How high will inflation go, how solid is the economy, and how aggressive will the Fed be in raising rates? Those are the questions as we enter 2022 and the post-pandemic world.
In this commentary, we outline the three things we believe will shape the answers to those questions. We also review how we believe portfolios should be positioned today.
Bottom Line Messages
- The strength of the consumer and corporate earnings should weather reasonable tightening through the year, as rates remain historically low and the wealth picture is solid. This should be favorable for equity investors, and the rotation into higher quality cyclicals and small stocks should continue as rates rise in a healthy economy.
- That said, inflation pressures are mounting, arguably requiring an aggressive response from the Fed. Strength of consumer demand, supply constraints, and debt relative to inflated assets will shape the course. Speculation about a slowing economy may make markets volatile, so investment discipline will be key to staying on track.
- We believe measured policy tools, along with natural reactions to higher prices, can keep inflation checked around 4% for the year. We think the bear case of hyperinflation and stagnation (1970s) is not the likely outcome, although we explore that scenario.
- Rising rates and inflation will continue to present a challenge for fixed income but should be good for real assets and manageable for equities overall.
Introduction: The Jolt in January
Two pieces of news started 2022 with a bang. First, investors learned the Fed may be more aggressive fighting inflation, meaning expectations for rates may be too low. Second, the monthly jobs report highlighted how tight labor markets are, showing inflation may stay elevated.
With this news, the yield on the 10-year Treasury surged to its highest since the pandemic started, and the Big Tech Nasdaq 100 index is off about 6% since the Christmas holidays, as rising rates make the value of their long-term growth less attractive. The bond yield curve is steepening—an indication of improving economic sentiment—and investors are trading into stocks that benefit from recovery, such as banks, energy producers, industrials and other “value” stocks. Markets overall are down, but important parts of them are up.
While we believe this positioning is ultimately correct, we anticipate the journey for investors through the year will be volatile. 2022 will likely be the year the Fed and other central banks take major steps to unwind their unprecedented stimulus for the economy. This is a complex and unpredictable process, which will involve a lot of speculation.
A wealth plan, governed by discipline and objectives, will be as important as ever, so that you stay on track.
What Will Shape the Outcome
As the Fed unwinds its monetary support, the wildcards for investors are INFLATION and the DIRECTION OF THE ECONOMY. They will be determined primarily by three things, in our view:
- The state of demand of the US consumer
- Supply constraints across key components of the economy
- The relationship of debt and asset prices at both the national and household levels
State of Demand
Will demand disappear or will it sustain as the Fed removes stimulus?
Initial answer: Demand should temper but not disappear.
We saw a lot of pent-up demand as pandemic lock-downs moved to recovery. The US consumer had steady income, high savings (over $2 trillion), and growing financial wealth from investments (about $25 trillion). They spent readily on goods, travel, leisure, and homes.
A nagging concern is that this demand was boosted temporarily—that once stimulus subsides, demand should slow down. No stimulus has been removed yet.
While early, we see emerging signs that consumer demand is expanding, boosted in three ways:
- A shift from “lock down goods” to broader services as the economy recovers. Even as demand for those goods subsides, it may move to other underused areas.
- Increased activity as successive strains of Covid are less severe.
- A resumption of credit usage.
From our perspective, consumer spending is stronger than expected and should accommodate reasonably tighter policy, supporting GDP growth of perhaps 4% and corporate earnings growth of 9% or more this year. This would be positive for investors and may explain why the yield curve is now steepening (economic optimism) and real rates are rising. This should be particularly good for cyclical stocks globally if it continues.
Persistent Supply Constraints
If demand expands, can supply keep up?
Initial answer: Demand should exceed supply in key areas, adding to inflation pressures.
Has stimulus created so much demand that supply cannot keep up, even if supply chain issues are addressed by summer? We start 2022 with greater concern.
The housing market offers important clues. Inventory is low, borrowing rates are low, and labor markets are tight. Demand for housing is likely to remain above supply as long as the economy remains healthy.
Likewise, the labor markets are showing major imbalances. Unemployment is now below 4%, and job vacancies (unfilled positions) are rising. The participation rate is strong among 25-54 year olds, and it appears that older workers have permanently left the market. Wage growth is growing 7-8% annually, and it doesn’t look like a balance will occur in 2022.
