Fifth Third Bank breaks down projected economic outlooks and market trends for the U.S. economy in 2022.
- U.S. economy will continue to grow, but face structural challenges created by the lockdown and policy responses
- The labor shortage and supply chain issues will persist, although both conditions will improve noticeably in the year ahead
- Inflation will show some signs of abating, but Fed policy will shift from seemingly unlimited patience to the start of rate hikes
- We believe that Investors will see continued gains in equities, bond investors will face challenges and portfolio returns will on average be positive but muted
By Jeff Korzenik, Managing Director, Chief Market Strategist
In some of our public discussions we have observed that the first phase of the business cycle has passed as the U.S. economy has successfully regained the ground it lost during the preceding downturn. By the end of the 2nd quarter, GDP was above pre-pandemic levels. At this point in the business cycle, the American economy must forge a new path, not simply recover with what was lost in the 2020 recession. That means that the business community and investors must confront the structural damage to our workforce, our supply chains, our federal balance sheet, and our expectations of price stability. This reckoning will influence economic growth, government policy and investment outcomes.
The good news is that there is ample support for continued growth in 2022: expansive fiscal policy, stimulative monetary policy and $2 trillion in excess money market mutual funds. Even the expected withdrawal of some of the monetary stimulus (as outlined by my colleague Claire Ellerhorst, below) will still leave us with a supportive monetary policy—interest rates well below the rate of inflation—for the next several years.
To note that the U.S. will likely continue to grow is not to say this growth won’t come without challenges. The primary challenges with which we must reckon are the disruptions to the supply chain and to the labor market. These are outgrowths of both the pandemic and the policy response to the pandemic. The lockdowns changed consumption patterns, creating a surge of pent-up demand once a semblance of economic normalcy was restored. This avalanche of spending for consumer goods was further fueled by the generous government transfer payments (stimulus checks, for example) of the past two years.
The larger issue is a labor market that was upended by the pandemic. The labor shortage has certainly contributed to the supply chain problems, but poor workforce growth is a fundamental constraint on all economic growth. The decline in birth rates decades ago and the expected retirement of Baby Boomers has long argued for a labor shortage that would have a gradual impact, but the pandemic made this an immediate problem. Older workers accelerated their retirements, some two-income households elected to become single income households with a stay-at-home parent, and millions of workers have needed additional time to land a job due to mismatches of skills, geography, or pay expectations; the pandemic changed the type of jobs demanded faster than the workforce could adjust.
We view the dual challenges of supply chain and labor shortage as issues that time will, at least in part, heal. Supply chain logjams are already showing signs of easing, both because some of the one-time surge in demand is being satiated and because of policies and procedures that are successfully combating the logistics problems (e.g. adding a third shift at California ports, improved container movement and storage). Similarly, millions of unemployed workers, now without federally augmented unemployment benefits, appear to be facing up to the tough choices of accepting a job that did not fit their initial criteria. Just as importantly, employers are accepting the inevitability of a less abundant supply of workers, and the business community is investing in nontraditional talent and making accommodations to attract the workers they need.
The benefits of workers returning to jobs would normally mean above-trend growth, but in this instance, consumer buying power had already been augmented by government subsidies, so newly earned paychecks will not have as much impact. We still argue that the net result will be good growth, above the longterm potential growth rate of 2% real annual GDP growth, but likely falling short of consensus expectations of GDP gains of 3.5% or more. While continued growth is of course, everything being equal, a positive for stocks, my colleague Tom Jalics below shows how actual performance is more nuanced, given the state of expectations and valuations.
Inflation and the Fed
By Claire Ellerhorst (Rubin), CFA, Private Bank Investment Strategist
The impact inflation may have on the policies of the Federal Reserve Bank (the Fed) is on the mind of investors as we enter 2022. The Fed is targeting inflation that averages 2.0% over time, reflecting a willingness to allow inflation to run higher and labor markets to run hotter by keeping interest rates lower, for longer. The Fed’s preferred measure of inflation is core Personal Consumption Expenditures (PCE), which was 4.1% year-over-year in October 2021. While this is well above the 2% target, the Fed is operating on a new monetary policy framework which says they are willing to tolerate inflation above target for an “extended period of time.” We believe the Fed is comfortable with this new policy and that they will not react very quickly to the rise in inflation. Although the Fed is backing away from using the descriptor “transitory,” the central bank still largely assumes that price increases will moderate over time.
At Fifth Third, we believe there is some complexity to the factors impacting inflation today. While the U.S. economy continues to emerge from 2020’s recession, economic output remains below full capacity as evidenced by low labor force participation (61.6%) and low capacity utilization (75.2%). Until the economy and labor markets begin to run hot (i.e. pushing against these capacity constraints), long-term structural inflation should not materialize. Further, the last 20 years have witnessed macro trends such as globalization, technological advances, and an ageing population that have put downward pressure on inflation. While these conditions remain present today, globalization is fading as a disinflationary force, and the complexity of the global supply chain is contributing to near-term inflationary pressures. While we agree with Fed officials that inflation will moderate in the intermediate term, we believe we will see a new baseline inflation that is higher than it has been for much of the past 20 years.
