Stocks drifted sideways yesterday in light holiday trading. More of the same can be expected for the rest of this week unless we receive some unexpected news. Over the past week or so, stocks have moved higher, recovering most of their early December losses. While Omicron will cause some near-term economic disruption, it looks like infection will peak in January and decline rapidly soon after. While the numbers of infected are scary, the spike in hospitalizations and deaths has been very modest. Economic values are determined by the present value of future cash flows. A few extra disruptive months won’t make a whole lot of difference. The 8.5% jump in holiday sales strongly suggests that, from an economic viewpoint, we collectively learned to deal with such disruption rather easily. Yes, many are working from home again and schools may be virtual for a few weeks in January. But domestic ticket sales for the new Spiderman movie demonstrates rather dramatically that those under 40 aren’t very fearful of the disease.
As we look toward 2022, the year is likely to end on a strong economic note, despite Omicron. Fourth quarter GDP, before inventory adjustments, is likely to grow 6-8%. With inflation also in the 6-8% range, nominal GDP will grow about 13%, maybe even a bit more. Since corporations report sales and earnings in nominal dollars, this is all great news. Indeed, look for more earnings upside surprises when reports start flowing in mid-January.
While that is good news, economies work best when there is balance. If supply exceeds demand, or demand exceeds supply, prolonged imbalances create chaos. Too much demand creates supply shortages. It pushes prices higher. Our money supply has been growing persistently at a 13% pace for months. That matches the current pace of GDP growth. It also supports 7% inflation. The Fed is tapering its pace of bond purchases, but tapering still means several hundred billion dollars of stimulus pushing through the economy at a time when inflationary pressures and supply constraints are elevated. Economists will tell you that it takes about a year for the full impact of stimulus and restraint to be felt. That strongly suggests that even if one believes the consensus that both growth rates and inflation will moderate as 2022 moves on, it is hard for many to believe that supply chain disruptions will be largely gone in a few months. The same forecasters who told us 6-12 months ago that supply chain problems would be gone by the end of 2021 are now saying maybe by the end of 2022.
Let me look at the problem another way. In 2021, the Census Bureau said our country’s population grew by 0.1%, a result of fewer births, an elevated number of deaths, and a sharp decline in immigration. Yet in real terms, the economy grew much faster, probably over 5%. That means that every man, woman, and child in this country bought 5% more, in real terms, than they did a year earlier. They did that mostly by taking advantage of government handouts. In some cases, they dipped into accumulated savings. But that isn’t sustainable. While the savings rate has fallen back to a normal pace of about 5%, bank and money market fund deposits are at record levels. Americans have accumulated massive amounts of money. In part, this came from higher income. In part, it came from stock market gains and higher home prices. In part it came from the inability to spend for reasons related to the pandemic.
On one hand, those dollars will support more spending in 2022, but with inflation elevated, those accumulated dollars won’t be able to buy as many goods. The savings cannot earn money to offset the rise in inflation. Deposits earn only a tiny fraction of a percentage point, while inflation eats away purchasing power at a 7% pace. Owning a home or stocks have made up the difference and then some for many, but it is hard to expect both home and stock prices to keep rising at a 10%+ annual rate unless inflation stays elevated or even rises further.
Obviously, the Fed sees this. That is why tapering was accelerated in January and three 25 basis point rate increases are expected later in 2022. But even if the Fed Funds rate gets to 1% before the end of 2022, borrowing in real terms will still carry a negative cost. Inflation incentivizes us all to spend now before the value of our saved dollars evaporates.
So why are most professional economists still supporting a consensus conclusion that inflation will moderate to 3% by the end of 2022 and that supply chain issues will be resolved by the same time? Perhaps it is because inflation hasn’t been present for over 30 years. Perhaps it is because economists underestimated the impact of Covid-19 variants. I noted earlier that Omicron’s impact shouldn’t be long lasting, but we all see the spike in infections. That will further disrupt efforts to unsnarl supply chains. Homebuilders are still seeing construction cycles lengthen. Car production has been flat for months. Anecdotally, there are few signs yet that supply chain issues are getting resolved.
We all learn to adapt. We repair older cars because we can’t find a new one. If certain food prices skyrocket, we buy something else. But then the something else faces short supply. One problem gets solved; another appears.
The problem right now is simple, it is too much demand. Too much demand makes me smile if I own a home that I might consider selling. Owning any asset of value usually benefits in inflationary times. But it also means the dollars we have saved and the dollars we are about to earn won’t be enough to offset the demand driven inflation. The “cure” will be demands for higher wages. That has begun and the trend is accelerating. Can the Fed solve the problem by simply easing off the accelerator? That is the big question for 2022.
Bringing this all down to numbers, I expect 2022 revenues and earnings to exceed expectations, largely because I expect inflationary pressures to remain for longer than currently forecasted. All the Internet forces that have given buyers the ability to shop for the best price matter a lot less when suppliers can’t deliver the goods. I also expect real growth to remain stronger than normal as the Fed continues to stimulate early in the year and some supply chain issues get resolved during the slower winter and spring months. On the other hand, even allowing for some correction in commodity prices fueled by temporary shortages, I see inflation higher than 3% by the end of 2022. Interest rates will remain low early in the year, a function of central bank stimulus continuing worldwide, and less Government borrowing due to a spike in expected tax receipts related to higher income. But rates won’t stay low if inflation is more persistent than forecasted. The Treasury may be able to manage money supply growth down from 13%, but it will take time for the impact to be felt.
I want to be clear that I am not forecasting the kinds of inflation we saw in the 1970s. But, at the same time, that is possible if the Fed doesn’t get out in front of the battle to control inflation before it gets out of control. There is plenty of time to win that battle, but not an infinite amount of time. This Fed often seems more sensitive to keeping markets and asset prices elevated than to its primary mandate of maintaining price stability. At the start of the current inflationary cycle, there were sharp spikes in key commodities like lumber, copper, and oil. Although those prices are still elevated from their pandemic lows, they aren’t rising fast right now. But what is increasing are wage pressures, rents, and prices for a broad array of consumer goods. Inflation is rapidly becoming the political hot button. Runaway inflation prevented Jimmy Carter from winning a second term. Presidents Trump and Biden couldn’t talk away Covid-19, and Mr. Biden won’t be able to talk away inflation. If there isn’t a healthy moderation in the pace of inflation by Labor Day, Democrats will face a very difficult mid-term. Holding White House meetings with leaders of shipping terminals or auto manufacturers isn’t going to solve anything. The only way to slow inflation is to put a lid on the cookie jar and raise interest rates to a point where demand growth moderates. Yes, increasing supply will also help. Producers have incentive to do that. But the shortage of quality available housing won’t be cured in a few months. Nor will wage demands from workers decline.
Thus, for investors, we face a year where higher than expected earnings will be the tailwind, while higher inflation will be the headwind. Which wins will determine whether 2022 is another year of solid growth in the stock market or not. A solid year of earnings growth and a modest decline in P/E ratios will still allow for single-digit gains in stock prices. But if inflationary pressures are still elevated at the end of 2022, and by elevated, I mean something over 3-4%, then interest rates could be higher than currently forecasted, a drag on stock prices.
Today, Ted Danson is 74. Jon Voight turns 83.
James M. Meyer, CFA 610-260-2220