they live, via home upgrades, electronics amenities, and at-home dining (groceries). This unusual and extended spike in goods consumption put additional pressure on supply chains that were already severely stretched due to the pandemic both here and overseas, and in turn has been a major factor behind the surge in inflation that became the main economic talking point of last year.
The big theme of 2022 will therefore be whether or not the extreme price pressures we have seen in 2021 extend into the new year, intensify, or abate. Our current base case is that 2022 will experience “disinflation,” i.e. inflation still elevated compared to pre-pandemic norms but materially weaker than what we experienced in 2021. This does not mean that incoming inflation measures cannot continue to get worse before they start to get better but by year end 2022 we should see annual inflation well off of the highs from last year. As for potential risks to this outlook, there is probably more right tail risk on the inflation front in 2022 than left tail growth risk, i.e. it is more likely that inflation stays hot than the recovery gets derailed. Put another way, 2021’s inflationary boom has a higher probability of repeating than the stagflation scenario many people warned about last fall.
Reasons growth could accelerate more, at least in the earlier part of this year, and lead to even greater price pressures include still relatively strong household balance sheets, a favorable labor market, and a likely rebound in consumer confidence should variant fears start to wane. It is also worth noting that it is easy to see the incoming economic data remain noisy (not provide a lot of signal) at least through the first half of 2022 as the reopening gains more momentum and the various supply and demand imbalances try to normalize. Basically this means that one should not be quick to shift their medium-term macro outlook if, for example, inflation data at the beginning of the year come in hot or cold relative to expectations.
And even if inflation pressures do start to abate right away that does not necessarily mean already elevated prices will not weigh on consumer spending, by far the largest component of U.S. gross domestic product (GDP) growth. The natural pushback is that we saw historic levels of inflation in 2021 yet consumer spending repeatedly surprised to the upside all year. However, in 2021 consumers were still flush with cash due to the various government relief measures, and the willingness to spend was buoyed by rising incomes, a resilient stock market, and other factors. Further, incomes can indeed continue to rise in 2022 but the pace of wage growth is likely to moderate as the labor market eventually starts to normalize.
Talent shortages have been a major problem for employers all last year but some relief may come as consumers’ disposable income is eroded enough to encourage more job seeking. And if pandemic concerns finally do start to fade away then more traditional economic forces can retake control and help mean reversions accelerate. Similarly, less COVID distortions will make it easier for prime-age workers who have been outside of the labor force recently due to childcare challenges finally return to the labor pool en masse.
We must also consider the significant amount of money businesses have been investing in productivity. The transitory nature of recent inflation can be debated but what will for sure be permanent is the productivity gains, which will either allow wages to rise further without forcing a big uptick in selling prices and/or cause businesses to learn to operate with a smaller payroll and/or longer work week as the new normal. The latter supports the argument that job vacancies should start to normalize, in turn increasing the amount of job seekers relative to openings. It is clearly a complicated process and can take a while to play out, but such conditions will eventually lead to lessening inflation pressures.
As for the Federal Reserve, the recent change in tone has shown that they have clearly noticed inflation and are not just going to sit by and let it continue at the current pace. If anything it seems like the Fed may tilt more hawkish now via smaller but sooner policy adjustments so that it can avoid having to make a more substantial (market moving) adjustment down the road should it find itself significantly behind the curve. As a result it seems likely that the Fed will indeed start raising interest rates this year. These will be modest hikes, maybe 25bps at a time with pauses in between, which along with the end of quantitative easing will provide the Fed with some policy options should another economic shock down the road occur while still allowing financial conditions to be historically loose. The Fed can of course change its approach in an instant based on incoming economic and virus data.
All of this can impact the stock market as well, particularly (in our view) the absence of quantitative easing which for the past decade has helped suppress volatility. As a result we see 2022 potentially being a choppier year for equities than what we were spoiled with in 2021. This does not mean stocks cannot keep rising in 2022 but simply that the ride may be bumpier. Fortunately this should not be a problem for 401(k) retirement investors who can remain focused on the long-term and potentially even use any short-term uptick in volatility as an opportunity.
What To Watch This Week:
- PMI Manufacturing Final 9:45 AM ET
- Construction Spending 10:00 AM ET
- ISM Manufacturing Index 10:00 AM ET
- JOLTS 10:00 AM ET
- MBA Mortgage Applications 7:00 AM ET
- ADP Employment Report 8:15 AM ET
- PMI Composite Final 9:45 AM ET
- EIA Petroleum Status Report 10:30 AM ET
- FOMC Minutes 2:00 PM ET
- Challenger Job-Cut Report 7:30 AM ET
- International Trade in Goods and Services 8:30 AM ET
- Jobless Claims 8:30 AM ET
- Factory Orders 10:00 AM ET
- ISM Services Index 10:00 AM ET
- EIA Natural Gas Report 10:30 AM ET
- 3-Yr Note Announcement 11:00 AM ET
- 10-Yr Note Announcement 11:00 AM ET
- 30-Yr Bond Announcement 11:00 AM ET
- Employment Situation 8:30 AM ET
- Mary Daly Speaks 10:00 AM ET
- Raphael Bostic Speaks 12:15 PM ET
- Thomas Barkin Speaks 12:30 PM ET
- Baker Hughes Rig Count 1:00 PM ET
- Consumer Credit 3:00 PM ET