What does this mean for Fed policy? The Fed is beginning to unwind some of the emergency measures put in place during the COVID-19 lockdown of 2020, but monetary policy today remains supportive of economic growth. The Fed announced it would begin tapering asset purchases in November 2021, a move that was well telegraphed to market participants. In addition to their price stability mandate, the Fed is committed to driving unemployment to pre-pandemic levels in a “broad and inclusive manner,” recently commenting that U.S. labor markets remain far away from the Fed’s goals. With labor markets far from goal, and a willingness to tolerate temporary increases in inflation, current conditions support our view that short-term interest rates will remain low over the intermediate term. Given all this combined, we expect two short-term U.S. Fed Funds rate increases in the second half of 2022, after the Fed concludes its asset purchase tapering program
By Thomas Jalics, CFA, Chief Market Strategist
The combination of unprecedented global monetary and fiscal stimulus, in concert with a global COVID-19 vaccination program, has led to a rapid recovery in global economic growth in 2021. Financial markets have been buoyed by these same factors as many global equity indices now sit near all-time highs, and global intermediate term sovereign interest rates have recovered to near pre-pandemic levels. As we enter 2022, investors will encounter an environment that includes low interest rates (thus a low cost of capital), increasing global vaccination rates, and broad economic and company specific fundamental data that continues to improve from 2020’s trough, driven by a surge in consumer demand. While most major global central banks are beginning to unwind their emergency liquidity programs, the US Fed and its major developed market brethren, remain dovish, maintaining near 0.0% short-term interest rates, likely for at least the next several months (see Claire Ellerhorst’s section titled “Inflation and the Fed”). This environment is likely to persist throughout 2022 as we view the global economy to be in the early stages of a new economic expansion. If past is prologue, these economic expansionary periods typically last for many quarters and many years, arguing for a continued bullish stance on equities and a modestly bearish stance on fixed income over the next calendar year.
However, the outlook for investors is not clear-cut. There are many bricks in the Wall of Worry for investors to consider with the largest brick being the threat of inflation. Recent global inflation readings appear to be a bit more than “transitory” in nature. Continued higher inflation readings over the next several months may slow global economic output, force global central banks to abandon long-standing dovish policy stances, and may cause additional volatility in financial markets. The pace of economic activity and inflation over the next several quarters will determine the sustainability of the economic environment as well as the prospective returns of financial markets. In addition to inflation, investors will encounter additional Wall of Worry bricks in 2022 that include the Delta and other COVID-19 variants, supply chain and labor market bottlenecks, global central banks becoming marginally less dovish, China’s regulatory crackdown, and stretched global equity valuations. All of these bricks have the potential to add to financial market volatility over the coming year.
While acknowledging these risks, for investors with the appropriate risk tolerance and time horizon, we continue to recommend remaining constructive on the Equity asset class. We expect global equity returns to climb the Wall of Worry and be positive in 2022. However, given the tremendous global equity recovery over the past 18 months and lofty current valuations, prospective expected equity returns are likely to moderate and revert to longer-term historical averages in the mid-single digit range. As we begin 2022, we favor high quality (strong profitability, stable earnings, strong balance sheets, and growing dividends), shorter-duration stocks with a modest bias towards value over growth, and a modest domestic bias.
For Bond investors, economic growth and inflation are likely to continue as the effect of monetary and fiscal stimulus measures on the global economy persists. This will put upward pressure on intermediate term global sovereign and corporate bond yields, making intermediate term bonds less attractive (relative to equities) on a portfolio basis. However, global central banks continue to provide liquidity to the sovereign and other credit markets in an effort to keep credit flowing to consumers and businesses, exerting downward pressure on intermediate term bond yields. Finally, much lower sovereign yields exist in Europe and Japan, relative to the U.S., which may push capital into U.S. Treasuries, limiting domestic interest rate increases. We maintain that these competing factors will ultimately cause global intermediate term interest rates to grind higher, but limit runaway interest rate increases. To contextualize this notion, our view is that domestic interest rates are likely to move higher over the next twelve months, eclipsing 2020’s high on the 10-year U.S. Treasury of 1.74%, while yields in excess of 2.50% on the 10-Year U.S. Treasury over the course of 2022 term appear unlikely. A good proxy for expected fixed income returns will likely be an investor’s entrance yield level for most fixed income subcategories. As we enter 2022, we favor high credit quality, shorter duration domestic fixed income, with modest allocations to high yield debt and the fixed income related categories.
Finally, allocations to Cash can help reduce portfolio volatility and preserve capital. However, with the Fed Funds rate at the lower bound (0.00%-0.25%), essentially 0.0% money market rates, rising inflation expectations, and a constructive global economic backdrop, our view is that more attractive opportunities exist in risk assets and in particular, the Equity asset class.
Note: The content in this article is based on Fifth Third’s current assessment of global markets and economic signals. It reflects the same ideas shared in conversations with Fifth Third clients, but does not constitute investment advice.