Every day the Bay of Fundy in southwest Nova Scotia sees a billion tons of water, more than the flow of all the world’s freshwater rivers combined, flow in and out twice a day. It’s the highest tide on the planet.
If the Federal Reserve stays true to its word, the U.S. economy will see a massive, once-in-a-century exodus of monetary stimulus this year. To paraphrase Warren Buffett, when this tide goes out, we may find out which financial assets are wearing bathing suits and which ones are swimming naked.
Financial markets entered 2022 with a tailwind of three spectacular years for large-cap U.S. growth stocks, many of them beneficiaries of Covid-19. The S&P 500 returned 31.5% in 2019, 18.7% in 2020 and 28.7% in 2021, a three-year string of numbers rivaling the late 1990s.
The underlying economy, however, is grappling with a series of crosscurrents that fog the crystal balls of even the most clairvoyant observers. Unemployment fell to 3.9% in December, a level normally seen only in the late stages of extended recoveries. Yet monthly job creation numbers have disappointed economists who expected the big bump in hourly wages to lure many Americans back into the labor force.
Paramount among all the wild cards in the 2022 outlook is how the economy and financial markets will react to the end of unprecedented monetary and fiscal stimulus. Some, like J.P. Morgan CEO Jamie Dimon, have proclaimed that the economy is strong enough to grow at 3.0% for several years and easily tolerate more than the three interest rate hikes the Fed has signaled. For the sake of comparison, real U.S. GDP averaged 1.7% from 2000 to 2020 and hasn’t reached a 3.0% annual growth rate since 2005.
Another camp fears that a fragile economy dependent on government transfer payments will slow in the face of a few rate bumps. Colin Robertson, chief investment officer of fixed income at Northern Trust Asset Management, sees inflation moderating to around 3.0% this year.
But over the next three years, it is likely to trend back toward the 2.0% level the economy experienced before the pandemic. “The fact that the Fed has thrown in the towel on the transitory [inflation narrative] is a good counter indicator,” he maintains.
Robertson’s contrarian view was not the dominant one in early 2022. But it’s worth noting that when the financial markets displayed pain in both the fourth quarter of 2018 and the first quarter of 2020, the Federal Reserve was quick to ride to the rescue. After the pandemic struck in March 2020, the central bank took the unprecedented step of purchasing junk bonds in the open market.
Averting A Slowdown
The Fed does have many options at its disposal. It may need to get creative to avoid inverting the yield curve and triggering an economic slowdown, if not a recession. Kathy Jones, managing director and chief fixed-income strategist at Schwab, wrote in a recent note to clients that a first step could be allowing maturing Treasurys and mortgage-backed securities (MBS) to roll off its balance sheet.
With the housing market booming, the Fed’s strategy of buying MBS has been widely criticized for adding fuel to an already hot market. If simply letting these bonds mature proves to be insufficient for cooling inflation, Jones notes the Fed could pivot and start selling long-term bond holdings. The central bank has plenty of bonds to sell. Since 2000, the Fed’s balance sheet has ballooned from 5% to a staggering 38% of GDP, a level many see as unhealthy.
Institutional investors are trying to gauge whether some of the economic shifts emerging in this decade could be even more dramatic. Phil Orlando, chief equity strategist at Federated Hermes, expects the Fed to raise its fed funds rate four times in both 2022 and 2023, taking it to 2.5%.
“The Biden administration and the Federal Reserve completely miscalculated inflation,” he says.
In retrospect, the notion that governments around the world could orchestrate a complete shutdown of huge areas of business activity and then reopen without disruption is proving to be fanciful. Orlando notes that, in recent months, average hourly raises have been rising at an annualized pace of nearly 7.0%. That rate actually may be transitory. In normal times, wage inflation of 4% can trigger recession concerns.