There's a reason it's called the 'Wall of Worry'
Market risks stay skewed to upside but inflation and possible policy errors lurk.
Clearly there has been no shortage of things to be worried about. Inflation. Potential policy errors on both the fiscal and monetary fronts. Incumbent Jay Powell or Fed Governor Lael Brainard as the next central bank chair (President Biden ended this uncertainty this morning by sticking with Powell, more below). Worries aside, we are at a point in the economic and market cycles where risks are still skewed to the upside. The Fed is still likely a half year away from the first rate hike, all non-inflationary indicators point toward continued economic expansion and companies thus far have been able to absorb and pass along—and then some—input cost hikes, keeping earnings on an upward trajectory.
Are we concerned that inflation rates higher than wage hikes could cause demand destruction? Sure. Are we concerned that the Fed or the government—and the House's approval of a $1.85 trillion Build Back Better (BBB) bill that still faces the hurdles of a razor-thin Senate and two key moderate Dems in U.S. Sens. Joe Manchin and Krysten Sinema—could further stoke inflation? Sure. But history has taught us that in periods of uncertainty like this, it is better to respond rather than anticipate. So, we continue to expect 4% GDP growth and 10% earnings growth in 2022, our 5,300 target on the S&P 500 for next year hasn’t changed.
Sticky inflation all about worker shortages
As for the drivers of inflation, they’re neither transitory nor persistent—they’re both! Lumber prices, airfares, used-car prices, even energy costs likely will prove transitory, particularly if supply chain bottlenecks ease (and there are signs this is starting to happen). But underlying inflation continues to persist, driven by wage growth that’s feeding on a stubborn shortage of labor. We were at full employment pre-crisis with economic growth of 1.5-2%. That’s less than half the current pace, yet the supply of labor if anything has been shrinking amid this growth surge on accelerating baby boomer retirements, latent Covid fears, child-care difficulties—even a work-life balance rethink.
Until this labor shortage subsides and labor force participation starts to climb again, it’s hard to see wage pressures subsiding. Companies are ramping up automation and capex to offset some of these pressures, but the accompanying productivity payoffs can take years to be realized. That’s why we’re anxious to see the Fed get more engaged. We hope it increases the pace of tapering, commences rate hikes no later than next June and generally demonstrates it’s not asleep at the wheel.
Fed chair selection possible BBB signal
This morning's decision by Biden to renominate Powell as opposed to shifting to a more dovish Brainard could well signal the fate of the House version of Biden’s BBB initiative. With polls suggesting a likely red, i.e., Republican, tsunami in 2022’s midterms, progressives see this massive reconciliation bill as a singular moment to push their economic/social agenda. Moderates, on the other hand, are concerned passing BBB could seal their fate in competitive purple or red districts.
In this context, the choice of Powell, whose approval by the Senate is likely, could be viewed as a consolation prize to Manchin and Sinema and a sign that progressives may be winning the day. If this proves to be the case, it will be interesting to see how the market reacts to these somewhat countervailing forces: a less dovish Fed under Powell versus potential tax increases to pay for the massive BBB bill. We’ll keep you posted.