Ugh. If there ever was just one word to describe the markets of January 2022, that might be it. If the past month seems like one of the worst starts to the year you can remember in recent history, congratulations, you would be correct. Perhaps there’s an opportunity as a Jeopardy! contestant in your future now that Amy Schneider’s record-setting reign has ended.
Figure 1: “I’ll take ‘Now That’s A Bad January’ for $200, please.”
Source: Cornerstone Macro
The equity market price action in late January was nothing short of breathtaking as volatility swept in with the power and turbulence of a Nor’easter bomb-cyclone. Perma-bears once again emerged to bask in a temporary spotlight whispering prognostications to stoke fear and doubt in the meme-stock retail crowd: Prepare for runaway inflation. The Fed is too far behind the curve. Rising interest rates will kill the housing market. Permanent labor shortages will lead to recession. The stock market is going to crash by 50%. Really? In a nod to ESPN’s pregame NFL crew, we’ve got to say, “C’mon, man!”
Figure 2: Record Volatility to Start 2022
Source: Bloomberg
After 13+ years of disinflation since the Global Financial Crisis (GFC), there’s little doubt we are finally entering a new cycle of rising inflation and rates. Of course, the question remains, how much? We hold firm in our view that the economic froth is coming off the boil and we are simply returning to a more normal growth trajectory, accompanied with moderate inflation and a stabilized level of interest rates as we move closer to the end of this two-year pandemic. Why are we so confident in our view? The data shows it.
Remembering back to just prior to 2020, growth was stable and steady, corporate profits were reasonable, employment full and the global economy was chugging along. The Fed and other developed economies had been trying to reach their inflation targets for years, with no avail. Of course, we know the tragedy of the pandemic occurred and the global economy went into a self-induced shutdown/recession to fight off the coronavirus. Fiscal and monetary support flooded the system to support impacted businesses and consumers during that time. Now, as we are now moving from the pandemic to an endemic stage, it’s time to start removing that support slowly so the world can get back to a more typical economic cycle. Have the pre-pandemic underlying economic fundamentals really changed? We think not.
Figure 3: Stimulus Money Was Off the Charts
Source: Cornerstone Macro
It seems everything is expensive these days. However, markets are wonderful things in that they are self-correcting mechanisms. While the “transit” in transitory is moving a bit more slowly than we all expected, the price spike in goods is clearly starting to roll over as lower demand, increasing supply and improving delivery times are moving us back towards more typical price levels later this year.
Figure 4: Watch for Goods Prices to Deflate
Source: Cornerstone Macro
How about wages? Labor force participation is once again increasing as fiscal stimulus programs wind down and people are returning to work. Unit labor costs, which are the difference between wage growth and productivity, are receding back towards the 2% level, which is consistent with the Fed’s target core inflation rate. Our expectation is that a wage price spiral is extremely unlikely.
Figure 5: Unit Labor Costs (ULCs) Rolling Over
Source: Cornerstone Macro
How about housing? Shelter comprises roughly 40% of the consumer price index (CPI) and clearly home prices and rents have boomed, contributing to the overall high rate of inflation. Supply and demand dynamics are at play here as well: migration from city centers to suburbs and rural areas have boosted demand and exacerbated the strain on an already-undersupplied residential housing market. Now, affordability is down and rising interest rates should start to act as a headwind to housing demand, as well as price growth, which should reduce inflation pressures.
Longer term housing fundamentals are still solid, as rising incomes and healthy consumer and bank balance sheets can withstand higher mortgage rates. Demographic trends are favorable too, as the percent of young adults (aged 25-34) living at home is at an all-time high and roughly 3% higher than 2014. If the trend reverses back to 2014 levels, that would equate to roughly 1 million additional home buyers entering the market.
Figure 6: Higher Mortgage Rates Cool the Engines
Source: Cornerstone Macro
We expect that goods prices will begin to soften, wage growth (in terms of ULCs) will stabilize around core inflation levels, and the rate of housing price appreciation will start to soften towards the end of this year and into 2023. If this expectation comes to fruition, then we are likely seeing peak inflation right now, and more importantly, it is starting to move lower.
Presuming this outlook is accurate, then there is no need for the Fed (or other developed economies’ central banks) to tighten monetary policy too abruptly or aggressively. Recessions are a natural part of an economic cycle and we will certainly experience one in the future, but we do not think the Fed is going to arbitrarily manufacture one in the next 18 months.
Of course, there are always risks to the outlook and geopolitics, policy error or a Covid resurgence could alter our forward expectations. The mounting Russia/Ukraine situation is serious and has significant implications for the global energy and commodities markets should open conflict occur. Slowing, but moderate economic growth in China is currently helping to ease global inflationary pressures, but the growing strain on the US/Chinese relationship as the US works to decouple from China raises risk in the markets.
While the start to 2022 has been a rough one in terms of volatility and price declines, there is reasonable evidence to suggest this is more likely a correction and not the beginning of a new bear market. Bond market credit spreads have remained very well behaved, and global equity market correlations have not increased, which is cause for cautious optimism.
Figure 7: Portfolio Diversification Still Works
Source: Ned Davis Research
Navigating this environment has been challenging and we know this recent volatility has been uncomfortable for many of you. Long-term horizons can suddenly seemingly get very short in market conditions like these and we encourage you to speak with your Relationship Manager if you have thoughts or concerns about the markets. Our investment team has been proactive throughout 2021 as well as into January by leaning into lower volatility assets such as hedged equities and other liquid alternatives. In our equity profile, we have increased allocations to more value-oriented and cyclical equities and have been underweight technology relative to broader benchmarks. Lastly, we continue to incorporate broad allocations of Private Real Estate, Credit and Equity for our clients as we believe these tools and strategies are ideally-suited for this environment.
Our Capital Insights readership continues to grow substantially and now encompasses clients, prospective clients, strategic partners, as well as friends of our firm. To our clients, we deeply appreciate your business and trust in your Capital Planning Advisors team. If you are not a client and are contemplating initiating a relationship with us, either directly with your personal or business assets, or by referring someone you think could benefit from our services and approach, we would be delighted to speak with you.
We continue to experience steady and stable growth and we are grateful that everyone on our team is healthy and safe. We sincerely hope that you and your loved ones are keeping well and please do not hesitate to contact us if you have any questions or if we can be of further assistance.
