Wilmington Trust’s Capital Considerations with Tony Roth
Episode 44: 2022 Capital Markets Forecast: An Economic Cycle Unlike Any Other
Tony Roth, Chief Investment Officer, Wilmington Trust Investment Advisors, Inc.
Luke Tilley, Chief Economist, Wilmington Trust
We think of the labor market as signaling that we’re in the deceleration stage or the very late stages of the economic cycle. We think that people will be coming back into the labor force and alleviating some of that pressure. So, it’s an almost a backward movement back into the accelerating stage and we think that that’s going to have some important impacts for inflation.
TONY ROTH That was Wilmington Trust’s Chief Economist, Luke Tilley. Luke is joining me today to discuss our 2022 Capital Market Forecast, sharing how he think about economic cycles and how we’re adjusting in this particularly unique point in the current cycle.
TONY ROTH: Welcome to Capital Considerations, the market and economic podcast that’s fully invested in your success. I’m your host, Tony Roth, Chief Investment Officer of Wilmington Trust.
At Wilmington Trust, we have an economic-led investment process. We talk about it a lot. It’s part of our DNA. We very much believe in the idea that the markets discount where the economy is going. The markets can figure out in its own inimitable way what’s going to happen in the economy in six, nine, 12 months, at least it thinks it can and it’s usually right. And so, as investors, if we can develop our own independent view of where we think the economy’s going, that gives us the ability to then look at markets, look at valuations, look at the costs that financial assets are trading for, and from that determine whether or not we think financial assets are trading at fair value given where the economy, in fact, will be in six to nine to 12 months.
When we have an economic-led investment process, therefore, we have to be really invested in the quality of our economic views. And at Wilmington Trust, we have a terrific Economics team that’s led by our Chief Economist Luke Tilley.
Prior to joining Wilmington Trust, Luke was a regional economic advisor to the president of the Philadelphia Fed, and prior to working at the Philly Fed Luke had previously worked in the private sector as a economic forecaster. And prior to that, Luke obtained his PhD from Temple University.
So, every year we step back, and we think about what the economy’s doing and where it’s going over the next year and we publish a Capital Markets Forecast. And this year, our economic analysis is even more critical than typically, because we have, to use one of Luke’s technical terms, a very wonky economy. So, Luke, we really are excited to have you here today to talk about the wonky economy. Thanks for being here.
LUKE TILLEY: Absolutely. Thank you.
TONY ROTH: So, Luke, one of the things that you felt was important to do this year in trying to decipher the wonky economy is to look at the economy through a lens of a cycle, the idea that the economy has dimensions to it, whether it be the labor market or economic activity levels or inflation or inventories and it goes through a typical cycle. And this year, the cycle is sort of broken. It’s not lining up the way it typically would. So, in order to launch into this conversation, maybe you could take us through, some groundwork around the economic cycle and how you actually sort of frame that in your mind and how you think about it.
LUKE TILLEY: So, you’re right. This is a wonky cycle and, you know, just to sort of set the stage, lay the groundwork, cycles typically have sort of a rhythm to them. There’s some part of the economy that overheats and then that part of the economy pops and you get a downturn. When you get the downturn, then a lot of people have lost their jobs and businesses are a little bit reluctant to invest. And then, over the course of years, you get more pressure that builds up.
Now, we’re not here to say that there’s cycles that are exactly like one another. They’re always a little bit different. You know, the housing bubble that formed in 2004 to 2006 and obviously ended that cycle was very different from the tech stocks of the late 1990s. But you have that familiar cycle, again, of something that builds up, probably gets a little bit too big. You have the Federal Reserve recognizes an economy that’s overheating and is usually tightening monetary policy. You end up getting a recession.
After the recession, you get a rebuilding. So, after the recession you have high employment, you’ve got low inflation, you’ve got companies very low in terms of the amount of capital expenditures that they’re doing, and business inventories have been pared down because businesses have reacted to that recession.
From there, the economy usually progresses kind of slowly. Some businesses are willing to stick their necks out a little bit. They try to increase their market share. So, they’re going to start to increase their capex. They may start to hire. There’s an opportunity there for disrupters with new technologies who – to grow quickly in that environment.
