As we begin 2022, our economic and market views hinge on the interplay among the public health situation, inflationary pressures, and monetary policy. The COVID-19 Omicron variant has thrown yet another roadblock into our earlier expectations for economic normalization and recovery of the ailing services sector. However, the latest viral strain will serve to delay, not derail, our expectations for a reversal in the relative dominance of the goods side of the economy over services. Moreover, we believe Omicron may represent the final major COVID surge, leading to an alleviation of the key trends that have caused the extreme inflation we are now experiencing in the U.S. and to a lesser degree, elsewhere. This outcome will not come fast enough however to forestall what we now see as the Federal Reserve working aggressively to tighten monetary policy in a bid to tame this largely unforeseen inflation. We believe the Fed’s efforts will succeed without breaking the economic cycle.
It’s all about inflation
The inflation trajectory is the single most important variable shaping the economic and market outlook in the year ahead. The inflationary surge experienced in the fourth quarter of 2021 was driven by the demand and supply sides and has weighed on consumer and business sentiment alike. We expect an abatement of pressures on both fronts as we move through the first half of the year, particularly if Omicron is the last major variant that allows us to transition from pandemic to endemic, as some experts and medical studies suggest. In fact, the dramatic upside surprises to inflation experienced in 2021 could be replaced by downside surprises as we move into the second half of 2022.
A long-awaited rotation from goods consumption to services is a pivotal element impacting both the demand and supply sides of the inflation equation. This rotation has been delayed time and time again, but we expect it to finally take hold in 2022 as consumer savings levels normalize and the struggling service sector fully reopens. This would relieve the unprecedented pressure on the supply chain from a stimulus-funded surge in goods consumption, which was then compounded by labor shortages. Prior to Omicron, supply-chain pressures were showing signs of peaking, with extended supplier delivery times, longer order backlogs, and receding input prices (Figure 1). Omicron will stall that recovery, but the speed with which the variant is running its course along with its reduced lethality suggest the setback will be short-lived.
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