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With the end of fiscal stimulus in 2022 and the Fed transitioning away from an extraordinarily accommodative stance, there is a risk that recent inflationary impulses will be short-lived.

Despite the volatility seen in January, many remain positive on the stock market, citing a robust economy and earnings growth. However, there are a few recent indications which give cause for reflection.

Last week, the New York manufacturing survey slipped into contraction. Consumer sentiment has fallen to its second lowest level in 10 years, with three-quarters of consumers ranking inflation, rather than unemployment, the most serious problem facing the nation. Core retail sales have been unexpectedly trending lower since November. The Citigroup “Economic Surprise“ index has gone negative, meaning that economic indicators have been lower than expectations. And yet, with financial conditions tightening into a slow-down in economic activity, few are discussing a serious slow down.

There is a high correlation at the moment between stocks and bonds yields. Inflation fears have driven the 10-year bond yield from 1.50% to 1.8% in the past three weeks, which has impacted stocks negatively. Inflation is currently at 7%, a 40 year high, and shows no signs of abating as Covid continues to create supply bottlenecks and is impacting the labor market. Making matters worse, a record 9 million Americans are out sick as Covid rates surge.

Three months ago, it was still uncertain that we would have any interest rate hikes in 2022. Now, the futures market expects four rate hikes this year, followed by three more next year. The US now has the lowest “real” (i.e., after inflation) Interest rates in the world except for Turkey.

Whether inflation begins to slow is still shrouded in uncertainty. Has omicron peaked? Will other variants appear? One important component of inflation, energy prices, do not seem to be the product of Covid, but rather low stock piles, low investment levels, cold-weather, and Geo-political tensions in the Middle East and in Ukraine. Many analysts see higher oil prices ahead, some topping $100 per barrel.

The last time inflation was at 7%, there was a double dip recession. In fact, 5% plus inflation has preceded all seven receptions over the past 60 years. However, inflationary expectations are coming down. The Fed’s favorite inflation measure, the five-year/five-year forward inflation breakeven rate, measures expected inflation (on average) over the five-year period that begins five years from today.

It indicates that inflation expectations are still around 2%, where they have been for some time:

This chart argues for the “storm in a teacup” argument that inflation is less worrisome than the stock or bond market is accounting for, and that Covid related supply chain bottlenecks that are causing inflation will be short lived.

Supply and transportation issues appear to have peaked in the second half of last year. The New York Federal Reserve Board launched its “Global Supply Chain Pressure Index“ earlier this month, and said that these pressures, “while historically high, have peaked and might start to moderate somewhat going forward“. There are many agencies tracking the inflationary pressures caused by supply chain disruption; most are showing signs that while these pressures remain elevated, they indicate relief ahead.

Before getting too pessimistic, the economy should still grow by 3 to 4% this year in real terms. Earnings estimates for the S&P 500 are still rising, and the consensus for Q1 2022 expects 8.5% growth over Q1 of last year, only marginally higher than Q4 2021. Going forward, year on year comparisons with depressed 2020 figures will go away, bringing growth figures back to more normal levels. For the full year 2022, current earnings estimates call for 9% earnings growth, with industrials and energy sectors projected to lead.

Aside from inflation, the two other preoccupying worries on Wall Street are over the Russia/Ukraine situation and Covid. While Omicron appears to have peaked, it is difficult to say how the Ukraine tensions will play out. A Russian invasion will surely push oil and gas price is higher, benefiting the energy sector. However, the stock market is likely to have a negative reaction.

As of this writing, 31% of S&P 500 companies have reported fourth quarter earnings. 81% are beating profit estimates by a median of 6%. While we do not anticipate any recession in 2022, we must respect that there was a tremendous re-opening of the economy in the summer of 2021, and that the basis for comparison will be difficult. The base effect between 2020 and 2021 was very favorable, and the question now is: by how much does GDP growth revert to trend at a time that multiples are higher, and how does the Fed respond to that in the context of inflation?

Grant Rogers

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