1st Quarter 2022 Market Outlook

What Hawaii Investors Should Know

January 4, 2022    |    Sage Capone

Key Points for Hawaii Investors’ Retirement Planning

Happy New Year!

As we begin the year, I would like to share with you the Market Outlook.

Key Points

  • 2022 is a year of transition from recovery boom back down toward long-run economic growth rates.
  • Monetary policy is transitioning from hyper-stimulative to potentially outright restrictive in an attempt to normalize interest rates.
  • After a period of below average volatility, this period of transition and uncertainty will likely lead to heightened volatility for the markets in 2022.
  • After a period of transition related volatility, stocks are likely to continue their secular bull market.

Long-run Economic Growth

The U.S. economic recovery has been the strongest among the G7. The Chinese economy was the first to fall into the pandemic-induced recession and first to recover.

However, this year it has been growing slower than its historical trend despite seeing a rise in exports.

Japan and Europe both saw strong bounces but have yet to fully recover.  The strongest part of the economic recovery has likely ended and 2022 is a year of transition from recovery boom back toward long-run economic growth rates.

Economic growth will be weaker in 2022 as the last of the monetary and fiscal stimulus has been circulated.

Prior to the pandemic, the steady-state U.S. economic growth rate was about 2.4% per year.  However, going forward, steady-state growth may have dropped to below 2%.

The two inputs into GDP growth are labor force growth and productivity growth. Productivity growth has been rather steady, but labor force growth has been in a steady decline for decades and the pandemic only accelerated this challenge.

The drop in labor force participation is due to early retirements. Approximately 1.5 million early retirements have been recorded since the start of the pandemic. The downtrend in the growth in the labor force has been highly correlated with GDP growth. [See Figure 1].

Figure 1: Labor Force Growth and GDP Growth

Labor Force Growth and GDP Growth Chart

The two largest economies, the U.S. and China, find themselves at two opposite policy transitions. China has been fairly conservative with its monetary and fiscal policy which has slowed the Chinese economy and put downward pressure on Chinese equities.

It looks like China is slowly beginning to transition toward a more accommodative monetary stance.

On the other hand, the U.S. Federal Reserve has maintained a very accommodative monetary stance, but headline inflation numbers are putting pressure on the Federal Reserve to remove that accommodative stance.

The Fed’s Shift from Transitory Inflation

Up to this point, the Fed believed inflation was transitory and the number one priority was stabilizing the jobs market. It was comfortable letting inflation run higher than usual.

The Fed recently made an abrupt pivot and dropped the term “transitory”. It is communicating to the market that it plans to tighten monetary policy. The market has already started to price in short-term interest rate increases at a very rapid pace. [See Figure 2].

Figure 2: Expected Rate Increases

Expected Rate Increases Projections

There is always a policy debate about where short-term interest rates should be to help regulate the economy. Economists always try to pin down what the neutral rate should be where policy is neither accommodative nor restrictive.

There is a continuous debate because the economy is dynamic and the neutral rate changes based on economic and market conditions. There is also a debate about what the Fed should prioritize.

When the Fed raises interest rates it is trying to take liquidity out of the market, so the excess liquidity in the economy does not fuel inflation. However, after this re-opening economic boom, liquidity is already very low. [See Figure 3].

Figure 3. Liquidity

Labor Force & GDP Growth Rates, 1970 - 2020

M2, the numerator in the above chart, is a common measure of money supply that comprises short-term cash availability.

Will the Fed Tighten the Money Supply?

The concern is that the Fed may stumble into a policy error by tightening when conditions have naturally tightened. A wild card is the twists and turns the next phase in the pandemic takes.

The combination of policy tightening, and pandemic uncertainty is likely to lead to a period of heightened volatility for the markets.

While the headlines report high inflation, market-based variables do not support that view and are showing declining inflation expectations. [See Figure 4].

The inflation story was strongly influenced by an aggressive stimulus-induced aggregate demand boost coupled with acute supply disruptions.

This time around, if the Omicron variant causes disruptions its impact could cause a fall in demand with deflationary impacts.

Figure 4. Inflation Expectations

US Inflation - Breakeven Curve Chart

What to Expect from the Market

As we enter 2022, we do expect a period of more heightened market volatility.

However, if market volatility and other storm clouds mount on the horizon, it is likely that the Federal Reserve will pivot backed toward a more accommodative monetary stance sometime during 2022.

This change would support the resumption of the secular bull market in stocks.

Every year brings its own challenges, but over time investors continue to be rewarded for committing to well diversified and disciplined investment strategy.

As always, if you would like to discuss your portfolio or re-visit your risk profile, please do not hesitate to contact us.

Figure 1 – Source: Alpine Macro®

Figure 2 – Source: Alpine Macro®

Figure 3 – Source: Alpine Macro®

Figure 4 – Source: Alpine Macro®

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