Year-end predictions tend to be futile, and accuracy rates tend to be low (or results random). But keeping tabs on more important issues can be helpful. Several items remain in a status similar to 2020-21, while progress seems to have been made in others.
- Covid. Just as immunity rates from both vaccinations and infections have steadily ticked to higher levels as a percentage of the total population, and reopenings have continued, a reemergence of delta variant cases in recent months and a new omicron variant in recent weeks have threatened this optimism. While the omicron variant is under intense study, and it’s difficult to make early conclusions, there are some glimmers of hope that it may generate less severe illness, despite being far more contagious. Regardless, it also appears an mRNA vaccine recipe could be quickly adapted to fight it, if needed. Regulatory approvals would represent the most time-intensive part of the process. If omicron is indeed less severe, one positive is that the new strain could ‘crowd out’ cases of the currently dominant delta variant. However, the fact that omicron may have emerged from just one person with a long-term case, or an animal carrier, is a reminder that the pandemic isn’t over, with the potential for surprises continuing. The increasing base case opinion is that Covid will change from pandemic to endemic—we’ll just have to live with it, as we do the flu. That brings the good news that it should provide fewer shocks to the global economy and daily life assuming that new, dangerous strains don’t emerge and spread. This evolving threat could keep markets on edge to some extent for an unknown stretch of time, just as in 2021. What is the ultimate financial risk? That cases rise to the point of filling hospital beds and straining medical capacity, which local governments have used as a benchmark for business and mobility lockdowns, effectively shutting down economic activity.
- Inflation. High prices of 2020-21 have been blamed on two primary culprits: (1) supply chain and logistical bottlenecks, where high demand for consumer goods has run up against delays in manufacturing and transportation of these goods; and (2) a surplus of cash from government fiscal stimulus payments and hoarded savings during the pandemic shutdowns. There have been signs that bottlenecks are easing, although the backups of anchored ships, stored containers, trucking delays, etc. remain at high levels. Based on comments from company managements and other sources, while some backups are expected to alleviate, others (especially more complicated items like semiconductors) may persist even into 2023. However, these disruptions haven’t ruined Christmas en masse. Economists continue to debate the near- and long-term impact of all this fiscal stimulus having entered the money supply. Inflation might seem the obvious result if this scenario were described in an economic textbook, but the question is how much is being spent vs. saved, and the size of the economic ‘hole’ needing to be filled before the ‘excess’ turns into persistent higher prices and wages. It’s not easy to separate the current two inflation inputs, at least until supply problems improve. However, the rising likelihood of the Federal Reserve speeding up their tapering efforts implies that longer-lasting inflation is being taken more seriously as a threat, with rate hikes being the next move.
- Jobs. Labor markets have repaired sharply since the depths of the early pandemic. But, hurdles remain in getting to the magical place of ‘full employment’—one of the Fed’s mandated goals. Why is this so difficult? This remains a current mystery among economists. The statistics point to a variety of influences, such as baby boomers on the cusp of retirement simply not bothering to return to the workforce, workers reevaluating their lives during a time of uncertainty and quitting unsatisfying jobs, high stimulus and jobless benefits allowing potential workers to boost savings and delay returns, continued child care and family responsibilities, continued aversion to Covid, and rising self-employment and ‘gig’ economy work (which is harder to measure through government statistics). Jobs stats are expected to improve, but the timing remains fluid. Measurement of labor markets is also imprecise and at a lag, which is another problem. The abundance of available jobs versus willing workers has driven up wages at least a bit, and even re-strengthened labor union activity to some extent, which had been in decline for decades.
- Federal Reserve monetary policy. As their mandate is in keeping with the two prior items, policy is evolving from ‘accommodative’ toward ‘neutral’ (as bond purchases are tapered down to zero), and eventually to ‘contractionary’ (assuming 2022 features at least 1-2 interest rate hikes). The Fed has been criticized in some circles for not being fast enough in ending tapering and starting to raise rates, due to the strong inflation impulses. Instead, they’ve held fast to their ‘transitory’/‘temporary’ language, believing that supply issues are at the root of high prices. It’s important to note that, from a long-term policy basis, the Fed would prefer a bias toward stronger inflation (which they believe can be handled through monetary policy, i.e. higher rates), to deflation, which is more difficult to tackle through monetary means.
- Interest rates. Nominal rates are a factor of a real yield plus inflation. As described in their summaries, the Fed’s long-term fed funds rate assumption is accordingly set at 2.5%, which is their inflation goal of 2.0%, plus an implied 0.5% real yield. This will take time to reach, considering we’re currently at zero. (By the way, financial markets are less optimistic than the Fed, pointing to 1.5% as a terminal fed funds rate.) The interest rate policy the Fed would ideally like to ultimately see is ‘neutral’ if conditions otherwise are in balance, which implies rates are neither expansionary (gas pedal) or restrictive (brake pedal). This is a moving target, though, so we rarely tend to ever get there precisely, or at least for long. But the Fed would at least like to begin the process, and this means moving away from the extreme emergency accommodation that zero rates imply. This looks increasingly inappropriate in a period of high inflation, temporary or persistent. On the downside, sharp rate increases have been historically negative for stocks, real estate, and other risk assets, due to their impact on financing costs and present values of future cash flows. In fact, the Fed has exacerbated recessions in the past by being overly aggressive and going too far. But, a slower ‘normalizing’ rise, such as a quarter-percent at a time, over the course of a few years, may be far less impactful and allows financial markets to gradually adjust.