And then, on the other side, there are less efficient firms who have not really kept up with times. They go out of business. And then, when we think about the labor, the labor impacts of all that, mostly there has been job loss. Lots of people need new skills if they want to enter the workforce and they’re not able to quickly find a job. The labor market actually doesn’t typically bottom out until well after a recession has ended and the recovery begins.
So, there are some other cycle phenomenon that are going on. Inflation, as I started to mention, starts out really low. Consumers are in, not in that great of a spending position. And really, what it’s all about, what the cycle is all about is resource slack. So, after you go through a recession, there’s jobs, there’s labor that’s not being used, there’s capital that’s not being used. And that’s where we get that cycle, the building, the expansion of the economy. As it progresses over the course of years, more and more resources are used, and that resource slack disappears and that’s where you get the tight labor market. That’s where you get the higher inflation. That’s where you get all of that activity. And that’s sort of the cycle that we think about in normal times, Tony.
TONY ROTH: If we look at things through the most basic lens, you have economies that contract, and they expand. They contract and they expand. From the beginning of an expansion to the next beginning of an expansion, that’s a cycle.
So that’s a pretty basic heartbeat, if you will to a cycle. And, in fact, we call our Capital Market Forecast this year Economic Arrhythmia, because that normal beat of the economy is off. It’s not really working the way we would typically have experienced it.
So, tell us about the – this cycle. Why is it not a normal rhythm, if you will, where things are lining up the way they typically would?
LUKE TILLEY: Right. So, and it is very different and it’s because of the nature of how we got here, right, with the COVID pandemic and then a lot of fiscal stimulus. And for me with the economic lens, it comes down to three things: Labor, inventories, and inflation.
So, when we think about the labor market, obviously things are wonky, again to use that real technical term. We’ve seen the unemployment rate come down almost to 4% now and that was after hitting nearly 15% during the shutdowns in the spring of 2020. Now, we know that the data from 2020 is going to be incredibly volatile. It was just such a crazy year with the pandemic.
But we can look at just 2021. So, over the course of this year, the unemployment rate has come down more than two percentage points since the start of this year. That’s less than 12 months here as we get near the end of this year. We don’t have the full data for the year but coming down more than 2%.
If you think about to the previous expansion that went on for more than ten years, in the previous expansion it would take anywhere between two and four years to get that kind of improvement in the labor market. So, we’re actually still above that pre-pandemic low.
We actually think the unemployment rate is understating the degree of tightness in the labor market.
We’ve had a sharp decline in the labor force and just the simple math of that means that when you have that sharp decline in the labor force that you’re going to have a little bit of a higher unemployment rate. But when we look at alternative sources of data, we use a conference board measure, which is consumer’s perceptions of the labor market, what we’re looking at is the tightest labor market on record in history, in the history of that data. So, even though the unemployment rate is not as low as it was before the pandemic hit our shores, we think we have the tightest labor market. And this is one of the, as we said, the key features of this economic arrhythmia.
So, why have so many people dropped out of the labor force? It was nearly three million people – it’s starting to come down a little bit now – that have dropped out. A lot of that is coming from retirement. We know that markets have performed pretty well. One of the things that we point out is that large cap equities bounced back after just six months in 2020; whereas, in the previous expansion it took 5.5 years for equities to bounce back. And we know that that has a big impact on people’s retirement accounts.
So, retirement in 2021 is up 74% over what we had seen in 2019, new retirement, new flows into this retirement category. It’s pretty remarkable. In the previous recovery, we didn’t see a surge like that in retirement until the markets had recovered in 2013.
TONY ROTH: We had a really great labor economist with us, Julia Pollak, who is the chief economist over at ZipRecruiter.
And so, Julia explained that a lot of people actually come out of retirement and one of the things we’re seeing in this particular cycle is that people that have now retired in larger numbers are also just absolutely not coming back out of retirement.
