Published December 3, 2021
Stock markets have come under pressure lately as the Fed begins withdrawing stimulus and a new Covid-19 variant hits investor confidence in the economic recovery. Over the remainder of the year, we will pass along Schwab’s 2022 outlook, breaking it into a few parts covering the economy and markets. Schwab, having acquired TD Ameritrade, is the biggest retail stock broker in the country. As such, their analysis and insights can have a substantial audience and potential impact on investors. Here is the first part of their outlook focused on a huge market influencer – inflation and its impact on Federal Reserve (e.g. interest rate) policy. Next week, we will provide their views on the economy and markets.
“Key to the 2022 outlook for the consumer, but also the broader economy and inflation, is the labor market. As shown below, total nonfarm payrolls have made a remarkable recovery since the trough in April 2020; but remain 4.2 million below the pre-pandemic peak. At the same time, the breadth of gains is lessened given the still-anemic labor force participation rate, which (as shown below) has moved sideways since August 2020 and is well below its pre-pandemic peak. While we think that the participation rate has room to increase in 2022—boosted by stronger business capital spending and a broadening out in job creation—the climb will likely be slow.
Strong Payroll Recovery Not Matched by Strong Participation
Source: Charles Schwab, Bloomberg, Bureau of Labor Statistics (BLS), as of 10/31/2021.
Participation vs. resignation
A slower improvement in participation is due to the unfortunate reality that, per the U.S. Census Bureau, 2.5 million individuals are still hesitant to re-enter the workforce because of the virus. Another large slate—estimated by the St. Louis Federal Reserve to be nearly 3 million—has retired early. Finally, a third cohort is reassessing their work/life balance.
In the face of the omicron variant news, it’s clear that the virus will continue to be a factor in the trajectory of labor force participation. A major side effects of the pandemic continues to be workers’ desires and newfound chances to change jobs. With that has come a delay in workforce re-entry and a subsequent strain on businesses’ abilities to fill roles. This, along with early retirements, has culminated in what has been dubbed the “Great Resignation.”
As shown below, job openings remain much higher than any pre-pandemic rate; while the quits rate recently hit a record 3%, signaling workers’ confidence in finding better/higher-paying jobs. While we think both job openings and quits will remain elevated in 2022, current levels are likely unsustainable—especially if some pressure is eased by virtue of a rising labor force participation rate and net job creation.
Power Back to the Worker
Source: Charles Schwab, Bloomberg, Bureau of Labor Statistics, as of 9/30/2021.
The main benefit of elevated job openings and quits has been rising wages. As shown below, the median wage is increasing at annual rate of more than 4% per the Atlanta Fed’s wage tracker; with the lower end of the income spectrum experiencing the fastest wage gains. While we expect wage gains to remain firm, the best days for low earners may be nearing, especially as they continue to find jobs, effectively closing the gap, and as productivity (hopefully) improves.
Wage Growth Wakes Up
Source: Charles Schwab, Bloomberg, as of 10/31/2021. Atlanta Fed’s Wage Growth Tracker is a measure of the nominal wage growth of individuals.
Inflation: putting the genie back in the bottle(neck)
Strong wage growth is a key input for the hot inflation environment; and rampant uneasiness is justified, given the Consumer Price Index (CPI) is well above the five-year average of its annual change. That is the widest spread since 1980, as shown below.
Source: Charles Schwab, Bloomberg, as of 10/31/2021.
Tying inflation to aforementioned trends in consumption, as shown below, core (ex-food/energy) goods inflation has by far been the primary driver of headline core inflation. That makes sense for several reasons:
- The world was effectively forced to shift spending to goods at the expense of services when the pandemic hit.
- Even as restrictions eased this year, goods demand didn’t fade markedly given the services sector faced rolling restrictions.
- Factory shutdowns in Asia (due to the spread of the delta variant) roiled supply chains, pushing goods prices up at an even faster rate.
