2022 Global Market Outlook
January 19, 2022
Executive Summary
The global economy faces several potential landmines this year. After three years of strong performance fueled by remarkable corporate earnings growth, barriers to a continuation of the trend are emerging. We believe several factors facing the equity markets will influence results in 2022.
US Interest rates are destined to rise as central banks across the globe begin to “normalize” rates to contain and mitigate inflationary pressures that have increased dramatically over the past 12 months.
Threats to global stability from Russia and China centered in Ukraine and Taiwan, respectively, are growing. Russian and Chinese leaders appear to be operating under a perception that the US is retreating from a leadership/confrontational role in world affairs, and that America’s word and commitments are fungible. We suspect these attitudes are, in part, based on the sudden US withdrawal from Afghanistan last fall. Conflict would surely aggravate existing supply chain issues, making the Fed’s job of mitigating inflation exponentially more difficult.
As mid-term elections approach, polls suggest a strong possibility that one or both houses of the US Congress will flip to Republican control. Fading Presidential approval ratings on myriad social and economic issues and the failure of Mr. Biden’s signature legislative efforts to become laws could be paving the way for a strong Republican showing in November.
Interest Rates and Inflation
At the end of 2020, US annual inflation was less than 1.4%.[1] By the end of 2021, the trailing 12-month rate had soared above 7%[2]. Unprecedented levels of government spending over the past two years have collided with a recovering economy to produce spot shortages amid soaring demand as consumers rushed to spend direct Covid relief payments.
The Federal Reserve has two legislated mandates: First, to support economic activity and target full employment and, second, to ensure price stability. The first goal has been largely successful since individuals who desire work are having little trouble finding a job. The most recent surveys of employment turnover statistics, the JOLTS surveys, show increasing numbers of employees quitting jobs in favor of higher-wage positions.[3]
Wage growth was robust throughout 2021, but inflation was stronger, leading to real wage contraction. We see little evidence the current configuration of labor markets will change materially during the upcoming 12 months.
The Fed, under Chairman Jerome Powell, facilitated the deficit spending in a series of Covid-related relief bills during 2020 and 2021 as well as in the bipartisan Infrastructure Investment and Jobs Act, passed last November. The asset side of the Fed’s balance sheet, i.e., the Treasury and other debt instruments it owns, has expanded to more than $8 trillion as of last November.[4]
In March 2020, to support bond market liquidity, the Fed began to purchase Treasury notes and bonds, corporate bonds, and mortgage-backed securities in the open market, acquiring an average of $150 billion of new holdings per month.
The program is in its final stages and ongoing purchases are trending down to zero within the next two months, but at this writing, assets are still being absorbed by the Fed. Once purchases have ceased, the Federal Open Market Committee (FOMC) has telegraphed up to four increases in its Fed Funds rate will follow over the course of 2022.
With this plan widely disseminated, one could expect a decline in bond prices as credit markets prepare to adjust to a regime of rising interest rates after nearly two years at the lowest levels in history. Yields have risen over the past month but to date, there appears to be no urgency among market participants faced with what will likely be a bear market in bond prices for the foreseeable future. With consumer price inflation in running at over 7% annually and producer prices at essentially 10%, real interest rates for the 10-year Treasury maturity and others, remain negative as 2022 begins (10-yr: 1.7%-7%=-5.3%).
Assuming (always dangerous) that the Fed restricts itself to four ¼% increases in the short-term rates it controls during 2022, it is difficult to envision inflation being quashed or even significantly moderated by this monetary policy since under the current roadmap, inflation-adjusted yields will likely remain negative.
The Fed may be anticipating prices will supplement their actions by moderating when supply chains begin to flow more freely, hopefully later this year. But the failure of bond yields to climb out of the cellar in the face of announced tightening suggests that the credit markets may not be taking the Chairman as seriously as they should.
Bond prices embarked on a nearly 40-year bull market in the early 1980s and it is entirely possible that investors have been lulled into a false sense of security, believing that Fed “infallibility” will allow a takedown of inflation without material disruption to the economy. Unfortunately, history is replete with examples of lagging Fed reactions followed by over-zealous rate increases when inflation fails to respond to tepid rate tightening.
Expect unplanned increases and in greater increments (e.g., ½% vs. ¼%) from the Fed this year as inflation becomes more universally recognized as an intractable problem. Should supply constraints in the economy continue and inflation accelerate further, the FOMC may be forced to take a more aggressive stance. More deficit spending by Congress would exacerbate the problem.
Real estate prices could be vulnerable under accelerated tightening as speculators acquiring blocks of properties in “hot” markets such as Florida may suddenly find a shortage of “natural buyers” to take holdings off their hands as mortgage rates follow Treasury yields higher.
This scenario could lead to periodic equity weakness as reductions in corporate earnings forecasts proliferate due to high raw material and wage expenses. Reduced capital spending as a result of profit margin pressures could lead to economic stagnation.
Supply Chain Challenges
Lockdowns resulting from the onset of Covid-19 in Spring 2020 are less pervasive than a year ago but blanket restrictions affecting commerce persist in areas integral to the transportation and distribution of imported goods, such as New York and California.
