While 2021 for most economies was a year of fiscal and monetary accommodation to counter the impact of the coronavirus on the economy, 2022 will be characterized broadly by policy normalization. Barring new variants of the virus that are highly transmissible and deadly, fiscal and monetary policymakers will stop pushing the pedal to the metal on stimulus to support economic growth.
U.S. Faces Weaker Growth and Inflation
Nowhere is this more evident than the U.S. The result will be a different growth and inflation outlook towards the end of the year than we are seeing now. In December 2021, Personal Consumption Expenditures (PCE) inflation, the Fed’s preferred metric of inflation, hit 5.8%, nearly the highest rate in four decades—while CPI reached 7%. The consensus was that the Fed was behind the curve on leaning against inflation and withdrawing monetary accommodation. This view was cemented further when the US saw real GDP growth accelerate from 2.3% annualized in the third quarter of 2021 to a robust 6.9% in the fourth quarter. Even Fed Chair Jay Powell retired the phrase “transitory” to describe higher inflation.
Economists such as Larry Summers and Olivier Blanchard warned early in 2021 that fiscal stimulus measures were overdone and would overheat the economy and drive inflation higher. According to the Brookings Institution’s Fiscal Impact Monitor, fiscal stimulus was a tailwind for growth in the first quarter of last year, but from thereon out it will be a drag. Based on estimates from the Office of Management and Budget, the fiscal retrenchment the U.S. will undergo in 2022 relative to the previous year will be the second largest in the country’s history.
Such fiscal retrenchment isn’t a concern if stimulus measures went into household bank accounts and will now be unleashed as higher consumption. According to data from the JP Morgan Institute, low-income households benefited the most from fiscal stimulus measures but have also burned through them faster. Low-income households have a high marginal propensity to consume (they spend a larger percentage of their savings on things like rent, food and healthcare). If they have already spent most of their financial cushion, they cannot be relied on to drive consumption higher in 2022. The upshot is that these people may reenter the labor force to find jobs, alleviating the shortage of workers we have seen over the course of the past year and reducing upward pressure on wages and prices.
The investment outlook will look less favorable in 2022 as well, as interest rates rise. U.S. Treasury yields have already backed up significantly in the first few weeks of 2022, with corporate yields following suit. Foreign demand will also remain tepid as China’s economy continues to slow.
Weak domestic and foreign demand and a strengthening U.S. dollar will take upward pressure off of inflation in the U.S. Supply chain disruptions may be even worse in the first quarter of 2022 than last year as workers fall ill, consumers stay home and outbreaks in China force factory closures and lockdowns. But on the other side of the omicron wave, supply chain disruptions should begin to abate. There are signs this may already be underway, as order backlogs and supply delivery times have improved in recent months.
As COVID-19 becomes endemic, with luck before the end of the year, the structural drivers of lower inflation over the past 15 years should reassert themselves. High market concentration, low worker power and technological innovation have all been turbocharged over the course of the pandemic and should put downward pressure on inflation.
Even with inflation abating in H2, we expect the Fed to hike rates three times in 2022, beginning in March after the balance sheet tapering process has concluded. We also believe the Fed will begin shrinking its balance sheet shortly after the first rate hike, using caps as it did in 2015-2019 to give investors clarity on the pace while also maintaining some flexibility. The balance sheet run-off will be faster than in 2015-2019, but we do not expect it to disrupt markets given that growth and inflation are stronger now than the previous period, the weighted average maturity of assets on the Fed’s balance sheet is shorter and the Fed has established a Standing Repo Facility (SRP) that should serve as a circuit breaker to prevent another spike in repo rates as reserves become scarcer like in September 2019.
Trouble in Emerging Markets
China enjoyed strong growth in the first half of 2021 (in part because of the weak year-earlier comparison) but slowed down significantly in the first half. The Chinese slowdown was deliberately engineered as President Xi sacrificed short-term economic growth in favor of longer-term goals such as financial stability (particularly in the real estate sector), common prosperity and achieving CO2 emissions targets. The outlook for growth in 2022 depends on how the Communist Party sees the balance of these priorities. At the 2021 Economic Work Conference in December, officials clearly signaled that they would support the economy in 2022 with fiscal and monetary stimulus. Still, we expect continued commitment to these longer-term goals, which will continue to drag on growth.
There are two key risks for the Chinese economy. First, China continues to pursue a zero-COVID-19 policy, which makes it particularly vulnerable to outbreaks of highly transmissible variants such as omicron. Lockdowns and factory closures will persist until the omicron wave passes, dragging on growth. Second, authorities aim to deflate the real estate bubble in China and reduce moral hazard in the sector by reducing investment, causing defaults among property developers. The government aims to manage these defaults, but if they begin cascading, we could see a hard landing for the Chinese property market, which directly and indirectly accounts for roughly 20% of the Chinese economy.
