Stocks soared yesterday, erasing much of the selling frenzy of the previous three sessions related to the rapid expansion of the Omicron variant. While the speed of spread has been a shock, most people who have gotten sick, especially those fully vaccinated, have had only mild symptoms. I don’t want to trivialize a disease, but it seems that, while some events and gatherings may be postponed or cancelled, the ultimate economic damage should be contained. Hence, yesterday’s rally. In the real world, the worst impact of Omicron may still be in front of us. But in the investment world, where we look 6 months or more ahead, it has been fully digested. Unless there is a material turn for the worse in the weeks ahead, Omicron has largely been discounted.
Once again, investors will turn to basic economic issues. The three keys to 2022 are the pace of growth, the yield on the 10-year Treasury bond at the end of the year, and the ongoing pace of inflation 12 months hence. Other trends are in place that will help determine the outcome.
1. The Federal Reserve has set a goal to stop adding to its balance sheet by the end of March. After that, the question is whether it will begin to raise interest rates. Right now, markets are pricing in three increases totaling 0.75%, but what happens will be determined by both growth and inflation rates throughout 2022. With that said, monetary and fiscal stimulus already in place will be accelerants to both growth and inflation, especially in the first half of 2022.
2. 2022 should be a year of inventory rebuilding as supply chain problems are solved. All won’t be solved next year, but a lot will.
3. As the Fed slows its pace of bond purchases, tax receipts rise, and Covid-related spending decreases, money supply growth will recede from 13%.
4. The savings rate spiked during peak pandemic times to over 30%, but now it is already back within historic ranges and continues to decline. At some point, consumers will need to dip further into savings if they continue to spend anywhere near the current pace. Some will return to the work force, helping to relieve some pressure exerted by labor shortages.
5. The auto industry, in particular, should grow at a rapid pace given the lack of inventory in 2021.
6. Congress could pass a watered-down Build Back Better bill and could increase taxes on businesses and the wealthy, but the odds fade as time passes. It’s hard to believe that Democrats want to increase taxes in front of spring primaries.
7. 2021 population growth was 0.1% in 2021, the smallest in memory, a combination of Covid deaths and lack of immigration. Even assuming fewer Covid-related deaths in coming years, it appears lower population growth will be a negative influence on long term growth.
8. China faces even worse demographic issues. Its growth, which was about 6% pre-Covid, could be cut in half within a few years.
Add all this together, and you get a picture of slowly decelerating growth in 2022. While growth should remain above average going into 2023 because of inventory rebuilding, strength in autos and housing, and positive impact from monetary stimulus this year, maintaining growth much in excess of long-term trends of about 2% in 2023 and beyond will be difficult, especially given the difficult demographic trends.
That takes us to inflation. We all know the pressures that have lifted inflation the past year. Surging post-quarantine demand sent commodity prices soaring. Supply chain snarls led to shortages and higher prices. A tight labor market pushed wages up. Housing shortages lifted rents. Some of these pressures will be alleviated over the next year as supply chain issues get resolved. In some cases, shortages will rapidly turn to oversupply. Look at hand sanitizers for an example. Initial shortages were satisfied quickly. Hand sanitizer was easy to make. Today, retailers give it away. Might that be the case with other products in 2022? For some it will, but it will be many months, or even years, before some shortages are resolved. Inflation is going to be with us for a while. The question is how much and for how long. Central bankers have underestimated the forces of inflation for a year.
As for interest rates, inflation is a factor, but any asset price is a function of supply and demand. While the Fed will be buying fewer bonds next year, deficits at both the Federal and state levels should decline sharply. The spread between rates in the U.S. and overseas markets is another important factor. European growth has lagged ours as many nations in Europe have battled Covid outbreaks. Rates across the continent remain largely negative.
Perhaps the biggest question, a hypothetical one now, is if the Fed is forced to choose whether to stimulate to bolster growth, or tighten to combat inflation, which would it choose? Right now, toning down inflationary pressures seems more relevant against a backdrop of GDP growth that might have approached 10% in the fourth quarter before the impact of the Omicron outbreak. But as growth inevitably slows next year, the question could become relevant, particularly if inflation remains stubbornly high. Everyone seems to assume that most supply chain issues will be resolved next year, but didn’t the Fed call inflation this year “transient” for many months? Like predicting long range weather, trying to isolate inflationary pressures 12 months hence is probably too difficult to determine accurately. The outcome will probably be the single biggest factor determining the outlook of markets in the year ahead.
Politically, inflation is rapidly becoming a major, if not the major, voter focus. In 2022, there will be many significant issues confronting voters, including the government’s role in the battle against Covid-19 and the coming court decisions on abortion. But the old saw is that Americans vote with their wallets. Higher wages are great, but if the benefit and then some is eaten away by inflation, voters will enter booths next November in a sour mood. Clearly, the Biden administration knows that, but it’s less clear whether it knows what to do about it. The Build Back Better bill, dormant for now, clearly adds to inflationary pressures, but much more modestly than Republicans suggest. Nonetheless, the optics of more Federal spending against the backdrop of persistent inflation won’t look good.
2022 looks to be a transition year. In some senses, that will be a positive. Covid-19 should be less disruptive a year from now. One couldn’t have said that a year ago. Indeed, while we are in the midst of the Omicron surge, economically it has been a year of forward momentum. More people are back to work, we are flying again, cruise ships are back in operation, and sports teams are close to normal schedules. We should be almost fully normalized in terms of activity a year from now.
Shortages will continue, but it will be a year of rebuilding inventory and supply chains. That is also good news. On the other hand, monetary stimulus will be reduced sharply, and Federal Covid-related handouts will disappear. Money supply growth, an engine for economic expansion, will slow. Hopefully, so will inflation. At the moment the calculus of these plusses and minuses is hard to decipher. It should come into clearer focus as 2022 progresses. Markets, as we all know, hate uncertainty. Thus, we get the volatility we have been witnessing so far in the fourth quarter. After three years averaging 20% returns, it’s hard to see how 2022 will be a fourth. Earnings growth will decelerate, and could fall further in 2024. Interest rates should remain low, at least early in the year. Nonetheless, the process underway now, purging some of the excesses out of the speculative end of the market, should continue. Perhaps no single stock demonstrates this better than Robin Hood, the trading platform that so many young retail investors embraced during the SPAC and meme stock peak. It is down over than 75% from its 52-week high and doesn’t look like it has hit bottom yet.
As for this week and next, trading should be light. There is no reason to bet against the normal seasonal Santa Claus rally. Tax selling is largely over, Omicron doesn’t appear as scary as first thought, and consumers are in a buying mood. A better barometer for the year ahead will be market performance in the first few weeks of January.
To everyone, happy holidays. Hopefully, it will be a time of joy and family gatherings for all.
Today Meghan Trainor is 28. Senator Ted Cruz is 51. Since we never publish on Christmas Day, we don’t announce birthdays then. So, I thought I would look a little ahead and see who celebrates a birthday on Christmas. Humphrey Bogart was born Christmas Day in 1899. Canadian Prime Minister Justin Trudeau will turn 50. And your favorite parrot head, Jimmy Buffett, will turn 75.
James M. Meyer, CFA 610-260-2220