Myriad economic surprises may be in the cards for 2022. The assumptions underlying currently high inflation, low unemployment, and interest rate outlooks are very fragile. Will the pace of growth slow more than expected? Will inflation remain elevated? Could there be geo-political surprises? How would the Federal Reserve (Fed) react to a change in the economic environment? Will there be a “soft landing” for the economy? Before tackling these questions, we will review what constitutes the current market consensus, then we will explore the fragility of this consensus and review how changing dynamics might influence the Fed, and close with a brief tour of what this fragility of expectations means for key asset classes.
I. Current Consensus
January 2022 started with a consensus forming around three themes:
(1) Elevated inflation in the U.S. and elsewhere is not transient, although it might abate somewhat in the second half of the year and into 2023. Market participants do not show signs of expecting long-term, persistently high inflation.
(2) U.S. labor markets are tight with an abundance of job openings and many people switching jobs for higher pay or a more flexible work environment.
(3) The Fed is pointing toward ending asset purchases early in 2022 and then commencing to raise short-term rates. The federal funds futures market as of January 24, 2022, was pointing toward three to four quarter-percentage-point increases in calendar 2022, commencing at the March 15-16, 2022, Federal Open Market Committee (FOMC) meeting.
This set of market consensus expectations is quite a shift away from a world of benign inflation, labor markets buffeted by the pandemic, and accommodative central banks. No wonder January was a volatile month for equities, bonds, and commodities as investors, traders, and asset managers embarked on a great portfolio rebalancing to manage their risks in an environment strikingly different from that of the past decade.
II. Reasons to Challenge the Growth/Inflation Fragile Consensus (or Not)
Consensus expectations are just an average around a wide distribution of alternative views. The assumptions underlying the consensus are notably fragile and the consensus itself is not necessarily held with much confidence. Here are some non-consensus ideas to consider when assessing the risk management challenges of 2022.
(A) The global economy slows down much more rapidly from the pandemic rebound period led by the U.S. in the West and China in the East – the world’s two largest economies.
(1) China. China’s Covid-Zero policy has dramatically slowed its domestic service economy, and the economic costs of the zero-tolerance policy seem to be growing larger in contrast to the “let’s figure out how to live with Covid” approach that is evolving in Europe and the Americas.
China has also been buffeted by the debt challenges faced by many large and small companies in its property sector. Containing the property market challenge has led to a more expansive monetary policy and a small cut in policy interest rates even as the Fed looks toward a year of raising rates.
Looking further ahead, the aging demographic pattern for China with more workers retiring from the labor force than the arrival of young workers is a huge long-term headwind for economic growth. Afterall, real GDP growth can be arithmetically decomposed into labor force growth and labor productivity growth. It is hard to envision a sustained decade-long increase in productivity sufficient to offset the headwind from a stagnant labor force.
China’s economy has, however, greatly benefitted from the pandemic-driven shift in Western consumption patterns away from services and toward goods, many of which are made in China. Consequently, Chinese exports have sustained the economy and supported the exchange rate.
Putting all this together, China’s officially reported economic growth, already down to 4% year-over-year growth in Q4/2021, could decelerate further toward 3% annually or even slower in the coming years, especially if Western demand for goods (i.e., Chinese exports) hits a speed bump. Moreover, given China’s outsized role in global commodity demand, markets from energy to agriculture may reflect some increased volatility related to Chinese uncertainties.
(2) United States. Following a rapid rebound from an economic shock, one would naturally expect real GDP growth to decelerate toward the longer-run trend rate. There are three additional headwinds to U.S. real GDP growth in 2022 that challenge the consensus view and, at the least, suggest that economic growth may go through a very disappointing period in the first half of 2022.
Consider Covid-Omicron and possibly future variants with which to contend. By mid Q4/2021, the Fed Bank of Atlanta’s “GDPNow” estimate had Q4 progressing at an 8%-plus annualized growth rate. Then came Omicron and retail sales had a weak, actually negative, December 2021. Airline traffic slowed. So did restaurant dining. That is, the weakness in the last month of the quarter caused Q4/2021 real GDP to be much slower than the 6%-plus of the first half of 2021. Heading into 2022, typical quarterly growth rates may be more like a 2.25% long-term trend, and that is before considering both fiscal policy and supply chain headwinds.
Regarding U.S. fiscal policy, there is a dramatic shift away from the super-stimulative policies of 2020-21. U.S. real GDP recovered relatively rapidly from the pandemic shutdown in the spring of 2020, especially compared to the much longer recovery period following the financial panic of September 2008 and the Great Recession that followed. The difference in fiscal policy responses gets most of the credit for why the pandemic rebound was so much more rapid than the recovery from the Great Recession. In 2020 and 2021, the U.S. government massively increased spending, much of which came in the form of direct payments to individuals, allowing consumption expenditures to be sustained even in the wake of severe job losses. By contrast, fiscal policy to contain the Great Recession was aimed at “shovel-ready” infrastructure projects, was paid out over a longer timeframe, and was not nearly as massive as the pandemic response.
