If the last two years have taught us anything, surely it’s that forecasting the future is a fool’s errand.  Who, at the beginning of 2020, could have predicted the onset of a global pandemic and the subsequent economic shock that followed, prompting unprecedented fiscal and monetary intervention, resulting in a new peak in economic output and a doubling of the stock market, all in 22 months? At many points over the past few years, time seemed to have slowed to a crawl, while more recently – at least as it relates to the economy and markets – time seems to have sped up. And the story is still unfolding. Although daily life has returned to some semblance of normality in most parts of the country, Covid-19 continues to mutate and spread, business as usual is anything but, and mask manufacturers are in no danger of closing shop anytime soon.

Chastened by the savage unpredictability of the recent past, we approach the outlook for next year with more than the usual degree of trepidation. Suffice it to say that 2022 is likely to be a year of even more change (how’s that for an easy prediction?), as economic leadership shifts from the emergency supports of government spending and low interest rates back towards more fundamental drivers. Transitions are tricky, and therein lies the risk as the new year dawns. Will a continued recovery in the labor market support household income and spending? Will companies be able to find enough workers to fill open positions? Will supply chains heal, or is higher inflation the new normal? Might inflation force the Federal Reserve to raise interest rates more quickly than markets anticipate? Can corporate earnings and profit margins continue to expand? And lest we forget the obvious, can the economy really return to normal with a backdrop of a lingering global pandemic?

We start the new year at the crossroads on many of these issues, with implications for the economy, business, and financial markets. Which way now?

What’s Past is Prologue

Let us start with a quick glance back at 2021 for context. As the new year dawned, the Pfizer and Moderna vaccines for Covid-19 had just been given emergency use authorization by the FDA.  Although this was undeniably good news, delivering the vaccine efficiently to at-risk populations proved to be a challenge. An article on page A1 of the New York Times on January 1 explained in great detail why the distribution of vaccines was taking longer than expected, thereby putting “the campaign to vaccinate the United States against Covid-19 far behind schedule in its third week.”  States rationed limited doses by imposed differing eligibility requirements based on age and the presence of underlying conditions, leading to long lines, “vaccine tourism,” and occasionally wasted doses.

Economic news was similarly unsettling. Although things had clearly improved from the earliest and darkest days of the pandemic, 2021 dawned with more economic questions than answers, particularly in the labor market. Unemployment stood at 6.7%. Over 800,000 people were filing initial claims for unemployment insurance every week, and more than 5 million people were filing continuing claims week after week. At the risk of mixing metaphors, there was light at the end of the tunnel, but the economy wasn’t out of the woods quite yet.

Because of this fragility, and on the very afternoon of his inauguration, President Joe Biden unveiled his proposed $1.9 trillion American Rescue Plan. Once debated and amended by the Senate and House, and enacted in March, the plan included, among other things, an extension of enhanced unemployment benefits of $300 per week, $1,400 direct payments to individuals, an expanded child tax credit, and a continuation of the Paycheck Protection Program. This legislation built on the $2.2 trillion Cares Act passed in March 2020, and the $900 billion in economic support included in the Consolidated Appropriations Act passed in December 2020, both under the Trump administration.  These three plans together added up to $5 trillion of economic stimulus, equivalent to about 25% of GDP. To put this into context, the American Recovery and Reinvestment Act of 2009, passed in response to the global financial crisis, was only $831 billion, or about 5% of GDP at the time.

The ultimate driver of the U.S. economy is personal consumption, which is precisely why so much of this fiscal stimulus was designed to put dollars into people’s pockets, in the hopes that they would then be spent. And it worked. The nearby graph illustrates trends in household income and spending. The gap between the two lines represents unspent income, or savings. The three notable spikes in disposable income in 2020 and early 2021 correlate to the three major pieces of legislation mentioned in the previous paragraph. This is not a new phenomenon: Previous government spending programs, usually enacted in periods of economic stress, were also designed to boost household income, but never to the degree of the past two years.