Inflation Remains Narrow for Now
Source: Charles Schwab, Bloomberg, as of 10/31/2021.
For those reasons, there has not yet been an equivalent surge in core services inflation, which contrasts with the hyperinflation of the 1970s and early-1980s. We believe services inflation has room to rise in 2022, but it could very well be curtailed by the omicron variant; while several forces could put downward pressure on goods prices:
- Reverse base effects: year-over-year changes in the first half of 2022 will be against 2021’s surge in prices, which could bring down CPI growth rates, especially if auto and hotel prices (culprits in 2021’s inflation surge) continue to drop.
- Supply side relief: freight shipping costs have rolled over, the number of containers sitting on docks has dropped, and factory production around the world is improving.
- Boomerang effect: companies’ double-buying efforts to satisfy recent demand is resulting in a swift inventory rebuild, which could bring about an eventual supply glut and attendant cooling in prices.
Mind the generation gap
There are rampant fears of stagflation akin to the 1970s-1980s, but the good news for now is that unemployment is not on the rise. As shown below, the toxic mix of high inflation and a surge in the unemployment rate brought the economy to its knees starting in the 1970s. The combined rate—known as the Misery Index—climbed above 20% at the height of the 1970s’ crisis, more than double the current rate.
Rise in CPI Pushing Up Misery Index
Source: Charles Schwab, Bloomberg, as of 10/31/2021.
A major driver of 1970s’ stagflation was persistently soaring unit labor costs, which weighed on companies’ productivity and profit margins. As shown below, the spread between productivity and labor costs moved in lockstep with profit margins back then; but for now, margins are bucking the latest decline in productivity.
Profit Margins Not Yet Dented by Higher Labor Costs
Source: Charles Schwab, Bureau of Economic Analysis (BEA), Bloomberg, as of 9/30/2021.
Some of that is attributable to globalization and the long-term decline in effective corporate tax rates, with which margins have become inversely correlated over the past couple decades. Yet, in the last year, the main driver of stronger margins was companies’ slashing of both labor and capital during the depths of the pandemic. The faster-than-expected recovery in both demand and pricing power resulted in a goldilocks environment for fundamentals, thus delivering a solid foundation for stock market returns.
We don’t expect productivity to continue its recent weakening trend relative to unit labor costs; but we also don’t think profit margins’ current levels will persist in 2022. That should result in a relatively benign convergence for both series in the chart above. Key to watch will be whether we transition into a “counter-cyclical” inflationary environment, in which companies’ pricing power would fade alongside consumer demand. We do know that the pandemic boosted productivity in certain economic segments, but also unleased a labor market mismatch; while massive stimulus arguably kept many “zombie” companies afloat.
Also important to keep an eye on is whether inflation continues to affect business confidence. As shown below, inflation has been a relatively dormant issue for the past decade, but companies are now facing strains from higher prices and the inability to find skilled workers. An easing in supply chain pressures should help to alleviate costs, especially for small businesses.
Inflation’s Surging Impact on Small Business Confidence
Source: Charles Schwab, Bloomberg, National Federation of Independent Business (NFIB), as of 10/31/2021.
Throughout history, CPI increases of recent magnitudes were typically accompanied by weakness in the stock market. In the pandemic era, asset inflation preceded real economy inflation, with an attendant record-breaking surge in household net worth. The weight of the stock market in terms of the economy, as well as its influence on confidence, cannot be overstated. The next significant drop in asset prices could deliver an outsized hit to economic growth, as was the case in 2001. That year’s recession was a direct result of the bursting of the tech stock bubble in 2000.
Tapering to pick up speed?
Top of mind heading into 2022 is whether the Federal Reserve will speed up the pace of tapering. The Fed announced a pace of reduction of balance sheet additions of $15 billion per month ($10 billion of Treasuries and $5 billion of mortgage-backed securities), but only for November and December. The emergence of the omicron variant put downward pressure on yields, and a knee-jerk assumption of less tightening to come, with an expected three hikes by the end of 2022 shifting to only two.