I remember well my father-in-law. He was an industrial psychologist and he was retired. And then about nine months after he decided that he had to get out of the house, and he went to Williams Sonoma, and he loved cooking. And so, he became a salesperson at Williams Sonoma, and he actually held that job down for three years.
LUKE TILLEY: It’s definitely a good point and I wouldn’t argue with Julia on that or your anecdotal story. And it’s certainly something that happens that people come out of retirement that I think points to some of the other issues that we’re having. But before I get to that, think about the broad structural setup here.
We’ve been talking for, what, two decades about the retirement of the Baby Boomer generation. We knew that this was going to be a challenge for labor supply, a little bit more retiring each year. The arguments I was making about retirement accounts and then also in the face of COVID is basically that we have pulled forward multiple years of what we thought was going to be a structural increase in retirement. We’ve pulled that forward into a very short timeframe.
Now, there are other impacts that are going to affect the overall labor force. We have a lifestyle reassessment. in surveys you’ve got 66% of people considering switching jobs and that can happen even if you don’t retire and come back into it, like you’re talking about, your father-in-law coming back and working in a different industry, in a different sector. Another survey, 55% of people know somebody who quit even though they didn’t have another job lined up, just because they’re looking for something different.
People have reassessed either the jobs that they’re in because they want more flexibility, they want to work at home, they want a change of scenery. So, even if you’ve got people coming back into the labor force, if they’re not going into the sectors that they were in before, you can have some sectors that are still facing bigger challenges in terms of rehiring and that causes all of this resource disorder for those sectors as well.
TONY ROTH: So we have this labor market where a lot of people have dropped out. How much of it would you describe as, I’m going to indulge myself here and use a term structural? And which is say something that’s really going to be more sort of permanent feeling versus something that’s more transitory, which is perhaps folks that still need to work or are still going to want to work, because to the extent it’s, quote/unquote, structural, it’s going to really I think weigh on the economy and lead to that inflation and that wage pressure because there aren’t enough workers. To the extent that it may be more transitory then we would think that it’d be less problematic for the economy and ultimately markets.
LUKE TILLEY: it’s not so clear-cut. A lot of people have retired. A lot of people have removed themselves from the labor force and they are not going to come back. Some people might be enticed to come back in. And some other people are still out of the labor force but are likely to come back. The most recent jobs report had 1.2 million people who said they did not look for work due to the pandemic and that is clearly something that could abate over time as the pandemic and the virus gets more under control. And then on top of that, you have the people that I was just talking about, who have the lifestyle reassessment.
So, you’ve got a pretty healthy mix of people who have left and are probably going to stay out, maybe come back in. You’ve got people who are reacting to the virus and could come back in. We think that as we look forward over the course of 2022, and this is what really matters for markets and companies, that there will be challenges for firms who are looking for labor, either in the sense of finding bodies to fill the seats, to fill the positions, or finding people who have the right skills.
TONY ROTH: We talk a lot about that in the second theme, the adaptive brilliance of business. Companies try to make do with what they have and they’re usually pretty good at it and that’s the beauty of the markets is that it incents them to be very creative and effective and efficient.
And that all means that, companies are going to increase their productivity. They’re going to get more units of output per employee. How much are they going to be able to make up for the fact that they don’t have enough employees by using technology, doing things better, bringing more efficiency out of the system?
LUKE TILLEY: It’s that we’ve seen a lot of productivity growth already and we expect to see more of that and that has some important implications, both for output and then also for inflation.
But let’s go back to the very beginning of our discussion and thinking about economic cycles. We talk about the economy expanding and then going into recession. That’s something that’s always happening. But along that path, as that is going on you’ve sort of got constant improvements in technology and productivity, because you’ve got innovators, you’ve got new technology that might have absolutely nothing to do with the cycle at hand.
Over time, what you have is that kind of technological change is always going on underneath the surface and you’ve got productivity gains. And what we have right now are those productivity gains basically on steroids.
I like to think about the very first time I walked through an airport – I’m sure a lot of people had this experience – and seeing iPads on all the tables where people could order right from that iPad. And I can remember thinking to myself, wow, because I’m an economist. I’m not just thinking about the convenience of ordering from the iPad. I’m thinking about they can probably serve a lot more tables with less servers because of that technology.