As is abundantly clear in the graph, this time has been truly different. As lockdowns and quarantines sharply curtailed normal consumption patterns, household spending fell by almost 20% in merely two months, while at the same time government spending was boosting income. By comparison, the effect of the global financial crisis of 2008-2009 on household finances is barely visible in the data history. This powerful combination of surging incomes and falling spending pushed household savings up to as high as $7 trillion, ensuring that once quarantines were relaxed and people could spend money again, there was plenty of money to be spent.

Congress and the White House weren’t alone in riding to the economic rescue. The Federal Reserve acted swiftly in 2020 to slash interest rates to zero while introducing a litany of acronymed programs designed to backstop different sectors of fixed income markets. Although many of these programs were never actually implemented, the mere potential of monetary “shock and awe” was enough to stabilize markets. Throughout 2021, the Fed continued to buy treasuries and asset backed securities to support the bond market, adding an additional $1.3 trillion of assets to its balance sheet (and a total of $4.5 trillion since the beginning of the pandemic.) The fed funds rate spent the entire year at a rounding error to zero.

As the calendar turns once again to a new year, this prologue is all in the past. Although the Biden administration continues to push for its $1.9 trillion Build Back Better plan, the urgent necessity of bolstering household income through policy has ebbed, as inflation rises and deficit hawks in both political parties find their voices again. The Fed is responding to the rise in inflation as well, and has begun the long journey back to a more normal state of monetary policy, starting with the so-called “tapering” of bond purchases and balance sheet expansion. At present, the futures market anticipates that the Fed will raise interest rates three times in 2022, bringing short term interest rates up to around 75 basis points (three-quarters of one percent) by the end of the year.  To be sure, this is still a very accommodative policy, but inflationary concerns (about which more later) could accelerate this rise in interest rates.

A Transition in Economic Leadership

An important economic plotline in 2022 will be the transition in leadership from the fiscal and monetary support of the past two years back to the traditional and fundamental drivers of household income and spending. As observed earlier, household savings rose to unprecedented levels in early 2021, but has since fallen back to $1.8 trillion (as of October), slightly below where it was just prior to the onset of the pandemic. In other words, households have spent all of the excess savings that government stimulus helped to create, implying that something else will need to propel spending – and therefore the economy – going forward.

This is a labor market story; people spend money when they have jobs and income, and are confident in retaining their jobs and income. The psychological component of job security is as important as the income itself. Analyzing the labor market today is like the old story of the blind monks who, upon encountering an elephant for the first time, each offered a very different description depending on what part of the animal he felt.  One monk who touched a leg claimed the elephant was just like a tree, while another grasped the trunk and described the animal like a rope.  Both descriptions are accurate in their detail, but miss the big picture. So, too, are the various measures of economic health today. Some data series indicate full employment and a healthy jobs market, while others show signs of fragility. Getting the full picture requires a broad view.

Let’s walk around the elephant and look at the good news first. The economy has added over 6.1 million jobs in the first 11 months of 2021, with every monthly report except one revised upward from the preliminary release. This brought the headline unemployment rate in November down to 4.2%, from 6.7% at the end of last year and a peak of 14.8% in April 2020. This is not far away from the 20-year record low of 3.5% set just prior to the pandemic. Furthermore, this impressive improvement extends across the employment spectrum. Unemployment for workers with a college degree or higher is a scant 2.3% (versus a record low of 1.8%), while at the other end of the educational scale, the unemployment rate for people without a high school degree stands at 5.7%, down from 21.0% in April 2020 and compared to a record low of 5.0%. 

If our analysis ended there, we would conclude that the labor market is in fine shape, well positioned to fuel continued economic growth in 2022. But this isn’t the whole picture. Although unemployment rates have improved dramatically, the total size of the labor force remains 3.9 million jobs below the pre-pandemic peak. As we travel (or zoom) around the country speaking with clients who own businesses, a common and consistent lament is a shortage of labor (although we can confirm a bull market in the printing of “help wanted” signs).