The reality for 2022 and beyond, though, is that the direct payments to individuals are in the past. The infrastructure spending package passed by the U.S. Congress in early 2021 spreads spending over the next eight to 10 years. Going forward, future government spending programs may be highly constrained by gridlock in Congress. The result is a rather stark removal of the fiscal stimulus that helped to produce the rapid real GDP rebound from the pandemic shutdown.
There are not many parallels to this situation to inform us; however, the Great Depression may provide a cautionary tale. The New Deal fiscal spending ushered in by President Franklin D. Roosevelt after his inauguration in 1933 was helping to lift the country out of its depression when Congress put the brakes on new spending in 1937, and a double-dip into a short period of negative real GDP ensued. This time around may be different, but the rapid removal of fiscal stimulus does strongly suggest U.S. real GDP will be much slower than many currently expect for 2022. As already noted, real GDP was going to decelerate naturally after a sharp rebound period; it just might be an even more dramatic deceleration of growth when the fiscal policy shift is factored into the analysis.
Supply chain challenges are not going away quickly and may even get worse in 2022. Part of the headwind from the Omicron variant was that it caused a large increase in temporary sick leave within the overall labor force, so that existing supply chain constraints, such as a shortage of truck drivers or port workers, were made much worse. As Omicron recedes, so will this challenge to the labor force, yet another challenge is likely to emerge – namely labor disruptions and strikes in search of higher pay and more flexible work arrangements.
The poster child for labor market disruption that may get serious market attention in the spring of 2022 is when longshoremen renegotiate their contracts with U.S. west coast ports. U.S. ports are already notoriously inefficient and less automated compared to their counterparts from Rotterdam to Singapore, to Shanghai to Tokyo, and beyond, and trying to work on quick fixes to the inefficiency has even garnered the attention and a visit from the U.S. President. Adding to that is the strong possibility of a U.S. west coast port strike coming in the midst of already severe supply chain issues. Periodic strikes by longshoremen are the norm, even in troubled times. If a strike occurs this time around, given the sensitivity of markets to inflation and supply chain issues, well, we have a prescription for increased economic uncertainty, even if a strike is only threatened or is short-lived.
Inflation Psychology can be critical. How consumers view inflation compared to how central bankers and economists view inflation may be on a collision course. Consumer psychology can be severely impacted by the persistence of high prices over a long period of time, not just the rate of increase in prices. By contrast, central banks and economists arbitrarily measure inflation as the 12-month percentage increase in the general price level. For example, if gasoline prices at the pump go up from an average in the U.S. for unleaded regular of $2.17 per gallon in December 2020 to $3.17 in December 2021, that is a 57% increase in 12 months. But what if gasoline prices remain in the $3/gallon territory for all of 2022? Consumers may view this negatively as they focus on the persistence of high prices, while economists will say that the end-2022 price percentage increase has dropped to zero. That is, the political pressure to contain price pressures may extend well after the measured 12-month inflation rate begins to decline.
Then there is the likely persistence of supply chain challenges because actions to resolve the problems require financial capital and the corporate will to invest. Put this another way, farmers tell us that the cure for high prices is high prices, as in the next season they will plant more acres and increase supply. In the world of goods, though, it may take years to find the new capital to construct more containers and build the ships to carry to them, to expand port facilities, to develop new computer chip factories, and so forth. We are talking about many supply chain challenges not being resolved until 2024; and certainly not in 2022.
Inflation psychology can also be impacted by the volatile food and energy sectors, even if central bankers typically focus on core inflation (excluding food and energy) so they will not get a short-term head-fake from these more volatile sectors. Energy markets are materially at risk from geopolitical tensions, including Russia-Ukraine (i.e., possible higher natural gas prices in Europe), or the Saudi-Iran tensions (i.e., the civil war in Yemen that could spread and impact oil prices). Agricultural prices are less influenced by the evolution of economic activity than by global weather patterns. We are now experiencing a La Niña with a drought in Argentina curtailing soybean supply. From geo-politics to the weather, these are factors that can influence inflation psychology that are well beyond the ability of central bank policies to mitigate their influence.
III. What might the fragile nature of the current economic consensus mean for Federal Reserve policy in 2022?
Given our appreciation of the serious risks to the consensus view that is embedded in the Fed’s forward guidance and decision to end asset purchases and commence rate hikes back toward a more neutral monetary policy, it is time to delve into the decision-making culture at the Fed.
First, the Fed, like most central banks, does not want to embark on a new policy direction which might have to be reversed quickly if the outlook changes unexpectedly. This means that the Fed is almost always going to be “behind the curve” as pundits like to say. That is because the Fed is data dependent, and the data has to be convincing before action is taken. Convincing data patterns take time to develop. One month’s data “surprise” does not a new trend make.