For now, the Fed plans to complete tapering before it begins hiking rates. Assuming no significant hit to economic activity from omicron, or a retreat in inflation pressures, we do expect the Fed to up the pace of tapering heading into 2022. Based on history, it’s not the timing of the first rate hike that matters, it’s the trajectory and speed once rate hikes begin.
As shown below, in terms of the first year of Fed tightening cycles (middle field) stocks historically performed best under “non cycles” of rate hikes—when no more than two hikes were instituted, before the Fed halted. Stocks also had little trouble digesting “slow” rate hike cycles—when the Fed took a break by waiting at least one FOMC meeting in between each hike. Worst case for the market was during “fast” rate hike cycles—when the Fed hiked rates at most FOMC meetings. As shown in the left field, stocks typically did well in the year leading up to the initial rate hike.
Source: ©Copyright 2021 Ned David Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at http://www.ndr.com/copyright.html. For data vendor disclaimers refer to http://www.ndr.com/vendorinfo/. Data is indexed to 100 at date of first Fed rate hike. Past performance is no guarantee of future results.
A relationship that bears watching and may help lay to rest the debate about whether inflation will turn out to be ultimately transitory, is between bond yields and stock prices. As shown below, for three decades starting in the late-1960s, they were mostly negatively correlated. That was an era punctuated by greater frequency of supply shocks, and an over-arching inflationary backdrop. For the two decades that followed, bond yields and stock prices were mostly positively correlated. This has been an era punctuated by a few demand shocks, but very few supply shocks; and an over-arching disinflationary backdrop.
Long Cycles of Bond Yield/Stock Price Correlations
Source: Charles Schwab, Bloomberg, as of 11/26/2021. Correlation is a statistical measure of how two investments have historically moved in relation to each other, and ranges from -1 to +1. A correlation of 1 indicates a perfect positive correlation, while a correlation of -1 indicates a perfect negative correlation. A correlation of zero means the assets are not correlated. Past performance is no guarantee of future results.
After a brief dip into negative territory in mid-2021, the correlation is back in positive territory again. Any sustainable move back into negative territory could signal an inflation regime shift akin to what developed in the late-1960s; which ultimately led to significant policy errors in the 1970s.
A policy error remains a risk for 2022; especially if stock market participants’ optimism continues to be boosted by the (perhaps-erroneous) assumption that the Fed will always have the market’s back. This may be particularly relevant for the younger cohort of investors who have been “educated” about the stock market only during the pandemic era.”
Investors came into the post-Thanksgiving week seeking to recover from the prior Friday’s Omicron-driven selloff. The rebound Monday recouped about half of the Friday plunge. But it was all given back Tuesday. Fed Chair Powell suggested that the central bank might need to become more aggressive in order to combat inflation. Selling accelerated Wednesday after a morning rally fizzled. Stocks gave up solid morning gains to finish sharply lower, off by -3% over the two day selloff. Yet again buyers swooped in to deliver a rebound; the market volatility reflecting the lack of information around the Omicron variant and the Fed’s path for reducing monetary stimulus. The Fed’s stated path has been a solid economic recovery driving interest rates upward. However, if the Covid-19 variant hits economic growth, the Fed will be pressured to reduce interest rates. So investors are stuck between the two competing scenarios right now. Friday’s employment report came in much lighter than expected as companies continue to have trouble attracting workers. The report was cause for another round of selling with highly-valued growth stocks getting hit particularly hard. For example, software stocks, long a market darling, were pummeled in Friday’s session. They were down almost -5% at one point, giving up five month’s worth of gains.
A volatile week as markets wrestled with heightened uncertainty. Friday’s hit left the S&P 500 down -1.21% for the week. The Nasdaq 100 (QQQ) tumbled -2.06%. The more cyclically-focused smallcap index, Russell 2000 (IWM), logged its fourth straight down week off -3.65% and falling back to the bottom of its months-long trading channel.
Warm wishes and until next week.