Economic Update Winter 2022
US economy grew at 5.6% rate in fourth quarter 2021 and 5.8% for 2021! Supply chain constraints, labor shortages, and Omicron related slowdown effects have modestly slowed down the world’s largest and most resilient economy. Economic growth rate will remain higher than normal but has peaked as fiscal and monetary stimulus is waning this year. Overall, consumer demand, household wealth, low employment, easy credit conditions, provide a backdrop for sustained expansion in 2022. Recession risks are quite low.
Recent economic data has been softer. The Citibank Economic Surprise Index fell into negative territory in January. Even so the U.S economy is in a sustainable expansion fighting the short-term slowing effects of Omicron. The ratio of Leading to Coincident Indicators continues to a rise as of its latest reading. ISM’s PMI has had nineteen consecutive monthly readings of more than 50, indicating U.S is in a strong expansion. What is more the latest readings for ISM Manufacturing and Services Indices, despite Omicron, are hovering about record levels. CNBC/Moody’s Analytics median GDP forecast for 2022 is a robust 4.3% compared to 5.6% for 2021, and 3.2% for the long-term average since 1947 reported by U.S. Bureau of Economics.
Headline consumer prices running at their fastest pace in 40 years and core inflation the hottest in about 30 years. Supply chain bottlenecks and surging demand have been the primary drivers of inflation, both expected to ease marginally. Inflation and continuing supply chain disruptions, as well as Omicron variant spread, pose risks to economic growth.
Wage inflation is the stickiest inflation contributor of all inflation factors. The Employment Cost Index (ECI) – an inflation indicator, is at 25-year high. Higher ECI is also a threat to profit margins. Maintaining current profits margins will be a challenge this year for companies. That is a negative for the equity market valuations.
The Fed is behind the inflation curve, and they will have to raise rates sooner than previously expected – in March. Faster more frequent hikes are pricing into market valuations causing markets to correct in January. High valuations stocks are in a deep correction now. The CME Group Fed Funds Futures expects the Federal Reserve to raise rates four times this year, one more than previously forecast. The estimate comes amid rising inflation and employment cost.
The normalization of Monetary policy should not stall corporate earnings growth, FactSet projections for earnings growth is an above average rate. Lower unemployment, wage gains, moderating inflation latter in the year should boost consumer spending. Household wealth indicators are at highest in decades. Projected rate hikes will bring yields to levels in the past that have not stalled credit growth and denied access to capital. The Fed funds rate expected to top out at 2%-2.5%.
The yield curve is a closely watched recession warning indicator. Historically, inversions of the yield curve are coincident with the topping out of the economic cycle and mean forward returns as well as economic activity are likely to be low. Presently, there is room for hikes before the Fed inverts the yield curve. When the Fed ends its emergency bond buying in March, I would expect long term bond yields to add to recent gains. The Yield curve by year-end will be flatter but not inverted. Inversion creates conditions for a recession. Previously, virtually all recessions had an inverted curve. For now, credit spreads remain calm as economic growth remains strong. I always keep a closer eye on credit markets which lead economic fundamentals.
The unemployment rate dropped to 3.9% in December, narrowing in on its 3.5% pre-pandemic low. Unemployment is below the natural rate. Latest continuing claims reading says employment conditions are tight. Businesses are dealing with labor shortages forcing firms to pay higher wages and bonuses to fill their ranks and get current employees back to work. Wage inflation is running hot.