Economy: Shifting policy and potential volatility

byFidelity Investments Canada

January 5, 2022

6 minute read

Investors should keep an eye on these "post-peak" themes in 2022.

by Fidelity Investments

Key takeaways

With US economic growth peaking, the maturing US mid-cycle offers both a constructive expansion and a more volatile backdrop for markets that have already priced in a lot of good news.
Inflation rates are nearing peak levels and should moderate in the year ahead, but inflation pressures may still prove more persistent than expected.
The peaking global industrial cycle should help alleviate some of the extreme supply-side pressures, with the trajectory of the pandemic and the Chinese economy the biggest wild cards.
With the Fed shifting monetary policy in the direction of normalization, liquidity growth is likely to switch from a tailwind to a headwind in 2022.
A relatively constructive cyclical backdrop should prevail in 2022, but a potentially bumpier landscape for financial markets warrants a high level of portfolio diversification.

The US mid-cycle backdrop should prevail in 2022. The economy has likely passed its peak rate of growth, but a sustained expansion is the most likely scenario.

The US consumer is bolstered by record-high net worth, pent-up savings, and strong employment markets.
However, high inflation is weighing on consumer sentiment. The percentage of consumers viewing the current backdrop as a good time to purchase large household goods hit its lowest point in 5 decades.
After massive stimulus and record-level peacetime government-budget deficits in 2020 and 2021, fiscal outlays in 2022 will be much lower and represent a drag on growth.
Mid-cycle environments have historically favored riskier assets such as stocks, but they also tend to experience the highest incidence of stock-market corrections (10% to 20% selloffs).

Inflation rates are likely peaking and should moderate over the coming year, but inflation pressures may still prove to be more persistent than anticipated.

Base-year effects will help to mechanically reduce inflation rates from current 30-year highs, and there are initial signs that some of the most extreme supply-related pressures are easing.
However, longer-term deglobalization trends imply goods inflation is likely to settle at a higher level than during recent decades.
While supply-related inflation tends to dissipate over a period of many months, price increases in categories that tend to be more persistent—such as housing and food—are now accounting for a larger portion of inflationary pressures.
Worker shortages should abate as more employees re-enter the labor force. However, labor markets will likely remain tight enough to support solid wage growth, putting a floor under how far inflation rates may fall.

After a dramatic rebound in corporate earnings during 2021, slower economic growth and persistent cost pressures will likely challenge profits in 2022.

Large companies were generally able to pass higher costs along to customers in 2021, resulting in a dramatic rise in profit margins and a nearly 50% rebound in earnings.
With profit margins back at all-time highs and having already outpaced typical mid-cycle gains, it will be more challenging to increase them going forward.
Many companies, particularly small businesses, will likely continue to face intense wage and cost pressures, and they could struggle with finding workers to fill open positions.
Investors are expecting solid but much slower high single-digit profit growth in 2022, which seems reasonable given the more mixed economic and inflation conditions that are likely ahead.

Monetary policy is shifting toward normalization, and liquidity growth is likely to switch from a tailwind to a headwind in 2022.

The Fed likely has little ability to affect supply-side disruptions and bottlenecks that have contributed significantly to rising inflation. However, it can no longer ignore higher and more persistent current inflation nor the fact that demand side factors—over which it has some influence—are contributing to the pressures.

The trillions of dollars of quantitative easing (QE) by global central banks over the past 2 years resulted in a large liquidity tailwind that contributed to the broad-based rise in asset prices.
With the Fed likely to end QE during the first part of 2022 and move to hike interest rates thereafter, slower liquidity growth may contribute to more volatile financial markets.

Global growth is likely to face challenges during 2022, but ultimately the global expansion should persist and stabilize over the course of the year.

China's industrial cycle appears to be bottoming after entering a growth recession in 2021. Monetary and fiscal policies are gradually shifting to a more accommodative stance, although the troubled property sector remains a key source of risk.

Most global economies remain firmly in the mid-cycle phase; the US expansion is maturing, while China's growth recession may be bottoming.

Most global economies remain firmly in the mid-cycle; the US expansion is maturing while China’s growth recession may be bottoming.

The diagram above is a hypothetical illustration of the business cycle, the pattern of cyclical fluctuations in an economy over a few years that can influence asset returns over an intermediate-term horizon. There is not always a chronological, linear progression among the phases of the business cycle, and there have been cycles when the economy has skipped a phase or retraced an earlier one. Source: Fidelity Investments (AART), as of Nov. 30, 2021.

* A growth recession is a significant decline in activity relative to a country's long-term economic potential. We use the “growth cycle” definition for most developing economies, such as China, because they tend to exhibit strong trend performance driven by rapid factor accumulation and increases in productivity, and the deviation from the trend tends to matter most for asset returns. We use the classic definition of recession, involving an outright contraction in economic activity, for developed economies.

The peak in global industrial activity is likely behind us, and the lagged impact of China's slowdown implies developed-country manufacturing may decelerate in 2022.
Manufacturing inventories have been rising relative to sales, which is likely to represent a mid-cycle headwind for developed-market economies such as Europe and Japan.
Improved supply and slower demand should take some pressure off the severe supply-chain pressures experienced this year.
The trajectory of the pandemic and particularly the new Omicron variant will be crucial to the global outlook, with emerging-market economies generally more susceptible to health setbacks.

We believe the mid-cycle environment should be generally constructive for asset markets in 2022, but markets will likely be more volatile.

Monetary-policy risk will be front and center, with the Fed facing a difficult balance of trying to address rising inflation expectations without overly tightening financial conditions.
Earnings growth outpaced stock price appreciation during 2021, but equity valuations still remain well above long-term averages. In fact, the valuations of almost all asset categories are expensive on a historical basis, implying less attractive return expectations over the medium term.
The possibility of greater economic reopening over the course of 2022 offers hope for prolonging the global business cycle.
From an asset allocation standpoint, we believe this complicated environment warrants a thoroughly diversified global portfolio that balances risks to growth, inflation, and policy outcomes.