Byron Wien: Gearing Up for the New Normal
At the beginning of this year, Joe Zidle and I set forth our outlook for the next 12 months. We were cautious. Most observers expected the Standard & Poor’s 500 to gain 10% or so (which is where the consensus usually is at the beginning of the year), while we expected the index to make no progress in 2022 and end the year where it started. Our thinking was that the economy would continue on its growth path, but inflation would become more of a problem; the Federal Reserve would increase interest rates to arrest inflation; intermediate and long-term rates would also increase as the Fed withdrew from the bond market and let its $9 trillion balance sheet run off; multiples would fall because of rising rates; and the economy would slow somewhat. Earnings would be revised downward but would still be good enough for the market to end the year flat. In the first quarter, the S&P 500 was down 4.6%.
As things turned out, the Omicron variant emerged around the world, inflation became even more of a problem than we expected, and Russia invaded Ukraine. The tragedy in Ukraine is the most serious geopolitical challenge in Europe since World War II. The stories of human suffering being reported daily are devastating. We hope for an end to hostilities, a ceasefire and negotiated settlement soon, but we don’t have any special insights into when or how that will take place. All of these events have left us in an environment changed in ways that will be long-lasting. We call this “The New Normal” and it has four components: COVID, the US recovery, deglobalization and monetary tightening. Let’s explore each of the four and speculate about their possible impact.
COVID: It looked as though we had gotten the virus under control until a few months ago. Most people in the developed world had been vaccinated, schools were reopening, and people were traveling and eating indoors in restaurants. Then the Omicron variant hit the US, followed by the emergence of the BA.2 subvariant. In the US, new daily confirmed deaths from COVID dropped to fewer than 5001, comparable to the numbers we saw last August. The number of new daily confirmed cases is down to around 50,0001 (the lowest since last July), but this level of cases shows that the problem has not gone away. The BA.2 subvariant is highly transmissible and is now recognized as the dominant COVID strain in the US, although current data suggest that people who have been fully vaccinated seem to be relatively well-protected.
The World Health Organization (WHO) has warned about a surge in cases in Europe and elsewhere. China is particularly vulnerable to new and highly contagious variants, given the proven ineffectiveness of its vaccines and a stubborn adherence to its zero-COVID policy. China’s draconian lockdowns are threatening its growth goals, as the recent lockdown of Shanghai could knock several points off the country’s GDP growth. The point is that COVID is likely to be with us for some time, perhaps – as I think – indefinitely. We will all need to get periodic booster shots to maintain our immunity, but the virus also will have a lasting effect on our behavior in other, more significant ways. Some may be more reluctant to travel or spend time in crowded event spaces, especially when case counts spike. These concerns may reduce consumer activity and spending, but mostly in the segments of the population that are more vulnerable to the virus, such as the elderly and immunocompromised. In short, it is reasonable to expect COVID to continue to have some broad impact on economic activity. For now, we believe the US can weather it.
The Surprising Strength of the US Economy: With all the problems throughout the world, the American economy’s ability to continue to expand and create jobs is impressive. The March employment report showed that employers added more than 400,000 jobs for the eleventh consecutive month, and the unemployment rate fell to 3.6%. Nonetheless, we still must face high inflation, the war in Ukraine, climate change, political gridlock at home and a host of authoritarian governments abroad. In spite of it all, we keep growing. Some people are still apprehensive about public transportation, but air travel for business and pleasure has improved. For two years, people mainly stayed home and spent money on durables like furniture and home improvement goods. Consumers have continued to spend a disproportionate amount on goods, consumption of which is above pre-COVID trend growth, whereas spending on services has struggled to regain wallet share. In our fourth Surprise of 2022, we wrote that people would return en masse to entertainment venues and that “normal conditions” akin to 2019 life would be “largely restored.” If we turn out to be right, this means that consumers will return to their more normal behavior of spending around 70% of their consumption on services (versus around 65% today). That will have big implications for easing supply chains, which have been overwhelmed by the volume of goods demand, and for the continued recovery of many small businesses in the US.
Housing is key to the continuation of the recovery. Rents and house prices in the U.S. are up about 20% year-over-year in recent months, and home prices are setting new records. Even so, strong personal income growth has contributed to affordability. Mortgage rates have exceeded 5% for the first time since 2011, and this is a concern for ongoing home demand. However, housing markets tend to hold up so long as the overall economy is expanding and labor markets remain strong. Home price growth is expected to slow, but the red-hot demand for housing over the past two years suggests that when it does, there will be buyers ready to step in. In the meantime, some would-be buyers might opt to postpone a home purchase and rent instead, implying incremental demand for rental apartments in the near term.
Many are worried about a possible recession, but there has never been one without employment turning down and corporate profits falling. The outlook for employment continues to be favorable, with 1.7 jobs open for every person looking for a job. As for profits, S&P 500 earnings grew by more than 30% in the fourth quarter and are estimated to grow by better than 5% in the first quarter, despite the headwinds. The current bottom-up projection for S&P 500 earnings in calendar year 2022 is above 10%. The other worry is stagflation, with inflation continuing but growth faltering. There are many examples of GDP growth estimates being cut by strategists, but so far, we have not seen anyone projecting zero growth. The outlook really depends on the Federal Reserve, and whether inflation is so intractable that short-term rates have to rise dramatically to bring it down.