- Fiscal stimulus. The first infrastructure bill ($1.2 tril. for roads/bridges/rail) having passed was important from a physical structures standpoint and releases a high degree of spending into the economy. The second bill (Build Back Better), with a social program focus, has been far more politically problematic. The price tag has already been negotiated downward (so far $1.75 tril.) with the timeline also being pushed out (possibly to December 31 or into early 2022) as the Senate debates fine points of policy and ‘pay for’ tax increases. Per some political strategists, the longer this process takes, the higher the probability of possible failure completely, considering 2022 is an election year. Americans as a whole don’t appear to know what’s in the bill, or how it affects them, but do know it’s expensive. Senator Joe Manchin, for one, who represents one of the key tie-breaking votes, has become increasingly negative on the bill in recent comments—pointing to the high price tag and potentially negative impact on both inflation and debt levels.
- Mid-term elections. Speaking of which, perhaps due to the back-and-forth over the infrastructure bill, Covid policy, and other partisan politics have led to President Biden’s falling approval ratings. These, combined with a surprise Republican win in VA’s governor’s race has odds of Republicans picking up Senate and Congressional seats in Nov. 2022. This would either close the Democratic majority gaps in the House and Senate, or reverse them entirely. This puts a damper on the current agenda. This mid-term reversal isn’t unusual by any means, but does close the window for the current administration to get their policy goals moved ahead. It’s safe to assume more Republican seats would remove pressure from tax hikes, raising net earnings, which is an outcome financial markets would be happy with.
- Equity valuations. These are no doubt high, by a variety of measures. The inputs of low interest rates, and the evolved composition of the stock market (dominated by low capital intensive-sectors like technology and communications), as well as ‘TINA’ (there is no alternative, to stocks that is) have been contributors. If interest rates rise substantially, bonds become a more attractive asset, and the input negatively affects equity valuations. However, equity prices follow earnings over the longer-term, so growth broadly has been a ballast for markets—with a recession typically being the most feared near-term threat. If investors move away from a U.S.-only view, though, foreign assets offer more attractive valuations in keeping with their cyclicality, more uncertain growth rates, and depressed sentiment. This is particularly true in emerging markets. Diversified asset allocation portfolios are obviously far less sensitive to single asset classes focused on most by the media (Nasdaq, ‘FANG’ stocks, etc.).
- Global economic growth. Since March 2020, paths of growth have been largely dictated by national/state policies of being open or closed in response to Covid. As we’ve learned, it’s a lot easier to close an economy than to open it again, particularly after several months. But the global economy has generally reopened, despite a few exceptions, with some sectors moving back toward or stronger than pre-pandemic trend (digital), while others have yet to get back to normal (travel/recreation). The strong reopening gains based on base effects of ‘zero’ activity peaked around Q2 2021. Growth levels since are expected to remain higher than average, but since affected by Covid variant outbreaks (delta in Q3, and likely now omicron this quarter and perhaps also Q1). This pent-up growth didn’t go away, but has been pushed into 2022, and may last another few quarters. However, by 2023, it’s expected that economic growth rates may settle back to their long-term normal level, which is 2-3% in the U.S.
- Climate change. This is an environmental and political issue, in a separate sphere, but does have economic ramifications. There is no doubt that global industrial and consumer activity is moving in a greener direction, particularly in Europe. Notably, it’s been pointed out that continued volatility in petroleum markets may persist due to a weakened transition ‘buffer’—such as pipelines taken offline, and a drop in exploration activity—causing petroleum supplies to fall off when they’re most needed. This leaves less room for error as short-term demand rises and falls, resulting in price dislocations, and OPEC+ again gaining pricing power. (That had reversed somewhat as North American shale production raised supply potential over the last decade or two.) Otherwise, ESG investing has become more institutionally popular, which tends to raise demand for ‘growth’ stocks (as ‘dirtier’ materials and energy are often excluded), with a heightened focus on technology, communications, and health care.
- Geopolitics. This is always the wildcard, with the political environment loosely related to the economic. Current areas of concern are China’s increasing aggression in the Pacific (especially rhetoric concerning Taiwan), Iran’s uranium activities, as well as the Russian military build-up at the Ukrainian border. Either a purposeful event or diplomatic accident has the potential to dial-up broader uncertainty, which often leads to short-term market volatility.
- Positive takeaway. Despite a difficult two years and great human toll, the rapid creation of effective vaccines and therapeutics for Covid have been described as ‘medical miracles’. Having been ill-prepared for a pandemic, the global economy has proven itself to be surprisingly resilient and adaptable. No doubt some lessons have been learned to make improvements in a variety of industries, from supply chains to education. It just may take time for the dust to settle to appreciate it.