As we enter a new year, we identified numerous imbalances in the financial market, so we thought it appropriate to make “imbalances” our theme for our quarterly update. We will focus on the imbalances impacted by Covid-19, supply chain disruptions, labor market, interest rates, inflation, the Fed and more and what those imbalances mean for the economy and financial market.
How is Covid-19 and its variants impacting economic activity? Each wave and variant bring certain issues and nuances just like economic cycles. We know the case rate is much higher with Omicron and much more contagious, but the good news is the death rate is much lower than the Alpha and Delta variants which is why it likely hasn’t had as much impact on economic activity and has run along reasonably well since this variant came to the U.S.
According to the Centers for Disease and Control, 62% of Americans are fully vaccinated, but every time we get spikes of different variants it does have some impact on consumption and economic activity. For example, in December, retail sales were down 1.9% with a modest negative impact on sales and consumption. We also anticipate with schools closing and additional mask mandates that consumers might be spooked and stay at home and not consume and retail sales will also be negative in January.
Throughout the summer of 2021, consumer confidence went up, but when the Delta variant showed up confidence waned and then remained at an elevated level somewhat stable to where we are today—even with Omicron spiking. So, it could be a modest disruption but not a clear imbalance in economic activity.
Supply chain disruptions
Another imbalance that has been in the news almost daily is supply chain disruptions and the spike in demand that went up for consumer goods as a result of the pandemic and we anticipate this imbalance to continue for at least the next 12 months. These disruptions are not unusual following a recession. We saw a large gap of inventory versus backlog of orders in January 2005 and January 2009, however, we hit an all-time high in backlog of orders and a nearly all-time low of inventories this month—resulting in more imbalance than we’ve ever seen before and this will likely take a while to solve.
Today, unemployment is 3.9%, nearly reaching pre-Covid levels at 3.5%. We forecast that unemployment will come down to 3.2% by the end of this year. Why? Nearly 30% of businesses are looking to hire people and 50% plan to increase compensation to attract jobs to build positions. The imbalance is finding people to fill these spots. Anytime you have product or labor shortage and wage pressure it causes questions about inflation.
Over the last 40 years, inflation has, for the most part, been falling and today, we’ve broke the long-term trend dramatically which has really sparked people’s attention. In the last 3-7 years, inflation have been very low—almost too low according to the Fed. With supply shortages, labor shortages, wage increases, inflation is almost up to 5%—nearly 3% higher than the Fed’s target. Contrary to the Fed’s outlook, we believe the inflation is both transitory, persistent and permanent. For example, while used car prices went up 50% in one year, we don’t anticipate this to repeat year-over-year—similar to oil and lumber prices. But when you start to have a serious labor imbalance and meaningful changes in wages, that is sticky inflation which will likely not be as transitory as the Fed would like.
Rates are rising
The Fed has signaled a higher path for rates and we expect to see rate hikes three times in 2022 and four more times in 2023—getting market rates to nearly 2%. This move was not completely unexpected, but the real shocker was to the markets when this news was changed so quickly.
Something we haven’t talked about in a while is the difference between a tightening environment versus a tight environment and how that impacts asset prices and economic conditions. Just because the Fed is tightening does not mean rates are tight or restricted. So, what does a tight rate mean? You have to see if rates are above or below what the Fed says is the natural long-term target rate. Right now, the Fed says the normal, or equilibrium rate is 2-2.5% so even with these changes, we are still in normal rates. We’re entering tightening phrase, but we are not tight. Once the Fed starts to move, likely in the spring or summer time, there is a lag effect on economic variables—likely up to a year or longer when it really starts to impact economic conditions.
There isn’t a reason right now to be scared that what is happening with interest rates will damage the economy in any way.
We’re going to be living in a zone where rates are rising, which we haven’t dealt with in a while. There has been a lot of news about how quickly the 10-year Treasury yield moved, from 1.4% to 1.76% in a very short period time—which gets peoples’ attention because it impacts mortgages rates. However, we think as this path grinds along the 10-year will move up to 2% but shouldn’t be damaging to the economy or the markets.
Over the last 30 years, profit margins are at records highs which are significant drivers for stock prices which is why these numbers are so important. Historically, margins pull back during recessions and then you see a sharp recovery which is what has happened this cycle at 12% on margins which is a very healthy number. But what we expect to see is margins fall to 11%. So, margins are elevated due to high costs but still strong enough to drive markets higher because we expect earnings to be up 9%. As long as the economy is growing and healthy, earnings, margins and revenues should be up.
Over the past 20 years, valuations have been out of balance and at elevated levels. What drives an asset price is earnings and valuations so with 21x valuation it is out of balance. But when we compare cycles and different interest rate environments, we argue that valuations can come down a little bit, but we expect this to be offset by earnings growth to drive asset growth.
This year, we forecast 7-10% but do expect there to be corrections that will be driven by a 9% earnings growth. But we do expect more volatility this year due to imbalance from a lack of volatility, which is a concern, but doesn’t mean to sell your stocks. In fact, we argue that equity provides a higher return profile than other asset classes.
The risk right now to the equity market is if everyone is wrong about inflation and additional Covid waves drastically impacts consumer consumption—but this is not in our forecast.
2022 economic forecast
Fundamentals of the U.S. economy:
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