The seeming mystery of low unemployment coupled with a labor shortage is reflected in a labor participation rate that dropped sharply during the pandemic, and hasn’t yet fully recovered. What explains this shortfall, and how might it improve? First, there is an easily overlooked demographic element at work here. Over 30% of the decline in labor force participation is attributable to workers aged 55 and older, a segment of the population more susceptible to the medical implications of Covid-19. The United States has suffered over 800,000 deaths from Covid-19 and an untold number of long-covid cases that likely fall disproportionally on this part of the population. To be sure, not all Covid sufferers are in the workforce to begin with, but the threat that Covid-19 poses to older workers may help to explain their exit from the labor force, or reluctance to return. At the same time, older Americans tend to have more financial assets and home equity. A rising stock market and housing prices therefore make early retirement easier to contemplate.

Second, and on the other end of the age spectrum, the disruption to K-12 education has similarly impeded the ability of younger workers with school-age children to return to the labor force. It’s not retirement driving this exodus, as much as it is needing to take care of the kids. If it’s not clear that one’s children will reliably be in a classroom, and might be sent home to learn remotely in case of an outbreak, it is difficult for parents to commit to a regular work schedule, particularly if their jobs require being on site.

The good news is that vaccinations are helping to reverse this dynamic. Progress is never a straight line: The surge of the delta variant over the summer of 2021 dented the recovery of the labor force, and omicron might be imposing a similar constraint now. Nevertheless, broadening vaccinations – particularly for school-age children – will increasingly shift these incentive structure to allow for a more robust return to the labor market as 2022 unfolds.

Finally, as illustrated in the graph of household income and spending we saw earlier, as savings are spent, the urgency to return to the labor force and earn a steady paycheck grows. It’s already happening. If the labor market continues to grow at the average monthly pace of 2021, the economy should return to previous peak levels of employment sometime in the third quarter of 2022.

In the meantime, there is sharp disconnect between the supply of and demand for labor. The nearby graph of the available supply of labor will look familiar as it is essentially the same shape as the unemployment rate, but measured in absolute available workers rather than a percentage. The last data point (October 2021) is 7.4 million unemployed – but available – workers. 

The blue line represents current openings for 11 million jobs, a figure which rose sharply over the course of the past year as lockdown conditions eased and the economy rebounded. The challenge at present is quite clear: There are roughly 3.6 million more job openings that there are workers available to fill them, a figure that is, coincidentally, very close to the overall gap of 3.9 million in the size of labor force shown earlier. Again, our expectation is that the supply of labor will rebound over the course of 2022 as people continue to re-enter the labor force, but as the economy continues to expand and more and more jobs are created, this gap between supply and demand may persist for some time.  

As we finish describing the various aspects of the elephant that is the labor force (to bring our earlier analogy to a close), we could conclude reasonably that despite the impressive improvement in job growth and unemployment rates in 2021, there is more work to be done. (Literally!)

It is a basic economic premise that when demand outstrips supply for anything for a prolonged period, prices rise. It’s true for pork bellies and steel, and it’s true for labor as well. As the economy shifted quickly from a surplus of labor earlier this year to a deficit at present, employers have had to raise wages to attract and retain employees.

In the early days of the pandemic, average hourly earnings shot upward, due entirely to a shift in the composition of the labor force. Higher-income workers generally had an easier time pivoting to remote work and retaining their jobs, while lower-income or hourly workers were more often furloughed or lost their jobs altogether. Removing lower-income workers from the aggregate calculation pushed the average higher in early 2020. As conditions improved and lower-income workers returns, the opposite effect took place, and the year-over-year comparisons dropped sharply. As this statistical volatility and comparison effects have waned over the past few months, we are beginning to get a truer picture of the wage environment. We know – anecdotally – that companies are having to pay higher wages to find workers, and the economic data is beginning to bear that dynamic out as well. Average hourly earnings were up 4.8% in November, and are likely to rise from there unless and until the supply and demand imbalances outlined earlier revert to the historical norm.

If one important economic plotline in 2022 is the continued recovery in the labor market, a closely related sub-plot is whether or not rising wages will lead to a sustained rise in inflation, a topic to which we turn next.

