The Big Idea
Lessons learned in the economy in 2022
Stephen Stanley | December 16, 2022
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
After two years dominated by pandemic, 2022 was primarily a return to normal activity as social distancing and pandemic restrictions finally lifted. The economy was anything but normal, however, with back-to-back negative GDP quarters without recession, 40-year highs for inflation and the sharpest tightening cycle in decades. The year taught a few lessons pertaining to the economy and economic forecasting, all with applications for financial markets and investing.
#1 Think creatively
No one imagined at the beginning of 2022 that the Fed would hike policy rates by over 400 bp. At the end of 2021, federal funds futures priced in 2.5 quarter-point hikes for all of 2022. And the end-2023 projection was below 1.5%. I correctly assessed at that time that the Fed was well behind the curve in starting to normalize policy and that inflation could accelerate sharply. And yet, my above-consensus call was for the FOMC to implement a “whopping” 100 bp of rate hikes in 2022. In retrospect, even though I beat the consensus, my forecast exhibited a distinct lack of imagination.
One lesson here is that tail risks may come to pass more often than we might expect. As an investor, it is worth thinking well beyond the consensus view. Investors can position for more extreme scenarios that may have a low probability of occurring but would result in huge price movements if they happen to take place.
#2 Momentum can be a powerful thing.
At the end of 2021, inflation had gathered speed but very few people imagined that we were heading to a 9% CPI peak within a year. Similarly, the labor market was far out of balance at the end of 2021. Job openings were zooming higher, labor shortages were said to be ubiquitous, and a feeding frenzy was developing as firms were recruiting away workers from other businesses and driving up wages in the process.
In both cases, moderation developed over the course of 2022. Supply chain issues dissipated, and energy supply proved more resilient than initially feared after Russia invaded Ukraine. Indeed, inflation peaked out on a year-over-year basis several months ago. However, price pressures remain unusually strong, and notwithstanding the euphoria of financial market participants, Fed officials insist that they have a great deal of work to do to get inflation under control.
Meanwhile, labor demand has clearly cooled, as the JOLTS job openings figure has declined by 1.5 million from the early-2022 high. Nonetheless, the labor market is still substantially out of balance, with demand exceeding supply. The consensus view is that the unemployment rate is poised to surge in 2023, but, given where we are going to be starting the year, this would require a sharp weakening in labor demand, well beyond what I expect.
The lesson here for investors is that when an imbalance creates a market opportunity, it is important to gauge how large that imbalance might be and how long it might persist. When the imbalance is really severe, as in the case of the labor market in 2021, it may require a large move in asset prices or a long period of time to bring things back into equilibrium.
#3 Rapid swings are possible.
This may seem contradictory, but the next lesson is that violent turns occur frequently. For example, in 2021, real GDP growth exceeded 6% annualized in three out of four quarters. However, the economy swung into negative territory in the first half of 2022. Another instance is the housing market. Home prices went from rising at an annualized double-digit rate as late as May to a sharp pace of decline by July. Neither of these developments were widely expected entering 2022.
For investors, it is a difficult task, but there is a big payoff in considering whether the underpinnings of a particular market situation have staying power or can shift abruptly. In retrospect, it seems obvious that home prices had moved to expensive levels by early 2022 and that a roughly 400 bp jump in 30-year mortgage rates would severely dampen the demand for homes, with the resulting impact on prices. The fundamentals for housing certainly shifted much more quickly than for the labor market, where it is taking a long time to get back into balance. Similarly, some market trends have durable drivers while others may be built on fleeting forces.
# 4 Look beyond the headlines.
Headline economic results do not always accurately reflect the underlying situation. As noted above, real GDP contracted in the first and second quarters, leading to widespread expectations that the economy had sunk into a recession. But the underlying details told a different story. Final demand in the first quarter actually grew at a solid pace, but a massive widening in the trade deficit dragged the headline GDP figure down to a -1.6% annualized clip. In the second quarter, a normalization in the pace of inventory accumulation led to a two percentage point drag and pushed real GDP into negative territory again. The underlying details were a better gauge of the economy than the headline figures, and continued strength in the labor market clearly refuted the prospect that the broad economy was contracting in a classic sense.
The monthly inflation figures in October and November offer another example that the headline aggregates often do not tell the full story. Financial market participants have euphorically decided that inflation has rolled over due to the lower core CPI results in October (+0.3%) and November (+0.2%). However, these benign headline results were driven by big moves in a few categories and mask a still-disturbingly fast underlying pace of price hikes. For example, the Atlanta Fed Sticky-Price CPI gauge rose at a 5.5% annualized clip (roughly 0.45% per month) in October and in November, and the Cleveland Fed Median CPI increased by 0.5% in both months. The FOMC economic projections and Chair Powell’s press conference remarks on inflation underscore that Fed officials are focused more on what the underlying details are telling them than on the headline figures, creating a major gap between market pricing of the 2023 policy outlook and the FOMC’s projections.
These examples serve as a reminder for financial market participants that there can often be a payoff to digging a little deeper. Merely trading the market based on newswire headlines is one strategy. But taking a little more time to study what may be happening beneath the surface can often reveal important nuggets.
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