Finding The Right Balance
Stocks surged last year, reflecting investors’ confidence in the country’s continued healing from the COVID crisis. In fact, the S&P 500 Index hit 70 new highs over the course of 2021, closing out the period at a new record. Equities have not only recovered from the swoon coinciding with the initial COVID-19 outbreak, they have risen 40% above their pre-pandemic peak of February 2020.
The melt-up in stock prices has been propelled by a V-shaped recovery in both economic output and corporate earnings. In the third quarter, corporate America produced record profits in both dollar terms and as a share of GDP. Earnings per share by the S&P 500 (which accounts for 85% of U.S. stock market capitalization) advanced 45% in 2021 to a level 25% above 2019 EPS.
Running out of Greek letters
Investors have largely shrugged off the recent explosion of new COVID cases emanating from the omicron variant. This strain has proven significantly more transmissible than earlier iterations of the SARS-CoV-2 virus. As of January 14th, new cases were running 800,000/day (7-day moving average), more than three times the rate at the crest of the worst previous wave.
Fortunately, preliminary data suggest that omicron is not nearly as virulent as its predecessors. Widespread vaccine adoption plus booster shots have also mitigated its severity. While still regrettably high, deaths from COVID are down to 1,700/day compared to 3,400/day in early 2021. And most serious cases have involved unvaccinated individuals.
While proportionately fewer cases have led to serious outcomes, the massive number of new incidents has pushed hospitalizations back to record levels. Some 150,000 patients are currently hospitalized with COVID, straining some healthcare systems and forcing a rationing of care. Several governors have issued states of emergency. One silver lining to the speed of omicron’s spread: The peak outbreak should be reached relatively soon.
The Food and Drug Administration recently authorized the use of two new oral therapeutics to treat COVID-19. Pfizer’s Paxlovid appears particularly promising. Studies have shown the drug to reduce the risk of hospitalization and death by almost 90%, if taken within five days of the onset of symptoms. The goal posts for containing COVID have shifted from flattening the curve to herd immunity and now, to endemicity — the notion that eventually, the virus will keep circulating but, like the flu, its prevalence and impact at manageable levels.
Will the good times roll?
The economic recovery has been hampered by labor shortages and supply-chain challenges which the omicron breakout will certainly aggravate. In recent weeks, countless businesses have had to curtail operations due to staff shortages from illness. The airline industry represents one glaring example. And overseas, China’s “zero-COVID” policy could potentially lead to the closure of one or more ports. But despite such disruptions, U.S. economic growth should remain above its long-term trend in 2022, albeit at a slower pace than last year.
First, consumer spending on goods has been robust while pent-up demand for services should be unleashed as individuals feel more comfortable getting out. Households still have over $2 trillion of excess savings; some will be spent over the next several quarters. And many have begun borrowing again, as evidenced by rising credit card balances. In November, consumer credit expanded at the fastest monthly rate on record. Feeding the fire, banks have been easing credit standards across all loan categories.
Secondly, business spending should grow meaningfully. After two decades of subdued corporate investment, capital goods orders have soared. And surveys of capex intentions have reached elevated levels. Firms need to add capacity in addition to rebuilding inventories to replenish empty shelves and warehouses. Another tailwind: Over the next five years, the bipartisan Infrastructure Investment and Jobs Act will provide $1.2 trillion in federal spending for roads, bridges, rail, airports, and the power grid, among other things.
Assuming it is realized, solid economic growth should translate into favorable financial results by corporate America this year. At present, Wall Street analysts — admittedly a chronically optimistic lot — forecast that the S&P 500 will grow revenues by over 7%, and earnings by over 9%. Such a pace would mark a notable step down from recent quarters but still decent from an historical standpoint.
Going forward, the Federal Reserve will be the 800-pound gorilla in the room. As MIT economist Rudi Dornbusch famously observed, “…none of the postwar expansions died of natural causes — they were all murdered by the Fed over the issue of inflation.”
Price changes result from an imbalance between supply and demand. In 2021, both those effects worked in the direction of higher consumer prices. From semiconductors to paper towels and truck drivers to waitstaff, supply shrunk while demand exploded. Notwithstanding omicron, supply-side factors should prove mostly temporary, but those pressuring prices from the demand-side may not.
Cash payments to households, enhanced unemployment benefits, mortgage/rent relief, and forgivable loans to small businesses buoyed citizens’ finances and spending power. Meanwhile, a tight labor market has led to rising wages. The U.S. Bureau of Labor Statistics reported that average hourly earnings rose at a 4.7% annual clip in December. Separately, the Atlanta Fed’s Wage Growth Tracker pointed to a 4.5% increase in wages.
Consumer inflation has accelerated with the headline CPI jumping 7% in December (year-over-year). The “Core” rate (excludes food and energy) increased 5.5%. The latest reading marked the largest move up in 40 years. Supply-chain issues continue to amplify these figures — for instance, new and used vehicle price spikes again led the way. Nevertheless, the Fed has become increasingly concerned that inflation pressures are broadening and may not be so ‘transitory’ after all.
It has been over four decades since the U.S. experienced a wage-price spiral. Lingering fears of COVID along with federal stimulus measures have discouraged workers from moving off unemployment rolls or rejoining the labor force. For much of last year, Fed policymakers had dismissed the labor shortages and supply-chain bottlenecks as short-term consequences of the pandemic. Yet employers still report 10.5 million job vacancies across the nation, a staggering number.
Monetary policy has been extremely accommodative since March 2020. After COVID initially locked down the economy, the Fed quickly moved short-term rates down to zero and embarked on a massive bond-buying program. Powell and company saw unemployment as a greater risk than inflation.
This narrative began shifting in December. Minutes from the Federal Open Market Committee meeting indicate that the Fed may need to increase short-term rates “sooner or at a faster pace than participants had earlier anticipated” to prevent an overheating economy. A March rate hike now seems likely and a total of at least three in 2022. In addition, the central bank may start shrinking its $8.8 trillion bond portfolio.
Friend or foe?
Confronting a less friendly Fed, equity investors have suffered some indigestion of late. However, even if the Federal Reserve did raise short-term rates three times this year (@ 0.25%), the Federal Funds rate would be at half the level it had been immediately prior to the start of the pandemic. So, on balance, monetary policy would remain accommodative.
The 10-year Treasury yield has moved up from its pandemic lows but currently stands below 2%. Historically, stocks have shrugged off rising yields as long as they did not increase to prohibitively high levels — levels that would significantly discourage economic activity. At the moment, longer-term inflation expectations are well-anchored so there has been little pressure on long-term rates. Of course, this backdrop could change if the bond market begins to sniff out a protracted period of inflation.
Looking ahead, it is not clear whether the recent price increases signal a coming wave of broad and persistent inflation or just a snapback following the unusually sharp economic downturn in 2020. The Federal Reserve will face a delicate balancing act — reducing the economy’s momentum to forestall inflation — without throwing the country into recession.
The U.S. economy’s growth rate will decelerate this year but should remain above trend. Stock market returns during the slowing stage of a business cycle tend to be lower than those during the recovery stage — where we have been for the last eighteen months. Returns also tend to be more volatile. In any event, it will be the central bank, not COVID-19, that will most impact the investment landscape.
Christopher J. Singleton, CFA, Managing Director
January 19, 2022