Pumping the Brakes on the U.S. Economy

Growing up in Dublin, my parents were of the firm belief that the streets of the city were safer without David behind the wheel of a car.? Consequently, I first learnt to drive in my early 20s on the backroads and highways of Michigan, with my future wife, Sari, as my instructor.? There were a number of perils associated with this including my tendency to ignore all traffic signs when focused on the task of steering the car or my habit of stalling out due a chronic inability to synchronize the application of the clutch and the accelerator.? It didn’t help that Sari would burst into a fit of giggles at the moments when I put us in the greatest and most imminent danger and was in particular need of quick and level-headed advice.

One especially tricky feat was trying to slow down the car while driving downhill in the snow.? This was in the days before anti-lock brakes and Sari told me I was to “pump the brakes”.? Easier said than done, however.? Apply too little pressure and the vehicle would sail straight into the intersection.? Apply too much and the brakes would lock, resulting in a quick and dramatic spin into the ditch.

Slowing down an economy that is growing too fast is also a tricky business.? A few months ago, prospects for a quick end to the pandemic and a combination of very easy monetary and fiscal policy suggested that the economy wouldn’t slow enough going into 2022, with inflation and interest rates potentially spiraling higher.?

Today, the Omicron variant, along with tighter fiscal and monetary policy are pumping the brakes on the U.S. economy.? But the question is whether this braking pressure is about right, allowing the economy to coast to a soft landing and an extended expansion or whether the economic drag might prove too much, leading to a more dramatic and less happy outcome.

On the virus, the good news is that Omicron is clearly much milder than earlier variants and the medical risk associated with catching Covid-19, particularly for those who are fully vaccinated, is far less than was the case at the start of the pandemic.? There is reason to hope that, once this wave wanes, and if no more lethal variant takes over, society can finally return to close to normality. ? However, Omicron is also, by far, the most contagious of the variants and this has led to very widespread illness across the country.? This has resulted in numerous cancelations of events and activities and is, once again, hitting demand in the leisure, entertainment, travel and restaurant industries, as indicated by high-frequency data.? It will also lead to widespread absenteeism in early 2022, applying a significant drag to the economy in the first quarter, following a very strong fourth quarter.?

On fiscal policy, the Administration was unable to forge a compromise to pass the Build Back Better bill before the end of last year.? While negotiations will continue, the most important immediate effect of this will be to end the mid-month payments of advance child tax credits to roughly 35 million families which had commenced last July.? The IRS reports that these payments totaled roughly $15 billion per month and their sudden cessation could curtail recently booming spending on food and other household basics.? More broadly, according to the Congressional Budget Office’s current estimates, without any further legislation, the federal budget deficit could fall from $2.8 trillion, or 12.4% of GDP last fiscal year to $1.2 trillion or 4.7% of GDP this fiscal year, implying a very significant fiscal drag.

There are, of course, some offsetting factors.? Social security recipients are seeing a 5.9% cost-of-living adjustment in their checks starting this month, the highest annual increase since 1983.? 21 states implemented an increase in their minimum wage entering 2022 and wages in general continue to rise quickly, as should be evident in this Friday’s December jobs report.? In addition, income tax refunds should be strong this year as taxpayers benefit from enhancements to the earned income tax credit and dependent care credit, as well as the part of the enhanced child tax credit that they did not receive in monthly payments.

Even with this, however, we now expect U.S. real GDP to grow by just 2.5% in the first quarter following a more than 7% annualized surge in the fourth.? Payroll job growth, which we believe may have exceeded 400,000 in December, could see a sharp slowdown in January before recovering later in the quarter as the pandemic eases.? This temporary slowdown in activity, combined with the dampening effect Omicron is having on demand around the globe, should reduce overall inflation pressure entering 2022.?

That being said, we still expect core personal consumption deflator inflation to run well above the Federal Reserve’s 2% long-term goal throughout 2022.? Provided the Omicron wave crests and falls in the next few weeks, we expect the Fed to stick with its plan to phase out bond purchases by the middle of March and begin a series of quarterly, 25-basis point federal funds rate hikes starting in June.

For investors, Omicron and the lack of further fiscal stimulus could mean a change in emphasis in 2022.? For some time, we have argued that U.S. value stocks and developed country international equities, which are both more cyclical than U.S. growth stocks, should benefit from very strong economic momentum exiting the pandemic.? However, this economic surge looks weaker today than as of three months ago.

That being said, we also believe that a reduction in the uncertainty caused by the pandemic and higher interest rates in 2022 should reduce the dispersion of valuations which has increased in recent years.? We believe this remains a key theme for the New Year.

Entering 2022, as we show on page 10 of our new 1Q2022 Guide to the Markets, the Russell 1000 value index had a forward P/E ratio of 15.8 times compared to 30.6 times for the Russell 1000 growth, the widest disparity seen in over 20 years.? Similarly, as we show on page 46 of the Guide, international equities at the end of 2021 were selling with a forward P/E ratio which was more than 30% lower than their U.S. counterparts and dividend yields which were more than twice as high.

Conversely, even as global central banks move towards tightening, real 10-year Treasury yields are at their lowest levels in decades, as shown on page 33, while credit spreads are almost all tighter than average, as displayed on page 37.? By contrast, alternatives, as shown on page 58, continue to provide strong income streams in a low-rate environment.

All of this suggests that long-term investors may want to consider being a little overweight international equities, U.S. value stocks and alternatives relative to long-duration fixed income and U.S. growth stocks.? However, more importantly, it speaks to a need to reconsider portfolio positioning entering the New Year.

Sari and I survived my early driving lessons and, as we quietly toasted in the New Year at home, we wished, like everyone else, for a quick end to the pandemic and a more fun and normal 2022.? Despite Omicron, there is a good chance that this will actually transpire and 2022 will be a much better year, from a social perspective, for all of us.? However, there are, as always, many political, geopolitical, economic, and market risks as well as dangers we can’t perceive at all.? The last two years have provided extraordinary financial gains.? However, they have also left investors even more narrowly concentrated in portfolios dominated by U.S. growth stocks and long-duration bonds.? Entering the New Year, a good resolution would be to rebalance across domestic stocks, international stocks, fixed income and alternatives, both to enhance long-term return prospects and to protect against the surprises that 2022 may bring.??

Disclosure

Any performance quoted is past performance and is not a guarantee of future results.

Diversification does not guarantee investment returns and does not eliminate the risk of loss.

Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.