Other factors generally break on the favorable side, according to Ed Hyman at ISI. These include some easing in supply chain congestion, continued pricing power on the part of companies, strong employment and wage growth, jobless claims at record low levels, and manufacturing PMI data at its best in a decade. The big story is what has happened to consumer net worth, which is now $150 trillion, up by a whopping 29% versus fourth quarter 2019 levels. Looking around the world, we expect that real GDP in the US will rise by an above-consensus 4% in 2022, and 3% in 2023. Growth in Europe will slow to something near zero. Whether or not these countries tip into recession will be dependent on the amount of policy support they are willing to engage in, and whether the flow of energy from Russia can continue undisrupted. In China, GDP is likely to decline below its announced growth target of 5.5% for 2022. I highlight this to show the diverging outlook globally, at a time when the geopolitical backdrop is already becoming more challenging, which is the next topic into which we will dive.
Deglobalization: The Ukraine situation has implications for world trade. Russia supplies one-third of Europe’s oil, 45% of its imported gas and half of its coal. In addition, Russia and Ukraine supply about 30% of the world’s wheat and barley, and these shipments have come to a standstill, contributing to rocketing agricultural commodity prices and exacerbating inflation globally. Russia and Ukraine also produce fertilizer and precious metals. Ukraine mines palladium for catalytic converters in automobiles and neon for semiconductors. The most important consequence of the war in Ukraine may be that it will cause a generational shift in our understanding of how the world works. In the West, many of us had become comfortable that territorial conflicts between two countries were a part of history, not current reality. The arc of the last century was one of walls being torn down. These were both physical (the Berlin Wall) and ideological (the Iron Curtain).
We were living in the harmonious reality of David Ricardo, an early 19th century economist who developed the theory of comparative advantage. In his view, countries would produce goods and services at the lowest possible price and sell them to other countries where costs were higher. Ricardo’s belief was that this interconnectedness would make war too costly, and it seemed to reflect the way the world was working. It explains why Europe would be willing to entrust its energy supply to Russia. That thinking is now being questioned. Countries are making plans to bring more manufacturing back home. In 1992, 53% of all Ford employees worked in the United States; by 2009, that was down to 37%. As recently as 1990, 80% of semiconductors were produced in the United States; by 2020, that was down to 20%. We must face the cost of a major shift toward bringing major manufacturing efforts onshore. Our labor costs are higher than they are in many places abroad, and many domestic companies are already having difficulty finding workers. The efficiencies and cost-savings of the global supply chains might be reversed, leading to higher prices. This will be challenging for profit margins, but could open a whole array of exciting investment opportunities as value chains are re-oriented closer to home. The initial efforts may be confined to strategic products, but it will be important to consider what happens if it doesn’t stop there.
As my colleague Joe Zidle has suggested in the past, if globalization were deflationary, it would seem that the reversal of this process would be unlikely to have the same outcome. And this leads us to the next big issue, which is how central banks are shifting to respond to elevated inflation around the world.
Monetary tightening: In the past, when America has experienced sharp increases in inflation, the Federal Reserve has always had to increase short-term interest rates dramatically. The most notable example of this was the 1970s, when Paul Volcker, then–Fed Chairman, moved the Fed funds rate deep into the double digits to slay inflation. Of the last eight periods when the Fed engaged in a rate hiking cycle, a recession followed six times. To be fair, some of these recessions, like the ones that followed the dot-com bubble and the housing crisis, were caused by problems that were external to the Fed. But in the two instances where the Fed was able to manage a “soft landing” – wherein a recession did not follow a Fed hiking cycle – inflation was nowhere near current levels. The bears believe that the Fed will have to raise rates aggressively to bring inflation down, which will be highly damaging to the economy and markets. Right now, inflation is the primary concern in the minds of consumers, and measures of consumer confidence have dropped precipitously in recent months.
Some observers believe that such a soft landing will be possible because of the economy’s current momentum. The yield curve is still steep if you look at three-month yields versus the 10-year, and Evercore ISI notes that the yield curve remains steep on a real basis. It seems that the Fed will accept higher unemployment in order to achieve its goals of bringing inflation down, but as discussed, labor markets are in historically strong shape, and may be able to handle it.
We Think There’s a Longer Runway for Growth
As for our team, we think that the fundamentals of the US economy remain strong and that the risk of recession in the next 12 months remains low. But we do acknowledge the growing litany of risks. The Fed is expected to raise interest rates by fifty basis points at its next two meetings and begin to shrink its balance sheet, which will tighten financial conditions further. However, the effects of monetary policy on growth are lagged by around one year, so the historically easy money of the last few years is yet to be fully reflected in the economy, and it will be some time before financial conditions can be considered “tight” on an absolute basis. The price of some commodities, like oil, may have peaked, but others, like foodstuffs impacted by the war in Ukraine, may remain high. As we move toward that point in the year when the year-ago prices were higher, comparisons will be easier, but stickier price gains in categories like shelter and wages may still prevail. There may have to be some demand destruction for inflation to come down.
Taking all these factors into account, we remain more optimistic than consensus on the prospects for US growth. But we will be diligently monitoring the risks that I’ve laid out, and we will continue as always in our efforts to keep you apprised on how to gear up for The New Normal.
Taylor Becker provided research and editorial assistance for this essay.
- Source: Our World in Data, as of April 24, 2022. Represents 7-day moving average of new daily confirmed cases and deaths.
The views expressed in this commentary are the personal views of Byron Wien, Joe Zidle, and Taylor Becker and do not necessarily reflect the views of Blackstone Inc. (together with its affiliates, “Blackstone”). The views expressed reflect the current views of Byron Wien, Joe Zidle, and Taylor Becker as of the date hereof, and neither Byron Wien, Joe Zidle, Taylor Becker, or Blackstone undertake any responsibility to advise you of any changes in the views expressed herein.
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