Ghosts from the Past?*
The last week of the calendar year, with Christmas at the beginning and New Year’s Eve at the end, often provides us with contradictory messages. We sing “Merry Christmas and a Happy New Year” while the ghost of Christmas past nags us with regrets and the ghost of Christmas yet to come taints expectations about the future. And among market watchers on the cusp of 2022, there are two ghosts, one from the present and recent past — Covid-19 — and one from the very distant past — inflation — which can trouble dreams of a profitable new year.
Covid-19 and its Greek alphabet of mutations continue to haunt the global economy. Now in its third wave of over 200,000 daily infections in the U.S., the persistence of this pandemic, now carrying the Omicron moniker, has become extremely tedious. Despite vaccines, mask mandates, social distancing, lockdowns and some degree of herd immunity, the virus keeps morphing and spreading. The damage to the economy, until recently, has been concentrated in the service industries, where social distancing has taken its greatest toll, rather than in the production of goods, where thanks to the internet and e-commerce, human contact can be minimized. After falling off a cliff in the first two quarters of 2020 and registering a very short recession, GDP rebounded in the second half of 2020 and remained in positive territory for the balance of the year and for all of 2021. Similar patterns of weakness in early 2020 and strength in subsequent quarters have been registered in most other economic indicators, though it should be noted that some series — Jobless Claims, Consumer Sentiment, Real Disposable Personal Income, seated diners (OpenTable) and airline passengers (TSA Traveler Throughput) — have yet to improve from 2019 levels.
Despite six successive quarters of economic expansion, however, there is still concern that the Omicron variant, or some subsequent Greek letter mutation, may require new restrictions, once again shutting down economic activity. We tend to think otherwise and that the lessons we have learned over the last two years will eventually translate to more workable responses to the disease: for example, added protection for the most vulnerable populations, peer acceptance of masking recommendations, consistent messages about disease mitigation and recognition that some form of Covid-19 will be with us for a very long time. There is also the possibility that the deadliness of Covid-19 may diminish with each variant: viruses mutate and adapt to increase their spread through populations, a goal best served by keeping hosts alive to infect others. And we may actually learn to live with the disease in the same way that we live with seasonal influenza.
The second spectral visitation, inflation, may represent a greater threat to the economy than the pandemic. As is the case with pandemics, large parts of the U.S. population are relatively unfamiliar with high levels of inflation. Americans under 60 — those who reached adulthood after 1981, the last year of U.S. double digit inflation — may not remember the social and political angst of the late 1970s: the Arab oil embargo, wage and price controls, “Whip Inflation Now” buttons, Stagflation, double-digit mortgage rates, inflation at 14.6%. What made this period of inflation so troubling was its intractability and duration: despite three recessions between January of 1970 and August of 1980, the conviction of the consumer was that high inflation, if not hyper-inflation, was inevitable. The general wisdom was “buy today because it will only be much more expensive tomorrow”. All this madness came to a screeching halt when Paul Volker, Chairman of the Federal Reserve, eventually pushed the Fed funds rate to 20% in June of 1981 (the prime rate rose to 21.5%) and precipitated two recessions between January of 1980 and November of 1982. The pain across all sectors of the economy was severe and Chairman Volker and the Fed were roundly vilified and maligned, but inflation dropped from a high of 14.6% in April of 1980 to 2.4% in July of 1983. We mention this brief history of the 1970s as a cautionary tale, not as a forecast. Inflation as a mindset is a serious threat, but not yet a probability.
Under the category of recent history, inflation (headline CPI) before the onset of the virus and for most of the last ten years, hovered between 0% and 3% (the last time the trailing twelve month or TTM inflation rate exceeded 3% was in January of 2012). For most of this period, the Federal Reserve was more concerned about deflation and depression than runaway inflation. Its antidote for falling prices was to keep overnight interest rates near zero and to invest heavily in government bonds and mortgage-backed securities (essentially printing money), thereby keeping the economy awash in liquidity. For a while, this strategy worked well: inflation remained within the Fed’s comfort zone and the unemployment rate reached fifty-year lows.
When the pandemic struck at the beginning of 2020, the unemployment rate jumped from 3.5% in January to a jaw dropping 14.8% in March and the economy fell into a recession. The government responded by passing several trillion-dollar stimulus packages that, on top of the continuing monetary stimulus from the Fed, ended the recession (at three months, easily the shortest recession in over seventy years) and drove the unemployment rate down from 14.8% to 4.2%. The speed at which these remedies returned the economy to a semblance of health might suggest that the actions, though salutary, might have been overdone. Politicians and central banks like to think of their monetary and fiscal activities as “fine tuning” for the economy. During a crisis, this fine tuning often is carried out with blunt instruments. Today, although the unemployment rate remains low, the inflation rate stands at 6.8% (TTM ending on 11/01/21). The Fed has announced that it will accelerate its tapering of bond purchases and plans three rate hikes in 2022.
The other major factor in today’s rising rate of inflation is the impact of the virus on logistics. The unemployment rate may be low, but the number of workers out sick or prevented from working because of Covid-19 issues has created a concatenation of disruptions in the chain of supply: whether it’s the shortage of truck drivers, shipping containers, parts from overseas, etc., the result has been a diminution of the supply of goods and services to businesses and consumers. This, in combination with an abundance of liquidity in the marketplace and a population, weary from Covid-19 restrictions and eager to spend, has produced an environment ripe for higher inflation.
We don’t believe that 2022 will be the beginning of another long 1970s style trail of increasing inflation expectations, double-digit interest rates and crushing recessions. Nor do we believe that the Omicron variant of Covid-19 will continue to cripple supply chains and drive the cost of goods and services ever higher. Inflation is a risk, and the Fed may be a little slow in removing the punch bowl, but the promise of higher rates should moderate inflation expectations. The stock market continues to set records — the S&P 500 is up 28.7% through December 31 — but the expected return on stocks still looks attractive when compared to fixed income, particularly with the expectation of higher rates in 2022. History suggests that if inflation remains below double-digit levels, and companies can pass along higher costs to their customers, stocks represent a good hedge against inflation. We continue to recommend that clients maintain their current allocation to equities.
*With apologies to Charles Dickens
Not Investment Advice or an Offer
This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing. Argent Financial Group is the parent company of Argent Trust, Heritage Trust and AmeriTrust.