Vaccine mandates and other regulatory hurdles have particularly impacted trucking, the “circulatory system” of the US economy. California regulations, for example, do not allow trucks models older than 2011 to enter the state to work. This has materially affected the availability of trucks to move imported goods from docks to domestic distribution and retail outlets. [5]
A recent Supreme Court ruling stayed the Biden Administration’s Covid vaccine mandate for corporations with more than 100 employees.[6] Although companies retain the right to include vaccination as a condition of employment, the government’s edict is suspended, which has been greeted with a sigh of relief from transportation firms.
The elimination of this roadblock for employees in many important industries could begin to mitigate the widespread labor shortages plaguing manufacturers. Insufficient labor resources remain a widespread problem. Industrial production statistics confirm sufficient excess capacity exists in the economy to accommodate significantly higher levels of activity without stoking inflation.[7]
Commodity prices have resumed their uptrends, recovering fully and beyond after a dip in late November and early December during the Omicron Covid variant’s initial onset. Closing prices for the Dow Jones Commodity Index since January 2020 are illustrated below. The index posted its most recent all-time high on January 19, 2022.
We expect corporations to benefit from an expanding pool of labor throughout 2022 as more Covid related mandates are eliminated, helping to offset diminished profit margins impacted by higher raw materials and wage costs. However, it is likely that existing import supply chain issues will not be resolved until transportation bottlenecks from US ports are fully freed from artificial constraints. Companies that depend on imports for materials will likely experience continuing delays and attendant elevated prices this year.
Geopolitical Challenges
Historically, adversaries have probed incoming US administrations to evaluate the strengths, weaknesses, and credibility of its leaders. The Cuban Missile Crisis in October 1962 is perhaps the most memorable example, but all Presidents are tested by foes directly or indirectly.
Currently, Russia and China are the main threats to global peace and stability. As leader of the free world, the Biden Administration is challenged by two ongoing situations: The Russians menacing Ukraine and exercising economic warfare in Europe through its natural resource reserves, and the Chinese openly posturing for an annexation of Taiwan.
President Putin has demanded NATO renounce any expansion of its membership as a condition to avoid further Russian incursion into Ukraine. In its history, the Atlantic Alliance has never acceded to any such condition. Europeans, most vulnerable to Russian expansionism, have hardened their positions against further encroachment in Ukraine and more recently, interference in Kazakhstan.[8]
Additionally, the Russians have facilitated a flow of Middle Eastern refugees through Belarus into Eastern Europe that has alarmed Poland and other nations, meanwhile stipulating that the influx will not cease unless and until financial assistance is provided to the Belarus regime.[9]
The US has entered, so far, unproductive negotiations with Mr. Putin’s government, specifically to address the Ukraine crisis. New leadership in Germany, a tough election for France’s Macron[10] and the withdrawal of Britain from the EU, however, have left Western Europe foreign policy in moderate disarray and not necessarily in concert with US diplomacy focused on negotiation.
Expect concessions to Putin from our Western European Allies to avoid further Russian encroachment in Ukraine, but with little or no reciprocity from the Russians. Should Putin invade Ukraine’s eastern flank, EU leaders will propose and/or impose economic sanctions but a military response seems remote. The net effect of any appeasement will likely be to increase Russia’s economic hold over Germany, the EU’s largest economy, and others dependent on Russian energy supplies.
China openly seeks control of the world’s semiconductor supply. To do so, it must bring the output of Taiwan Semiconductor (OTC-TSMC), the globe’s largest producer of semiconductors, essential components of items from military systems to refrigerators, under its aegis. After pouring hundreds of billions of yuan into domestic production upgrades, CCP Chairman Xi’s efforts are still unable to match the capabilities of the advanced products flowing from TSMC.[11]
Will China invade Taiwan and return its “runaway province” to the mainland’s umbrella and gain control of global semiconductor output? It seems clear that the only methods would be by either military invasion or by TSMC peacefully transferring ownership to the Chinese. At this point, neither of these options appears viable, despite the consistent increase of incursions by Peoples Liberation Army (PLA) aircraft into Taiwanese airspace and public invasion drills on coastal areas closest to the island republic.[12]
Military support and/or defense of Taiwan has not been established through treaty or agreement, but there exists an implied threat that the US would respond should an invasion appear imminent. The level of potential response has historically varied depending on the US administration in power. The Navy’s 7th Fleet cruising the Taiwan Strait has traditionally been the US’ most forceful exhibition of support when tensions increase.
We expect China to maintain pressure and to continue saber-rattling against Taiwan until the US draws a line. The output of TSMC is a national security issue for our military and an interruption of semiconductor production would be an intolerable defense degradation.
Additionally, the impact on manufacturing of any product containing advanced semiconductors, of which TWMC produces 90% of the world’s supply could produce significant global commerce disruption with far-reaching negative consequences.[13] Whether it occurs will in large part depend on Premier Xi’s perception of US resolve to support Taiwan’s sovereignty.