Many service sectors of the economy have not spent aggressively on capacity and inventory—a product of low growth before the pandemic, but accentuated even more by Covid. Their ability to serve strong demand may create supply challenges in new areas.
All-in, supply constraints may well persist for the year, driving prices higher and presenting a challenge to policy-makers regarding inflation. This poses a risk to investors, if the gap between demand and supply is enough to alarm policy makers that inflation must be stopped aggressively.
Debt and Asset Prices
If assets deflate (“bubbles pop”), where is debt a problem?
Initial answer: Some areas have deflated a bit; we don’t suspect systemic risk yet.
The initial good news entering 2022 is that the behavioral bubbles we saw last year—meme stocks, digital currencies, unprofitable tech companies—have deflated meaningfully over the past few months.
On the debt side of the equation, retail investors opened margin accounts at record levels last year, but we don’t yet see evidence that meeting margin calls has presented broader risk to the system.
More broadly, the risk would be that if stock markets and housing markets drop in value, does it create a liquidity crunch? Inflated asset bubbles and high debt levels are a bad combination. We do not see that as a meaningful risk yet. We do not think US stocks are in a bubble.
While we don’t consider housing to be in a bubble either, we believe a meaningful slowdown in housing activity due to rising rates would create volatility in the markets.
The same debt-asset dynamic could apply to national debt levels for the US and other countries. We do not think this is a 2022 issue, and we’ll point out that as rates rise, global demand for Treasury bonds should likely remain strong, helping to keep long-term rates in check and support re-financing.
Implications and Outlook
Integrating our read on demand, supply, and debt-to-assets, we believe that:
- Inflation pressures will be greater than expected, forcing the Fed to commit to rate increases in March and meaningful tapering.
- Consumer demand will decelerate naturally in response to higher prices, more expensive credit, and less liquidity. It is to be expected.
- Still, the strength of the consumer and corporate earnings should be able to weather this environment, given that rates remain historically low and the wealth picture is solid.
The risk to our outlook is that:
- Labor and housing markets are so imbalanced that they cannot clear fast enough, meaning prices risk escalation into hyperinflation.
- The Fed is too aggressive in response by withdrawing stimulus and raising rates quickly, potentially choking off demand in the process… which could be worsened if new variants of the pandemic emerge.
- Investors do not see evidence of sustained economic growth, even as inflation is rising—giving way to fears of stagnation or stagflation of the 1970s.
We believe it is important for the Fed to remove stimulus from the economy as the pandemic recedes, since it is arguably distorting rates, risk assessment, and economic decisions. Higher rates can be productive, supporting savings and taming asset bubbles. Under reasonable scenarios, we believe the consumer, credit markets, and corporate profitability should remain solid as rates rise.
We recognize, however, that unwinding the current level of monetary stimulus is unprecedented. There is room for policy mistakes and misinterpretation. With the complexity, we believe markets will be volatile in the face of uncertainty regarding inflation and economic growth.
The best way to address uncertainty is not to react to headlines or try to predict outcomes. Instead, the best path is to have a disciplined investment plan that matches your risk tolerance and strives to balance your current and future spending needs.
As a final comment, markets are inherently volatile. It is impossible in our view to avoid the inevitable swings, whether to the upside or downside. A diversified plan that seeks to incorporate a mix of investments across equities, fixed income, real assets, and alternative strategies offers the best solution for the long term, in our view.
 Removing stimulus would come in the form of slowing bond purchases (“tapering”), buying bonds back (cleaning up the Fed balance sheet of $8.8 trillion), or raising the fed funds rate.
 This contrasts with the second half of last year, where the yield curve was starting to flatten. Investors were pushing short-term rates up (expecting the Fed to raise rates) and long-term rates down (indicating economic concern, especially if the Fed were too early or too aggressive). A flattening yield curve is not necessarily a bad omen—but history shows that an inverted curve (no longer upward sloping) tends to foretell recession. Recall that the shape of the curve measures the difference between long-term rates and short-term rates.
 At 21-times earnings for 2022, stocks as measured by the S&P 500 index are not cheap—except relative to bonds and their historically low yields.