Second, legacy matters to central bankers. Central bankers, in general, and the Fed, in particular, are certainly in this camp, and are especially concerned that inflation does not get started on their watch and then become persistently high. The Bundesbank will always remember and never want to repeat the hyper-inflation of the 1920s in Germany. In the U.S., Professor Arthur Burns was the first Ph.D. economist to chair the Fed, but he is remembered for the inflation of the 1970s that occurred on his watch. Burns is also remembered as one of the most political Fed chairs because of how he expanded monetary policy ahead of the 1972 Presidential election, providing a nice assist to help President Nixon win re-election. By contrast, Paul Volcker is considered a Fed hero. Volcker was appointed by President Jimmy Carter late in the 1970s with a mandate to beat inflation. In the parlance of the day, Volcker “got out a big hammer” and hit the economy with 20% short-term rates, causing a deep recession, yet curing inflation while also contributing to Carter’s defeat in the 1980 election (the Iraq hostage crisis did not help Carter either).
When we put these two observations together, it presents an ambiguous interpretation of Fed policy in 2022. That is, the strong labor market data and elevated inflation in the second half of 2021 is what convinced the Fed it was time to end asset purchases and commence moving rates higher. Having provided such forward guidance, the Fed is committed to this path and likely to require as much as two quarters of changed economic data before it would reconsider. The real GDP and labor market data might well weaken in the first half of 2021, as a possibility we have highlighted, but the inflation data is likely to stay elevated for longer regardless of a deceleration of GDP. This challenges the Fed and its dual Congressional mandate to strive for full employment and stable prices. Add into the analysis the inflation-legacy factor, and this time around the Fed might over-weight inflation concerns even if the economy slows dramatically as opposed to a knee-jerk reaction to reverse course if economic weakness were to appear. Of course, all of this is conjecture, and only time will tell. Our purpose here is to frame the debate and raise issues in order to appreciate the risk management challenges being faced.
IV. What about markets?
The bottom line is that the consensus, or shall we call it the most likely or base case scenario – for elevated but abating inflation, tight labor markets, and a withdrawal of central bank accommodation – may not go nearly as smoothly as hoped, if we experience surprises coming from geo-political events, more supply chain disruptions, or the abrupt shift back to austere fiscal policies. Not a forecast – just risks to the consensus view of which we want to be aware and to manage, given that the base case scenario is quite fragile.
(A) U.S. rates. The debate over the course of Fed policy will not likely diminish in March 2022 even if the Fed ends net asset purchases and commences to raise short-term rates. To the contrary, the debate may intensify if the data from the real economy is weaker than expected while inflation remains stubbornly high. The yield curve remains especially in play, as the two-year Treasury note discounts rate-rise expectations over the short-term, while longer-term bonds reflect a conflicting dynamic of Treasury supply, equity-fixed income asset allocation preferences, and changing inflation expectations.
(B) Equities. The days of a dependably accommodative Fed are gone. Earnings are expected to be strong in 2022 following a good performance as profit margins expanded for many companies in 2021. That view could be challenged, since 2021 margin expansion was partly driven by the use of raw material inventories charged at original cost, while 2022 will see production costs increase with higher, newly acquired raw material prices as well as wage increases. We may also see sectors perform in different ways depending on their interest-rate sensitivity. Long duration sectors, which is those with high growth expectations, may be more influenced by what happens to long-term bond yields than shorter duration “value” sectors.
(C) FX. Exchange rates may well reflect the discord among major central banks. While the Fed is on course to raise rates, European Central Bank (ECB) President Christine Lagarde recently characterized the Fed rate hike plans as “ruthless”. The Peoples Bank of China (PBoC) lowered its policy rate. The Bank of Japan (BoJ) is welcoming higher inflation after deflation psychology kept growth depressed for decades. Emerging market currencies are a mixed bag, but where interest rates have been raised FX traders may be drawn to the risky carry trade (i.e., buy the high-rate currency, sell a dependable low-rate currency such as the yen or the euro).
(D) Energy. Energy markets are dealing with the conflicting dynamics of the de-carbonization movement simultaneously with rising geo-political tensions. De-carbonization pressures have led to (1) some energy companies prioritizing capital expenditures for alternatives above new investments in fossil fuels and (2) some banks are also becoming less aggressive in their approach to lending for fossil fuel development. Geo-politics is in play in both the Russia-Ukraine theater (i.e., watch natural gas prices in Europe) and the Saudi-Iran tensions involving Yemen (i.e., impact on crude oil production in the Middle East). OPEC+ may be encountering production challenges as it may have over-estimated its ability to expand production, even as oil prices rise and provide incentives to raise production levels.
Gold. Gold is often considered an inflation hedge given its super-performance in the 1970s. But gold bears no explicit interest, and US short-term rates are set to rise. And crypto-currencies are seen as challenging gold’s role as a portfolio diversifier.
Agriculture. Soybeans especially are impacted by the La Niña induced drought in Argentina. Both corn and soybeans reflect uncertainties over Chinese demands. Wheat is truly a globally produced commodity and it could be impacted by Ukraine tensions that ripple through the global wheat market.
The bottom line is that the consensus view is fragile and there are myriad uncertainties such that the probability of the consensus view being interrupted by economic, political, or weather-related surprises seems much higher than usual.
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All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.