US Political Landscape
Midterm elections are less than 10 months away, with control of Congress up for grabs. An average of recent polls showing the President’s job approval around 42%[14] and, so far, retirement announcements from 26 sitting House Democrats,[15] suggest that Republicans have a high probability of attaining a significant majority in the House and possibly gaining the Senate.
Mr. Biden’s legislative agenda began to stall last fall after the bi-partisan infrastructure bill passed, culminating with failure of the Build Back Better legislation in December and rejection of a filibuster suspension to pass the John Lewis Voting Rights Act last week. Democrat Senators Manchin and Sinema have categorically refused to eliminate the minority’s power to require a 60-vote majority to pass most non-budgetary legislation.
At present, with the President’s overall job approval underwater and on a host of issues ranging from the economy to inflation to immigration as well,[16] it seems unlikely that any new spending legislation would survive the Senate, regardless of how widespread its support in the House.
Republicans have yet to outline an agenda other than stopping the leftward drift of policy by reversing Progressive initiatives. Whether simply running against the President’s low approval ratings will be sufficient to produce a durable majority remains unknown.
Expect Republicans to gain control of the House with a margin of at least 20 seats. If President Biden continues to lose voter support over the next few months, the Senate will likely see a shift of 2-3 seats in favor of Republicans, a solid majority but not a filibuster-proof margin. Legislative gridlock would be the probable result given the President’s ability to veto legislation.
Conclusion
Equity markets are likely to face headwinds periodically in 2022. After three years of strong gains, investors may have become somewhat complacent, expecting corporate earnings growth to continue without interruption despite clear warning signs.
The Federal Reserve’s efforts to address inflation will unfold this spring, but it could be a too little, too late story if shortages do not diminish, and wages and raw materials prices continue to rise. Energy costs, which have been a major source of upward price pressure show no signs of moderating. Further acceleration of inflation could push the Fed to act more quickly and ln greater magnitude than markets currently expect.
Tensions and potential conflict between Russia and the West as well as China’s expansionary ambitions regarding Taiwan could further interrupt supply lines that continue to operate at less than full capacity. Since the US withdrawal from Afghanistan last fall, leaders of both these adversaries have increased their challenges to the status quo, so far, facing only rhetorical resistance.
The Biden Administration has seemingly abandoned negotiating from a position of strength with Russia and China, instead seeking to learn from those countries what concessions the US and its allies must make to keep aggression in check. Appeasement does not have a positive historical track record.
Markets have already begun to discount a slowdown in profit growth, especially among smaller companies and high earnings multiple technology issues. Reduced earnings expansion for stocks selling at high price-earnings multiples could lead to some grim faces as guidance during the first-quarter reporting season will likely include cautions surrounding labor shortages, rising interest rates, and higher costs of doing business.
What we can be certain of is that bond prices will be in a downtrend as the Fed launches efforts to curb inflation, but if real interest rates remain negative (nominal rate minus inflation), the uptrend in consumer prices is not likely to reverse.
We don’t expect bond yields to provide significant competition for equity returns this year, but stock investors will be discounting slower growth as the Fed takes away the proverbial punch bowl and credit tightens at an as yet unknown rate.
Nonetheless, markets will quickly and efficiently digest foreseeable and unforeseen developments affecting the global economy. As always, a coherent, disciplined long-term investment plan will be investors’ best refuge if the going gets tough.
Byron A. Sanders
Investment Strategist
[1] “CONSUMER PRICE INDEX – DECEMBER 2020,” www.bls.gov, January 13, 2021.
[2] “CONSUMER PRICE INDEX – DECEMBER 2021,” www.bls.gov, January 12, 2022.
[3] “Job Openings and Labor Turnover Survey,” www.bls.gov, January 4, 2022.
[4] “Federal Reserve Balance Sheet Developments,” www.federalreserve.gov, November 2021 data.
[5] “California’s shipping backlog is, in part, caused by a “California Truck Ban which says all trucks must be 2011 or newer and a law called AB 5 which prohibits Owner Operators.” www.politifact.com, October 1, 2021.
[6] “Supreme Court blocks Biden Covid vaccine mandate for businesses, allows health-care worker rule,” www.cnbc.com, January 13, 2022.
[7] “Industrial Production and Capacity Utilization - G.17,” www.federalreserve.gov, January 14, 2022.
[8] “Russia’s European Neighbors Rattled By Putin’s Moves,” www.wsj.com, January 17, 2022.
[9] Ibid.
[10] “Macron’s conservative challenger Pécresse vows to get tough on crime, “www.france24.com, January 6, 2022.
[11] “If China Controls Taiwan’s Chip Manufacturers, It Will Control The World,” www.thefederalist.com, November 1, 2021.
[12] “China ‘Clearly’ Developing Ability to Invade Taiwan, Top General Says,” www.usnews.com, November 3, 2021.
[13] Op. cit., www.thefederalist.com.
[14] “Presidential Job Approval, Average of Current Polls,” www.realclearpolitics.com, January 18, 2022.
[15] “Rep. Ed Perlmutter says he will not seek reelection, joining more than two dozen other Democrats who plan to leave the House,” www.washingtonpost.com, January 10, 2022.
[16] Op. cit., www.realclearpolitics.com.
