Three fundamental events have shaped the first quarter of 2022: Russian invasion of Ukraine, Federal Reserve’s hawkish monetary policy guidance and delivery of its first policy rate hike since the pandemic began, and greater reflationary efforts by Chinese authorities to stimulate growth. All these happened on the backdrop of a strong U.S. economy, loose financial conditions, and supply shortages plaguing many industrial sectors and commodities. Year to date, growth stocks fell while energy and material stocks were bid amid rising yields, spreads widened, and earnings guidance have stopped surprising to the upside. In a discussion of the possible path of U.S. economy and financial market, in this piece we analyze the issue from the perspective of growth and policy outlook.
It is important to note that the U.S. economy is already running above pre-pandemic trend in Q4 2021 (Chart 1), which is partly the reason inflation and wages have been growing rapidly – warranting tighter monetary policy by the Fed. In March FOMC statement, Chairman Powell noted that the current labor market is strong and wage growth is rising at a rate that is inconsistent with its inflation target (Chart 2), and the Fed will do what it takes to prevent inflation from spiraling further – including a 50-bps rate hike in May meeting. The narrative initially was that employment will take few years to rise to 2019 level, but in recent quarters it became increasingly clear that lower participation rate from early retirement and slower come back of productive-age worker – coupled with strong rebound in the economy – have created a mismatch in the labor market. This is also highlighted by job opening and quit rates that are significantly above pre-pandemic average across all sectors of the economy (Chart 3).
With the labor market being tight and inflation is higher for longer, the Fed has to raise policy rate to slow demand while the supply side adjust from pandemic and war-related disruptions in order to prevent a wage-inflation spiral. The question is whether the U.S. economy could handle an above 2% policy rate by the end of the year.
The growth outlook going forward, however, is much less rosy. The rise in oil prices, yields, and U.S. dollar amount to a growth tax to the economy that historically slowed growth in the subsequent 6-9 months. For example, a relatively inelastic demand for gasoline – and food – and the rise in prices mean households must reduce spending in other categories, reducing their demand (Chart 4 and 5). Worryingly, the rise in energy prices tend to also push other goods input cost higher, which we are seeing in the past several months. Meanwhile, the rise in yields and mortgage rates will weigh on the affordability of housing, and hence demand, for property and its related industry. A more expensive financing will also moderate M&A activities, which experienced a boom in 2020/21. Taken together, consumption growth will likely slow significantly or even decline in the second half this year. The outlook is even worse in Europe where the manufacturing sector is hurt by the spike in energy prices and supply constraints are prolonged by the disruption related to the war in Ukraine. Countries with large auto manufacturing will continue to suffer, i.e., Germany, Poland, Czech, and Hungary.
The late cycle behaviour and slowing growth outlook complicate the Fed’s job in normalizing financial conditions. In the case where the Fed is behind the curve in normalizing its policy, wage-inflation spiral could intensify and force the Fed to tighten abruptly at a later point in time to regain its credibility – potentially causing a recession. On the opposite scenario, the Fed could overtighten at a time when the growth is deteriorating and supply chain-related bottleneck eases. We think the pricing of 10/2-year spread, FOMC dot plot, and OIS forwards currently point to the latter risk (Chart 6).
In addition to the rate hike, the Fed also expects to begin reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities at the coming meeting. Although little is understood about the impact of QT to financial conditions and the timing and size of quantitative tightening (QT) remain unclear, it will amount to a drain of liquidity in the market. What we know today is that 10-year Treasury yield tend to fall following the end of QE. As money supply growth moderates from base effect and reduction of Fed’s balance sheet, market volatility tends to rise and multiples slide lower, which we will discuss in the next section. A steepening in the yield curve would be a sign that the economy could handle higher policy rate and a green light for risk assets (Chart 7). In the meanwhile, we remain cautiously overweight equities in a balanced portfolio.
We still believe that the current inflationary pressure is driven by supply disruptions affecting many industries and commodities. For example, chip shortages in the auto sector pushed used and new car prices much higher in the past two years, which was significant contributor to headline inflation. Similar case could be made to food and energy prices, which were already creeping higher even before the war in Ukraine. More worrisome is the stagnation in global trade to GDP as companies’ priority shifts from efficiency to resilience, which mean higher goods prices for consumers in the long run. But so far there are little signs that we are entering a major inflationary period. Chart 8 shows that money velocity (nominal GDP divided by M2) has barely risen in Q4 2021, contrary to what happened in the previous high inflation periods in the 1970s.