And, you know, some people think, well, I’m always going to want a server and sort of that traditional experience. But the fact of the matter is that’s a big increase in productivity. And I can remember thinking how long is it before that industry, the restaurant industry, adopts that en masse and it’s not just in airports? And I would’ve thought it would’ve taken a very long time to do something like that. But the COVID pandemic has basically put that development on steroids and we can all experience how different it is in a restaurant right now.
And I think of that as a microcosm for the amount of productivity and technological gain that we’ve been forced to adopt and it’s not just restaurants, of course. And that kind of technological gains across the economy are happening in a big way. It has an impact on inflation, has an impact on profits, and we think that we’re going to continue to see those productivity gains certainly through 2022 and throughout this coming cycle
TONY ROTH: So, when you put it all together and you think about some structural change to the labor force. And you think about the problems with the supply chain, how do you bring all those elements together to build an inflation forecast?
LUKE TILLEY: So, with the labor question, we do think that some people will be returning and when we think about the cycle construct that we have, we think of the labor market as signaling that we’re in the deceleration stage or the very late stages of the economic cycle, which if it wasn’t for such a strange cycle you would think, oh, we must be getting near the end and we must be headed towards the next downturn. We think that people will be coming back into the labor force and alleviating some of that pressure. So, it’s an almost a backward movement back into the accelerating stage and we think that that’s going to have some important impacts for inflation.
And we see that at the ports, that it looks like the peak in challenge at the ports and the backups were back in September and October. The most recent labor market report showed a big rush of people back into the labor force. So, we think that those things are starting to improve, both on the labor force front and on the supply chains, and that’s what gets us to the inflation outlook.
Much like the labor signals, if I say the labor signals are pointing towards the deceleration phase and sort of that late cycle phenomenon, inflation looks that way too. We’ve had the most recent inflation report. It’s measured by the CPI. More than 6% inflation year-over-year. It’s the highest since 1990. Same for the other major measure of inflation, PCE.
But when we think about inflation and what has gotten us here, it’s not that slow build and that slow tightening of resources that we talk about with the familiar economic cycle, as I talked about resource slack. It has not been this slow building and running out of labor and running out of plants, equipment, and machinery. It’s more been driven by supply chain shortages, either the delivery but also the production. If you don’t have people returning to the factories because of that labor force issue, then you’re not going to have as many physical goods being made or you’re not have people working in the restaurants, you don’t have as many tables being served even though you do have more technology.
But then, the other major impact over the course of 2021 was big fiscal stimulus. We had direct checks sent out in January. We had them sent out in March. That really supported a lot of consumer spending through this year.
When you ask, you know, what is the inflation forecast as we look forward in 2022, we do think that inflation is going to be slowing down, decelerating from where it is now. And it’s because of all of those impacts. We see the ports improving. We think people will be moving back into the labor force to some degree, not everybody but to some degree. And we’re also not going to see that same kind of fiscal stimulus, so not as strong of demand, and that’s how we arrive at our outlook of decelerating inflation, which is important, because again, going back to that economic cycle, even though we’ve got that high inflation right now we think it’s going to recede a little bit.
TONY ROTH: So, one of the key variables that we always think about is where is the Fed funds rate, because the Fed funds rate sort of sets the, to a large degree, the sort of the shape and the level of the yield curve. And when we invest in risky assets, the background opportunity cost, if you will, of not investing in bonds, which is a function of that yield curve, sort of determines how attractive or not attractive those risky assets are, equities and commodities and other kinds of things.
And so, we’re always very focused on what the Fed is doing, what they’re saying, how they’re thinking, where they’re going in managing the yield curve. It’s been interesting that Chairperson Powell has clearly indicated that that inflation has turned out to be a bit more persistent than they thought and to the point now where they just went into the taper in the month of November and now we’re in December and it seems pretty clear that they want to increase the speed of the taper.