A slowdown in China and higher interest rates in the U.S. could cause instability in a number of emerging markets (EM). EM countries plan to retrench in 2022-2023 as they try to reign in their fiscal dynamic after paying for measures to address the pandemic. Many EMs, particularly in Asia, are heavily reliant on China for demand. In addition, EMs have reduced their reliance as a whole on Eurodollar bonds for sovereign financing but increased it for private sector financing. As the Fed hikes rates and the U.S. dollar appreciates, that will make this foreign denominated debt more difficult to service. Furthermore, much of EM trade is invoiced in U.S. dollars, making imports more expensive in local currency terms. According to data from the Institute for International Finance, EMs excluding China saw a sudden stop in capital flows at the end of 2021. These factors could prompt a series of sovereign debt crises in EM in 2022-2023.
Is Europe a Bright Spot?
EU countries will continue to benefit from what one Italian policymaker referred to as “free money from heaven” in 2023 as Recovery and Resilience Fund (RRF) money is dispersed. These funds come in the form of both grants and loans and are financed by mutualized debt issued at the EU level. A significant portion must be earmarked for the green transition and digitalization, both of which should boost potential growth in member states. Eurozone countries in particular will also continue to benefit from significant monetary accommodation as the European Central Bank (ECB) is likely to maintain negative rates through 2022.
There are two risks regarding the use of RRF money. First, they are dispersed with conditionality; member states must implement the European Commission-recommended reforms to receive tranches of funds. Many of these reforms have been proposed for decades and have not been implemented previously because they’re politically difficult. Even if member states do manage to carry out these reforms, they may not find good projects to spend the money on, and administration may be bureaucratic and slow. On average, EU member states tend to absorb roughly half of the structural funds dispersed by Brussels. Spain and Italy absorb about 35% and 39%, respectively, but are set to receive the largest chunk of the RRF in absolute terms. If member states cannot absorb the RRF money by the time it expires in 2026, northern European countries are unlikely to agree to mutualized debt again.
Top risks:
- The U.S. finds itself in an energy crisis, with demand for energy reverting to pre-pandemic levels in 2022 while supply lags. This is a result of chronic underinvestment in fossil fuels; despite energy equities performing very well in 2021, institutional money has not flowed into the sector in part because of ESG targets. If the shale wells cannot be turned on quickly and Iranian gas is not tapped and transported this year (pending a nuclear deal), brent oil prices could exceed $100/barrel. This would push inflation up and could serve as a drag on growth, putting the Fed in a stagflationary environment in which its tools are ineffective.
- U.S. corporate profits falter as rates rise in the U.S., causing a swathe of defaults in the corporate sector. Many economists were concerned about leverage in the U.S. corporate sector sparking the next downturn back in 2019. The sector is even more leveraged now as a result of monetary policy accommodation. Many corporates have built up strong cash positions, but some may run into trouble with lower profits and higher borrowing costs.
- Productivity growth underpins much higher growth and lower inflation. We witnessed significant wage growth in the U.S. in the second half of 2021, and some economists have worried that a wage/price spiral will drive inflation higher. But if wages rise and productivity growth increases, then firms do not pass the higher cost of labor through to the end user in the form of higher prices. Higher wages and productivity can raise living standards without driving inflation higher. Investment has been weak for 15 years, credit will remain cheap even with rates rising and many firms have taken the opportunity to automate during the lockdowns of 2020. This should boost productivity growth.
- The Fed fell behind the curve and has to hike rates more aggressively. If inflation doesn’t abate in 2022, the Fed may have to withdraw accommodation faster than it currently expects. This could prompt a rotation out of equities into fixed income, and within equities out of growth into value stocks.
- China overdoes stimulus. China has shown time and time again that even though it is a centrally planned economy, fiscal and monetary stimulus measures are not precise and frequently officials overdo it. If China’s economy slows more than expected in 2022, either because of cascading defaults in the property sector or because of extensive lockdowns as part of China’s zero-COVID-19 strategy, then officials may pull on traditional levers to reflate the economy such as fixed asset investment and the property market. This would generate more demand globally than expected, but could also necessitate a larger slowdown further down the line as President Xi remains committed to financial stability, common prosperity and the green transition.
- Geopolitical conflict erupts. There are two main candidates for hot spots in 2022: Russia/Ukraine and China/Taiwan. Of the two, the first is the higher probability but lower impact event. Russia continues to amass troops and weapons along the Ukrainian border. If it does invade Ukraine, the U.S. and Europe will likely impose further sanctions, falling short of kicking Russia out of the Society for Worldwide Interbank Financial Telecommunication (SWIFT). Russia’s economy would certainly suffer, and Russia could retaliate by cutting off energy to Europe at a time when oil and gas supplies are already low. This poses significant upside risk for inflation in the eurozone. An open conflict between China and Taiwan is less likely but would have an even larger impact on the global economy. This is partly because Taiwan is the source of most of the world’s semiconductor chips, already in short supply. But moreover the U.S. has pledged to come to Taiwan’s defense. Open conflict with China is not in the U.S.’s best interests and would probably be avoided at all costs, with the role of the U.S. on the global stage suffering significantly as a result. Both China and Japan would consider the U.S.’s actions a precedent for what would happen if tensions in the South China Sea also erupted, and the U.S.’s reputation as an unreliable ally would be further cemented.
