Outlook and Market Review - Fourth Quarter 2021

The economy grew 7% in the fourth quarter of 2021 based on the Bureau of Economic Analysis revised estimate. Third quarter growth of 2.3% was closer to the trend growth rate. Much of the growth in the fourth quarter came from inventory accumulation, which often bleeds off growth in the following period. Going forward, first quarter growth is likely to be closer to 2%, due to drags from the Omicron virus and rising energy prices. In the short run, households will draw down on accumulated savings as a buffer. In the longer run, the danger of stagflation exists as inflation and a slowing economy develop in tandem, similar to the early 1980s.

The unemployment rate was 4% in January compared to 3.5% prior to the pandemic. A changing labor market makes it difficult to regain the remaining million or so lost jobs. Capacity utilization has been improving and is slowly closing in on the benchmark for full employment. Wage growth in 2021 was approximately 4%, which looks good to workers on the surface, but recognition of rising prices and lower real wages will eventually stimulate higher wage demands. While there is room for improvement, the economy may be getting close to full employment given current conditions.

In January, inflation measured by the Consumer Price Index reached 7.5% on a year-over-year basis with core inflation of 6%. At the same time the Personal Consumption Index gained 6.1% on a yearly basis while the core PCE index gained 5.2%. Inflation in 2021 is the highest since February of 1982. The Producer Price Index is also trending upward, suggesting that inflation is embedded in the system. Oil prices are rising to new levels and may well stay around $100 a barrel. Almost all goods are affected by oil prices, either as an input or as a cost of delivering goods and services. Inflation and sentiment data will be adversely affected by the invasion of Ukraine by Russia. This is especially true for European countries that are dependent on Russian oil. Global conditions could worsen as countries not affiliated with alliances like NATO may become fair game for conquest by Russia or China.

The Fed is walking a tightrope where moving too aggressively against inflation may well end the recovery. On the other hand, if inflation is not calmed a spiraling effect could lead to stagflation. The Fed is expected to increase the fed fund rate in the March meeting by as much as 50 basis points with another 150 basis points of increases in 2022. The Fed balance sheet runoff will become more aggressive after the March meeting, but conditions will remain expansionary. Even so, the federal fund rate will be well below the neutral rate estimated to be around 4%. Higher interest rates should dampen growth for the remainder of 2022. While government fiscal deficits will continue to a tune of about one trillion dollars, the stimulus effects from prior programs are waning.

Financial markets have a lot to deal with in 2022. Risks are elevated. While the level of interest rates will remain low, the markets will likely focus on changing rates. Geopolitical turmoil will clearly dampen investor expectations and portfolios will tilt more toward defensive investments. Cash instruments suffer the most with inflation. Longer term fixed income instruments also lose when rates rise with inflation. Many investors may prefer either asset-based investments, precious metals, or short maturity interest sensitive investments that can be rolled over at higher rates in the future. Normally, the yield curve will get steeper as expected inflation increases.