And I wonder whether that’s because they have a desire to get into position where they can start to raise rates and normalize their toolkit so that they can then lower rates when they need to in order to stimulate the economy or whether it’s because they’re sort of seeing the whites of the eyes of inflation and they’re really nervous that they want to be able to raise rates in order to break that inflation cycle.
So, when you look at the Fed and its take on inflation, what’s your read on that? Do you think that they are starting to get really concerned about inflation or do you think that they’re using it as an opportunity more to just to start to maybe bump rates a little higher and start to get some more ammunition should they need it later in the cycle?
LUKE TILLEY: At the highest level, the Fed has had, you know, their foot on the accelerator since the pandemic, right. And like you said, we’re tapering that a little bit with the purchases. They had been buying $120 billion in securities per month. They announced early November that they would be buying less in November and December. And I liken that to starting to let off the accelerator a little bit. The other part of their policy which we think will start in 2022 sometime is raising short-term interest rates that you referred to, and we think of that as starting to press on the brake pedal.
Right now the debate is whether they should take their foot off of the accelerator a little bit faster. Should they accelerate the taper? And it looks like they are set up to do that after Powell’s testimony last week.
The answers that he gave I think made it pretty clear that he is inclined to take the foot off the accelerator a little bit faster. We’ll see at the December meeting. And that is because they are surprised a little bit by how long inflation has stuck around. I mean the first impacts earlier this year of the reopening and people returning to flying on planes, we saw the surge in airfares, we saw the surge in hotels and accommodations and those really drove some of those initial high numbers of inflation, April, May, and June. Later in the year, what we’ve seen is that higher inflation is sticking around. Not only is it sticking around, it’s more broad-based and also appears to be driven by the labor markets to some degree and this shortage of labor, if you will.
So, what Powell and the Fed are doing in my eyes is seeing that they’ve been a little bit surprised by that, that even though their forecast is for inflation to slow down, they’d like to take their foot off the accelerator a little bit faster than they had earlier planned. They might tap on the brakes earlier than they had initially planned, but the key is to get that foot off of the accelerator so that they have the ability to tap the brake if they see a need to earlier. In my mind, it’s going to be a little bit more important not when they start to tap the brake, but how hard they push on it, Tony.
TONY ROTH: So, you’re certainly not reading a panic here. In other words, their quick shift to a little bit of a tighter posture is not a massive change in outlook.
LUKE TILLEY: I think, yes. I think of them as moving along a continuum. You’ve got are you going to be a little bit tighter? Are you going to be a little bit looser? Clearly, inflation sticking around has inclined them to move on the more hawkish side and being a little bit more tighter or at least wanting to tighten.
And then, the other thing that they need to do is communicate to markets. They do not want to relive the so-called taper tantrum of 2013 when long-term bond yields doubled over the course of five or six months. That was a big challenge and I think broadly recognized by, even by the Fed, as a lack of communication.
So, they’re communicating those possibilities right now and that’s a key part of it too is to not surprise markets. And that gives them that latitude to be more hawkish if they need to be. So, I think that they’re giving themselves that latitude.
TONY ROTH: You’ve made it clear that your base case scenario is for inflation in fact to moderate. We haven’t talked about specific GDP numbers. But – I know that our forecast is for GDP to have what I would describe as a soft landing from pretty high numbers this year to 3 ½ % next year, which is still a real incredibly healthy number almost double where we over the decade from the great financial crisis when we couldn’t get to 2% GDP. Very, very slow, gradual expansion. And that, those are numbers that would be or that would be a scenario very consistent with our risk opposition for equities where you have nice, steady economic growth and receding inflation, even if it’s still at a healthy level, still coming down in a very persistent drop.
That’s our base case. Our alternate scenario is inflation, in fact, doesn’t come down as quickly, the Fed needs to raise rates more rapidly than expected as we get into the second half next year, and potentially signaling or triggering an end to the economic cycle more rapidly. And that would be a contraction. That would be a different kind of market regime where we probably would want to be in safer assets, more bonds, shorter-term durations.
