Markets Pause to Consider Potential for Faster-Moving Fed

While the pandemic has been the ultimate wild card over the past two years, it’s reasonable to assume the omicron variant may be exerting its near-maximum impact on the U.S. economy right now. Given the trajectory of infections in South Africa, caseloads could decline as quickly as they rose. The omicron variant, though spreading rapidly, appears to yield milder symptoms. And a growing contingent of health officials believe the omicron variant could push COVID-19 from a pandemic to something more endemic. Of course, predicting the twists and turns of the pandemic has been difficult, so time will tell.

Meantime, markets have remained buoyant through the latest surge. As we’ve said in prior commentaries, each wave of the virus exerts a little less influence on the broader economy. Looking ahead to the rest of the year, we think growth remains strong in the first half of 2022. Inflation is poised to moderate as supply chains catch up and workers come off the sidelines. That should, in turn, allay fears of Fed tightening.

But the second half of 2022 could prove more challenging, especially if a good chunk of those 10.6 million job openings is filled, and we start to approach full employment. That would put the economy closer to 2019 conditions, when the labor market was close to running out of slack. At that juncture, markets will begin to contemplate how far along the economic cycle has progressed, which could lead to heightened volatility. Still, we think productivity enhancements, driven by technology and efficient operations, can help economic growth push onward for some time. We’ll spell out this 2022 outlook in more detail in our forthcoming quarterly commentary.

Now, to the week that was and the week ahead.

Wall Street wrap

U.S. factory activity expands as supply chains and labor improve: The ISM Manufacturing PMI registered 58.7 in December, marking the 19th consecutive month of expansion in the sector (any read above 50 indicates growth in the sector).

Encouragingly, the prices index was 68.2, down 14.2 points from November, which is an indication supply chain issues and material costs are starting to ease. Hiring conditions are also improving, though high worker turnover and COVID-19 absences remain a challenge. Still, it’s good to see some of the stickiest issues that fueled inflationary pressures in 2021 are showing early signs of receding.

The ISM Services PMI, representing a far larger share of the U.S. economy, hit 62 in December. That’s about 7 points below November’s all-time high of 69.1 but marked the 19th consecutive month of expansion in the sector. The prices index rose slightly in December, and inventories remain low as supply chain issues linger. Despite these challenges, growth remains strong. Supplier delivery times have started coming down from elevated levels and could indicate we are on the other side of supply chain woes.

Job openings remain elevated, quits hit a record: A record 4.5 million Americans quit their jobs in November as the U.S. labor market improved, with workers likely looking to boost their pay and working conditions or retire. Turnover, in addition to finding workers, remains a challenge, with roughly 10.6 million job openings.

There are roughly 1.7 jobs for every person looking for a job right now, which means there are plenty of options for people who are employed or on the sidelines. That’s a boon for workers, but it’s putting pressure on companies to boost wages and other incentives to keep and attract workers. As we said at the open, we think it’s likely the labor market will approach an equilibrium in a few quarters.

Job growth accelerates: Employers added 199,000 jobs in December, which was well below the monthly average of 537,000 throughout 2021. Job gains in October and November were revised up a combined 141,000. Also worth noting: December’s job tally appeared lower due to seasonal adjustment calculations. We won’t get into the weeds here, but without these adjustments job growth would’ve been over 400,000. For context, the December employment report from ADP (a private payroll company) showed businesses added 807,000 jobs.

But let’s look at the entire year. The economy added 6.4 million jobs in 2021, and that’s a record. The unemployment rate fell to 3.9 percent in December from 4.2 in November. Keep in mind, the unemployment rate only accounts for people looking for work. There are a fair number of people who dropped out of the workforce that can still step back in. So, on the surface it looks as though the economy is approaching full employment, but we’re likely further from full employment than the headline rate implies.

While the economy remains 3.6 million jobs short of its pre-pandemic level, if hiring continues at a similar pace in 2022, we may be nearing full employment sometime late in the year or into 2023. (Of course, a lot can happen between now and then.) At that point, as discussed at the open, markets will begin to assess where we are in the business cycle. Full employment is one condition for an economy to run out of slack (i.e., it lacks the labor and capacity to satisfy demand). However, it’s possible that workers will become more efficient through technology, training and other enhancements, and that can help boost productivity further and prolong the business cycle. We think economic slack will become a primary focus of markets later this year, and that could generate some volatility.

Fed minutes give markets a hiccup: Markets flinched a bit on Wednesday when the Federal Reserve released minutes from its December policy meeting. The issue? The Fed outlined a plan to accelerate the pace of tapering, with some committee members discussing raising rates sooner and at a quicker pace, with the first hike potentially landing in March. Another nugget: Some committee members recommended shrinking the Fed’s balance sheet to tighten economic conditions rather than using rate hikes as the primary policy tool.

Keep in mind, these aren’t concrete policies. Rather, markets are simply getting a look at how the “sausage” is made and pricing in projections. While monetary policy may cause sharp reversals in highly speculative, overvalued pockets of the market, we think Fed policy will have less of an impact on the broader market’s trajectory in 2022. The yield on a 10-year Treasury rose 25 basis points, from 1.51 to 1.76, which was a big move and added to the pain for growthier areas of the market. Economic growth is strong, and even after the end of tapering and a rate hike or two, Fed policy should remain accommodative; but policy risks are certainly in focus for 2022.

The Week Ahead

Here’s a look at how the week will pan out:

• Tuesday: The NFIB’s small business index for December is due in the morning. It’s a good overview of business-owner sentiment outside the big names traded on Wall Street.
• Wednesday: The focus, as it has been for several months now, will be on CPI and core CPI reads from December. Inflation has become central to markets, as the market believes it is the hinge that Fed policy will pivot on. While we’re seeing some early signs that price pressures are easing, we (and the market) will be watching this number closely. However, if inflation is in line with expectations, it won’t likely be a market-moving event.
• Friday: The week closes with a few more reports of interest. Retail sales for December will be important, as that captures peak holiday spending. Keep in mind, consumers pulled a lot of purchases forward as concerns about prices and supply prompted shoppers to tackle their lists a bit earlier. Industrial production and consumer sentiment are other notable reports coming on a busy end to the week.

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