All Rise

There is no debate as to whether or not inflation is here. It is. The Consumer Price Index (CPI) has risen sharply for well over a year now, from a recent low of 0.1% in May 2020 to a 39-year high of 6.8% in November 2021. Core CPI, which removes the more volatile elements of food and energy, stands at a more modest 4.9%, but even this is a 30-year high.

The interesting debate as we enter 2022 is not the existence of inflation, but where it is coming from, and how long it will linger. To resort to a rather overused word, how “transitory” is the inflation illustrated in the nearby graph?

As with the labor market, inflation represents the twin effects of rising demand and falling supply, in this case across the entire economy. Widespread lockdowns in the early months of the pandemic resulted in pent up demand, as consumers were unable or unwilling to spend money. Yes, we could all binge Netflix and order groceries from Amazon, but purchases of capital goods such as automobiles and appliances fell sharply as people stayed close to home. As we’ve seen, government stimulus created an unprecedented rise in household income so that when consumers felt more comfortable spending money, the money was there to spend. In economic terms, this pent-up demand, once released, pushed out the aggregate demand curve, resulting in higher prices.

But wait, as they say on TV infomercials, there’s more! At the same time that demand was rising, supply chain disruptions pushed the aggregate supply curve down, leading to even more pricing pressure. Put simply, over the past year people have been more and more eager to spend more and more money on goods that are less and less available. The economy restores balance to this equation through higher prices. And just as the pandemic was a global phenomenon, so, too has been this inflationary combination of pent-up demand and constrained supply led to higher inflation around the globe.

So much for the recent sources of inflation; how long will it last? We do not believe that higher levels of demand are sustainable. As we have seen, excess savings have largely been spent down, and pent-up demand, once met, is sated. For example, if a buyer in need of a new dishwasher has finally bought one, he isn’t likely to buy another one next week. It may take some time, but demand will “catch up,” and should return to more historically normal levels as 2022 unfolds.

Similarly with disrupted supply chains, which largely reflect constraints in transportation and (as seen earlier) the labor force that is required to make goods move. Here, too, we are beginning to see some relief already, and should continue to do so as the new year proceeds. Consider, for example, the cost of transporting goods as shown in the nearby graph. The Baltic Dry Index is an index of the cost of shipping dry goods (that is, not oil and gas) across 20 different global routes. The sharp rise in the index over the first nine months of 2021 speaks to shipping constraints, delayed deliveries, and upward pressure on inflation. From the peak in early October, rates are now down almost 50%, indicating easier shipping, fewer delays, and less inflationary pressure. We expect that these cyclical drivers of inflation – pent-up demand and disrupted supply chains – will ebb in 2022, and that inflation will start to subside.

The Federal Reserve intends to do its part to make sure that this happens. Just as the federal government stopped passing stimulus packages earlier this year, the Federal Reserve has similarly taken the first few steps toward restoring a monetary policy more appropriate for current and expected economic conditions. This will have no effect on restoring the health of supply chains, but should (at least at the margin) help to rein in excess spending and investment. In October, the Fed announced that it would trim its bond buying by $15 billion per month, with a goal of bringing balance sheet expansion to an end by the summer of 2022. In December, the Fed accelerated this tapering to $30 billion a month, acknowledging that “supply and demand imbalances related to the pandemic and the reopening of the economy have continued to contribute to elevated levels of inflation.”

Once the Fed’s balance sheet plateaus, it will likely begin to raise interest rates, albeit at a gradual pace. At present, the fed funds futures market anticipates that the Fed will raise interest rates three times in 2022, bringing the fed funds rate to 0.74% by year end, with two or three more hikes to follow in 2023, bringing the fed funds rate to 1.41%.

Two important notes: Nothing in this graph is a contract or guarantee, just current market expectations, which can shift rapidly as market conditions and inflation warrant. Second, although this represents a move towards more normal monetary policy, by no means does this qualify as tight, or restrictive conditions. Indeed, the futures market currently doesn’t expect the fed funds rate to exceed 2% at any point before 2026. Interest rates are likely to remain lower for longer.