Luke, when you look at the probability of that base case scenario relative to the alternatives, how would you describe your level of confidence today compared to a typical cycle? I think it’d be helpful for us to understand that because we’ll be talking to our colleague Meghan Shue in a subsequent episode around how we’re deploying assets in the portfolio today and that level of background economic confidence is always important in how we actually deploy assets.
LUKE TILLEY: The uncertainty of the forecast is definitely greater. There’s always a lot of moving parts to a cycle and where you’re headed. But I think that they are just on parallel right now from our historical experience, because we have so many things that hinge on the pandemic in the near-term. You know, we’ve had the new variant crop up here just in recent days and it’s hard to predict both how that is going to transpire from a health point of view, but also how people are going to react to it.
So, our outlook is based on what we think will happen with people returning to the labor force, how they are going to be spending, all of the behavior over the course of 2022. And we do have our base case, but as you said, the riskier case and the risk is that inflation continues to be as high or, you know, just not decelerate as much as we think. And that could certainly happen, because we don’t know what’s going to happen with the virus. If you do have challenges getting people back into factories and other places of work, then you have that upside risk for inflation, and I think that the uncertainty is definitely higher now than it has been in the past around where the cycle is headed.
TONY ROTH: So, we’re going to have to stop here. But I’m going to summarize three key takeaways, as I always do, from the really insightful conversation that we’ve just had with our Chief Economist, Luke Tilley.
And I’m going to start with understanding that we look at the world from an economic standpoint when we invest and that economies follow cycles. And the way those cycles work is at its core the question of resource utilization whereas you go through a cycle resources become more abundant and then less abundant and when they’re more abundant it essentially fuels the economy and then when they become less abundant it fuels inflation and ultimately causes the economic cycle to end through a higher rate environment.
And so, that backdrop allows us to really develop a very strong lens of what’s happening in today’s world.
And when we look at the world through that lens, and this is sort of the second and probably more complicated takeaway, is that we see a significant amount of arrhythmia relative to a typical cycle. We see an inflation environment and a labor market, very tight on the labor market, high inflation environment as a result. We see lots of disruption in the supply chain and all those suggest that we’re getting to the end of the economic cycle, despite the fact that our overall level of economic activity is quite high and could be thought to stay that way for some time if, in fact, the labor market settles down and we have more people enter back into the labor market.
The inventory picture, on the other hand, is one of almost the bottom of an economic cycle where there’s nothing left on the shelves. And so, we need to reconcile all of those different dimensions of the economy and we conclude that we’re actually mid-cycle and that the inflation and labor picture are in a sense going to move backwards in the cycle and abate without having very significant intervention by the Fed,
That’s our base case scenario. And then the third point is that we have to recognize that there is a pretty material risk that we’re getting it wrong, that the Fed is getting it wrong in terms of the immediate outlook and that inflation will not abate as quickly, in which case the Fed will have to, indeed, not just accelerate its taper, but moving across the continuum from a very accommodative approach to a much tighter approach, have to reverse that continuum more quickly. And that would probably involve more hikes, faster, of potentially greater magnitude in order to calm down the inflation situation. And so, we will discuss in our next conversation with our head of Investment Strategy, Meghan Shue, because the economic cycle is a bit less clear than we typically would see it at this stage, we have to be a bit more diversified in our portfolios to hold assets that could perform in different kinds of environments and that can provide a hedge to less desirable outcomes should in fact the market and the economy move in that second scenario that we’ve talked about with Luke.
So that is our conversation for today. And, Luke, I want to thank you again for your terrific insights. And I know you’ll be with us every step of the way as we figure out how to move forward and as this play unfolds.
LUKE TILLEY: Thanks for having me.
TONY ROTH: You can find the entirety of our 2022 Capital Market Forecast, download the PDF, or peruse the content on our website wilmingtontrust.com. I also encourage everybody to visit wilmingtontrust.com for a roundup of all of our investment and planning ideas. You can subscribe to Capital Considerations on Apple Podcast, Spotify, Stitcher, or your favorite podcast channel to ensure you get updates on future episodes. Thank you, again, for listening today.
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