Taking Off the Training Wheels

• Abundant liquidity is poised to fade, monetary policies will tighten, and a drag from fiscal policy all means the coming year will be more challenging for growth and equity markets. What the receding tide of policy support reveals could create more uncertainty that will breed a year characterized by higher volatility.

• The good news is that the economic recovery is on solid ground. Corporate earnings growth will be strong and equity markets are poised to grind modestly higher despite rising interest rates that compress earnings multiples.

• The risk of more negative outcomes has nevertheless risen. Uncertainty will be driven by growing risks that inflation is less transitory than now being priced in, that central banks may need to tighten more aggressively, that interest rates rise more than expected, and that growth rises less than expected.

Taking Off the Training Wheels

The past two years was characterized by massive fiscal and monetary policy support. Growth rebounded sharply, equity markets soared, household balance sheets grew flush, and borrowing costs in real terms collapsed to record lows. Any semblance of volatility was repeatedly and convincingly kept at bay as trillions of dollars flooded the financial system. With central bank support “having our back” the ability to price risk became more difficult than usual and in many ways, from a purely markets perspective, it felt like the best of times. Inflation did surge to multi-decade highs. However, the market perceived this to be transitory, and still does, and with real returns on equities near historic highs it felt like an acceptable trade-off to the policies that generated those returns.

Now the training wheels are coming off. If a rising tide lifts all boats, what gets exposed when the wave of liquidity and accommodation move the other way? Fiscal policy was a huge boon to growth and liquidity in 2021 but will be a drag in 2022. Central bank purchases have already diminished and in the case of the Federal Reserve the $1.3 trillion injections into the system last year turns to zero by the end of Q1. The certainty of the past year is now giving way to more uncertainty in the current one. Some key questions on our minds is how far rate hikes go, the degree to which inflation is persistent putting monetary authorities behind the curve, the extent to which a stubborn refusal for interest rates to move higher gives way, and of course how well the global economy fares both with Omicron, and without it. We are the least concerned with the growth outlook. Nevertheless, taken together these uncertainties are a recipe for more volatile markets in 2022.

Monetary Policy & Inflation

Most developed market central banks (Fed, BoC, ECB) may be slow to the rate hike parade, but that parade is off and running nonetheless as seen in Chart 1 which captures the net number of central banks raising rates relative to those lowering them. That number stands at a 10 year high. The Fed is expected to follow suit in Q2 2022 with the market currently pricing in 3 rate hikes this year, the BoC perhaps sooner and with more tightening; the ECB later and with less. In the case of the Fed and the BoC the urgency to do so is clear. Growth is robust, inflation is at 40-year highs, and the level of monetary stimulus is still at a record high judging by real policy rates which have now hit a record low -7%! Real investment grade and high yield rates are similarly at record lows. Rarely have we seen such a gap between policy and reality. The risk has risen that more aggressive policy tightening looms and in the past that has been a recipe for a very negative outcome. This will be a source of uncertainty in 2022.

Inflation will drive this uncertainty. The good news is that base effects indicate prices in Y/Y terms will decelerate over 2022. This deceleration will be supported by easing of supply constraints in goods (underway), and by a credit impulse in China that is at multi year lows which has been a good leading indicator of key commodity input prices. Nevertheless, inflation risks are very much intact. Goods inflation may give way, but service inflation, which is the bulk of the CPI, has yet reared its ugly head. Moreover, supply constraints are not confined to goods. The bounty of cheap global labor is over, and in the US labor shortages will persist pushing wage inflation higher. If inflation continues to surprise to the upside and show signs of persistence, then the policy balance will tilt decisively to fighting inflation at the expense of nurturing real growth.

Growth outlook

Global growth will be modestly lower in 2022 but remain comfortably above real potential GDP. In the US, growth is expected to be around 4.0%, twice the rate of potential GDP. The underlying metrics for growth remain, for lack of a better term, sensational. Household balance sheets have never been so pristine, debt service so low, net worth so high. Consumption will remain strong and assuming Omicron related economic shutdowns are averted, we expect the baton to pass from goods to service consumption which remains well below its pre pandemic trend. Pent up demand for capital investment among corporations whose balance sheets also look flush will pad growth further. In the absence of a covid shutdown or geopolitical shock (think Taiwan, Ukraine) global growth prospects in 2022 look firm, especially in the US.

Fixed Income & Equities – Real Perspective

Less accommodative financial conditions would be magnified by higher yields. We can animate the potential

Over successive quantitative easing (QE) regimes real US rates have tracked well below potential GDP, as seen in the top chart. If growth is strong and QE liquidity injections are ending, real rates should move higher. Higher rates are not a good recipe for owning fixed income. It is also not helpful for equity multiples even if earnings growth is robust. Higher interest rates alone, however, are not the killer of bull markets. Higher interest rates and persistent high inflation in the teeth of slow growth is what kills bull markets. In 2022 the bull market will persist as growth remains firm and inflation risks ease.

That is not to say equity markets are a screaming buy. The real earnings yield is close to 40-year lows as demonstrated in the second chart, and at this level the track record for subsequent equity returns have been poor. However, equity markets will shrug off low real earning yields for two reasons. First, real returns in fixed income will remain even lower. When viewed in that way equity markets are undervalued, at least according to the Federal Reserve equity model. Second, the market is pricing a benign inflation outcome. This is evident in 5y5y forward inflation expectations which, while higher, remain at the low end of the Fed target range as seen above. In effect, the market is looking past the recent surge in inflation. We may have a different view on inflation, but without a more aggressive view on inflation risk, the market will view low earnings yields as temporary. That would change if long term inflation expectations rose another 75bps. In that case, both equities and fixed income would perform considerably worse.

As the training wheels come off 2022 will be characterized as a year of more uncertainty. Equity markets can eke out modest gains as earnings growth offsets a compression in multiples owing to rising interest rates and reduced liquidity. That is a benign outcome. However, the risk of more negative outcomes, on growth, inflation, and monetary policy has also risen. This will keep volatility more elevated in the year ahead.

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