Conventional wisdom holds that higher interest rates are bad for the economy and stock market.  But the important nuance here is not that the Fed is raising interest rates, but why. If interest rates are rising due to growing confidence in the health of the labor market, durability of economic activity, and strength of corporate earnings, then the market and economy can thrive even as interest rates head higher. On the other hand, if rates are rising because the market has concluded that the Fed is behind the curve on inflation and is raising rates to catch up, this can be disruptive. It is too early to tell which narrative will win the day as the Fed embarks on raising rates in 2022, but it is a nuance worth watching closely.

We have focused on the cyclical inflationary impacts of pent-up demand and supply chain disruption over these past few paragraphs. In addition to abating cyclical pressures, longer-term trends in demographics and technology should further help to prevent current levels of inflation from becoming the new normal.

Older populations tend to have lower rates of inflation, theoretically because spending patterns shift as people grow older and downsize homes. The correlation in the nearby graph between median age and average inflation over the last decade in 114 countries shows a rough correlation (0.48 to be precise) that bears out this observation. Japan is a case study in this relationship, with the highest median age in the world of 48.6, and annualized inflation of only 0.5% from 2010 through 2020.  Median age in the United States is 38.5 (and rising), with inflation of 1.8% over the past decade.  The correlation between inflation and age is far from perfect, but suggests that demographics in the US ought to help to prevent higher inflation from becoming endemic.

A second secular disinflationary force is technology. As an example, the rapid and (largely) involuntary adoption of technology during the pandemic resulted in meetings taking place on Zoom instead of in rooms, requiring fewer car trips, hotel rooms, meals on the road, and airline tickets.  We won’t leave Zoom and other technological innovations behind even as and when we return to normal, and this should provide further long-term constraints on rising inflation.

Indeed, the accelerated adoption of technology is likely to have not only a dampening effect on inflation, but also a beneficial effect on productivity, which are ultimately two sides of the same coin.  Enhanced productivity may be the lasting and most beneficial silver lining to emerge from the otherwise dreadful experience of the Covid-19 pandemic.

Productivity

We have yet to address perhaps the greatest conundrum to arise over the course of the past few years. Recovery in the labor market is far from complete, disrupted supply and demand is pushing prices higher, and the omicron variant reminds us that the pandemic isn’t quite over. And yet economic output and equity market prices are at all-time highs. How can this be? In stark economic terms, how can GDP surpass previous peak levels with 3.9 million fewer workers? The answer to this question, and perhaps the broadest silver lining to emerge from the pandemic, is that productivity has surged.

GDP per worker has risen 5% from the end of 2019 through 3Q21. This may not seem meaningful, but over time, productivity growth averages only about 1% per annum. The graph shown here is based on real GDP, and therefore adjusts for inflation. Nominal GDP per worker is up 9.1% over this same six-quarter period, versus an average annual pace of 3.0%. This is quite an acceleration. A similar productivity phenomenon happened as the economy recovered from the global financial crisis, albeit over a longer time period and at a slower pace. Note that the rise in productivity from 2009-2010 did not revert once the crisis passed – the improvement persisted. It turns out that necessity really is the mother of economic invention, and this is playing out once again in this cycle.

This is admittedly a broad and rough picture. It is easier to measure productivity directly in an economy defined by industry and manufacturing. If a factory buys new machines and improves its output from 100 widgets per minute to 110, the resulting 10% improvement in productivity is obvious and simple to calculate. As economic leadership has shifted to technology, however, it has become far harder to quantify productivity gains. There is no question, for example, that having a navigation app on my phone enables me to get where I’m going more quickly and safely. I am therefore more productive because of Waze, but measuring that improvement is difficult.

This productivity phenomenon is evident in the corporate sector as well. Company earnings have rebounded robustly from the early days of the pandemic, and continue to exceed analysts’ expectations, even as these expectations continue to rise. In 3Q21, fully 80% of companies in the S&P 500 index reported earnings that were higher than analysts expected. More often than not, the upside surprises were due to rising profit margins, another reflection of surging productivity.