Despite the tighter monetary condition in a slowing growth, it is not inevitable for the U.S. to fall into a major growth slump; the Fed could timely pause its rate hike if growth fall to a worrying level and the business cycle could start to pick up again towards the end of this year. More importantly, Chinese economy is bottoming, and the authorities have made a sharp U-turn of late amid prolonged property sector crisis, moderating exports demand, and covid-related lockdown. This should provide a cross-cyclical support for global growth. Few interesting observations:
- Inflation in the U.S. (7.9% yoy) is at record-high level since the turn of millennium while Chinese headline inflation is at only 0.9% yoy. It is important to note that China is also a large energy importer, with large portion of its energy generation powered by coal. The divergence between inflationary pressure in the U.S. and China lies in the role of government subsidy and regulation of domestic prices. For example, food and transportation price inflation in the U.S. is 7.9% and 21.1%, respectively. The figure for China is -1.8% and 5.5%, respectively.
- Chinese policymakers are still trying to reflate its domestic growth. In contrast, the Fed is trying to curb demand from the hot U.S. economy characterized by booming housing sector, strong domestic goods consumption, and service sector recovery.
- The risk in China is tilted towards deflationary slump, whereas in the U.S. stagflation is the greater worry. For a while now China has been championing a dual circulation policy to boost its domestic consumption and reduce its reliance on exports demand, however, the crackdown on private companies in multiple sectors (property, tech, education, etc.) have dented confidence for domestic private investment. This further stress the reliance on government spending and investment to boost growth.
All these highlight the likelihood of Chinese credit impulse to continue to rise in the coming quarters, which has historically led to stronger economy and a tailwind for EM assets with a lag (Chart 9). The divergence of monetary policy between U.S. and China also could bolster the dollar vs Chinese yuan (Chart 10), which should be deflationary for U.S. imports prices.
In the first quarter of 2022, Bank of Canada and the Federal Reserves raised interest rates for the first time since the pandemic began as inflation continued to rise and commodity prices spiked amid Russian invasion of Ukraine – worsening the supply chain disruption in few industries such as auto manufacturing. Both Canadian and U.S. economy is estimated to be running above potential with signs of tight labor market and strong wage growth, which justifies normalization of monetary and fiscal policies. Indeed, the Fed ramped up its hawkish commentaries in March FOMC meeting, sending 10-year Treasury yields to rise to 2.4% from only 1.5% at the beginning of the year while equity rebounded in mid-March as concerns related to the war in Ukraine diminishes.
Going forward, the macro environment is becoming more unfavorable for risk assets and the outlook for U.S. stocks is cloudier despite still being attractive relative to other asset class. There are two fundamental drivers of stock price movement, namely earnings and multiples. Currently, the market consensus is expecting 15% growth ($228) for S&P 500 earnings in the next 12-month and the index is trading at 19.8x forward earnings. Both of variables will likely face rising headwinds going into the second quarter of the year:
Despite the macro environment turning gloomy, a downturn in the business cycle does not necessarily turned into a recession or a stock market collapse. There were many occasions in history when the Fed was able to stage a soft landing of the economy and the stock market continued to rise.
Chart 14 highlights previous periods of peak to through in U.S. business cycle, proxied by ISM manufacturing PMI, and the corresponding S&P 500 return. Clearly, the most bullish periods for stocks are when the business cycle is rising and earnings are recovering from the prior downturn. Most of the gains in stocks have been during these periods. However, stocks tend to also do well in the late phase of the business cycle. Getting out too early could mean forgoing sizeable gains, especially when recession is avoided. In the highlighted periods below, stocks continued to rise following the peak in manufacturing PMI, and only corrected once it was becoming clear that manufacturing activities will contract (i.e., PMI falling below the 50-threshold level).
The argument for equities also comes from the limited alternatives investors have in their portfolio allocation. The real (inflation-adjusted) returns of bonds and cash real returns are even more depressed compared to equities, and the former has suffered from the rise in yields as the Fed hikes. For the time being, investors should focus on active management and sector selection rather than trying to time the market. Within the equity team, we continue to hold growth at reasonable price (GARP) approach, favoring undervalued companies with long-term growth opportunities.
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