The nearby graph illustrates the operating profit margin – operating profits divided by sales – for the S&P 500 index. As is evident, margins are cyclical: They drop during recessions (all the way to zero during the worst quarter of the global financial crisis), and then rebound as economic conditions improve, to average about 9% over the course of an entire cycle. Margins fell to 6% in 1Q20, but improved quickly starting the next quarter, reflecting the quick recovery in the economy. Margins improved to 10.4% by the end of 2021, and then kept rising. For each of the first three quarters of 2021, margins exceeded 13%. As with the improvement in economic output, this may not seem like a meaningful increase. Nevertheless, a margin improvement of just a few percentage points across the entire equity markets represents a significant tailwind to earnings growth. This story should continue to play out over 2022, as companies accelerate the adoption of technology and use fixed assets (such as real estate) more efficiently.

For the 2021 calendar year, earnings of the S&P 500 are likely to be up 65% year-over-year, whereas the index itself has risen about 25% (through mid-December). As earnings have risen more rapidly than the index price, the price-to-earnings (PE) ratio has dropped from over 30 at the beginning of the year to roughly 23 at present. Consensus expectations conservatively call for earnings to rise an additional 9% in 2022, which would bring the PE multiple down to 21 times based on forward earnings estimates.

The S&P 500 index increasingly does not capture the breadth of opportunity and risk on offer in the equity market today. The top ten stocks by market capitalization (price times the outstanding number of shares), along with performance and forward PE multiples, are shown in the nearby table. As of mid-December, these ten household names accounted for over 30% of the value of the S&P 500 index, and account for well over 100% of the performance of the index. Put differently, if this small basket of very large companies outperformed the index in aggregate in 2020 and so far in 2021, then the other 490 stocks in the market, in aggregate, underperformed.  This has been a tough market for active investors.¹

The final column in the table illustrates that many of these companies are rather highly valued compared to the overall index, at least on conventional valuation measures. A more robust analysis of intrinsic value on a stock-by-stock basis requires a deeper understanding of cash flows than a PE multiple alone captures, but the broad message from this table is clear: For the past two years the S&P 500 index has been increasingly dominated by a small handful of large companies, many of which in the broad technology sector. This dominance helps to explain both the performance and valuation of the overall index.

There is both good news and bad news in this dynamic. The bad news is that narrowly-led markets tend to be more fragile, and more susceptible to bouts of price volatility. What goes up occasionally goes down, and if one or more of these stocks stumbles, the overall index will suffer accordingly. It is a timely reminder as we enter 2022 that price volatility is a feature of financial markets, not a bug.  The good news is that active investors can avoid the tyranny of the index by looking for companies that offer a more appealing tradeoff of risk and return, and many of these companies have not enjoyed the price appreciation of their larger brethren. We believe that active management is the best approach to preserving and growing wealth over time, and is particularly important in times like these when the index is so skewed by a small number of names.

Looking Ahead

The last two years have been unprecedented. To be sure, plagues litter the history of humankind, but a global pandemic in a global economy is a new thing. Never before has a pandemic had such broad and lasting economic implications, and never before have the policy responses to these disruptions had so many zeroes at the end of their price tags.

The pandemic itself is like a rock dropped into a still mill pond. At some point – and may that point come soon – the pandemic will come to an end. This doesn’t mean that the virus disappears altogether, as viruses rarely do, but that the impact of Covid-19 on our lives and businesses becomes a seasonal nuisance instead of a constant menace. Yet even then, as the rock in our analogy sinks to the bottom of the pond and stops moving, the ripples on the surface will continue to reverberate for some time to come. 2022 will be “ripply,” as the labor market, wages, inflation, interest rates and corporate earnings settle back to a new definition of normal.

Financial markets will likely reflect this lingering uncertainty. One of the most unusual aspects of the last few years is that there hasn’t been more market volatility. Part of the reason for this, as we have seen, is the silver lining of productivity that has boosted corporate earnings and profitability, and therefore equity prices. Yet volatility is inevitable as an economic transition continues to unfold. A disciplined and patient approach to investing is important in any market environment, and even more so as the economy recovers from a period of unprecedented turmoil.