Gerald Connor / January 24th, 2022

Delay of Game

A football analogy seems appropriate at this time of year and is also an accurate assessment of the economic recovery that we anticipated last fall. It has been delayed by the Omicron variant. For how long? Well, that might depend on where you are and your perspective on things.

If you’re in Quebec, you’re not only shut down, you’re shut in with a curfew. Ontario isn’t too sure what to do. You can’t go to a restaurant or your office, but your kids can go to school. Well, I’m currently in Florida and it is open for business. The sentiment here is ,”Bring it on and let’s get this over with”. They’re more concerned about dying than getting sick and this latest variant seems to be mild and less serious. So, either get your shots or get sick, but either way let’s get to “herd immunity.” Besides, even if you’ve been vaccinated, you’re still probably going to get it. Omicron is the fastest spreading virus known to mankind. According to the infectious disease experts at Massachusetts General Hospital, one case of measles, until now the most infectious virus, would cause 15 new cases within 12 days. One case of Omicron gives rise to 6 new cases in 4 days, 36 in 8 days and 216 in 12. A simple extrapolation would suggest 14 million people will be infected in 60 days compared to 760,000 for measles.

Are they right and as Canadians are we being too cautious? I don’t know the answer to that, but I can tell you that I’m having more fun down here than I would be sitting around a wood burning stove watching Netflix on Saturday night up north.

So far, the market seems to agree with the “let’s get on with it” view and that this latest wave will flame out sooner rather than later. Infections along with vaccines will result in herd immunity.

So, what are our thoughts? Well, not much has changed since my fall commentary except the recovery we expected has been pushed out by a couple of months due to Omicron.

Our thinking then was that liquidity drives the market and there was still lots around. And, that the economy would recover as bottlenecks got resolved and most importantly inventories got rebuilt.

Maybe it’s best to just revisit last quarter’s thinking and give you an update.


Last quarter we pointed out that there were two economic camps. One believed that economic growth was about to slow as government stimulus was behind us. The other camp, which we supported, believed that there was still pent-up demand due to supply shortages and that the service sector, think airlines, hospitality and restaurants, had yet to open up. This will show up in real final sales, about 75% of GDP. However, another important factor in the GDP calculation is inventories. When they are increasing, they add to GDP growth and today they are still very low and likely to expand which keeps manufacturing companies busy. This trend is being exaggerated by company’s reactions to the supply shortages and bottlenecks by holding more inventory than normal as security. The Atlanta Fed’s GDP Now model suggests that the economy grew at a 6.8% annual rate in the fourth quarter with real domestic investment growing at 17.8% as businesses try to improve productivity in the face of chronic labour shortages. Job openings still total 10.56 million, which amounts to 1.5 available jobs for every unemployed worker. However, this level of growth is unlikely to be sustained once pent-up demand and inventories are satisfied. Manufacturing will recede to production levels that more closely match final sales and that is probably the best-case scenario.

Realistically, companies are likely overestimating demand by extrapolating current sales and are double ordering to press manufacturers for product. It is also likely that a lot of demand has been pulled forward by stimulus checks and current sales levels will not be maintained. Furthermore, year over year comparisons start to get tough in the second quarter as we anniversary huge government stimulus which then, in contrast, becomes a drag on economic comparisons. Employment gains and savings can offset this for a while, but as employment gains reaches limits and savings are spent, there will be little follow up for further consumer spending. You also lose some remaining fiscal stimulus. February 1st, 39 million students will again be obligated to make payments on their student loans of $300/ month. That amounts to $22 bn per month or $144 bn per year of drag. The childcare tax credit of $300/ month also ends in May. As we go through this normalization one should expect to see economic growth revert back towards a trend of 2% and this could be threatened by a Fed that has to respond to above target inflation.


Inflation has been another controversial issue. We’ve consistently said that we think it will recede from the current spike which reached 7% in December, a forty year high, but that it wasn’t going to go away and would remain stubbornly above acceptable levels. The Federal Reserve seems to have come around to our view as their repeated use of the word “transitory” has now been replaced with the word “persistent” as they see the current economic outlook as much stronger with higher inflation and tighter labor markets than at the beginning of previous normalization episodes.

Our belief that inflation starts to subside is based on our expectations that pent up demand for durable goods, which have lead the consumer price inflation, would largely be met by the second half of this year as supply chain bottlenecks get resolved. Yet, a number of economists are now projecting inflation to slow only to 3%-4% in the second half of this year and to remain elevated around that level though 2023.

Our elevated inflation expectations are based on three secular trends that we think will persist. The first is employment costs. Not long ago, the Phillips curve that says tighter employment leads to higher wages was dismissed as old thinking. Globalization had eliminated the correlation. With factories moving out of China and re-shoring, we’re once again dependent on domestic labor. And there is none. The working age population in the US is barely growing as the excess demand for workers was met by the baby boomers, the first of which are turning 75, remained in the work force. This population bubble pushed the percentage of workers aged 16-34 from 37% of the labor force in 1962 to 51% by 1980. It has now fully contracted to 35%. However, Covid has caused a rethink here and a number of those who extended their careers are now retiring. Immigration which also supplemented the work force was further curtailed by the Trump administration. We are now back to the pre pandemic unemployment rate of 3.5% a 50 year low. Not surprisingly, the average hourly earnings for production and non- supervisory workers, about 80% of workers, rose 5.8% in November. Furthermore, the Biden administration is probably the most pro-union administration of modern times with popular support of unions reaching levels last seen in 1965, which could exacerbate this trend. It’s true that productivity improvements can relieve the situation, but the capital that is required is also in competition with environmental demands and proponents of better fair sharing between capital and labor. Consequently, we don’t see this as a transient issue.

Our second secular inflation issue is the cost of housing. With record low mortgage rates, thanks to the Fed and their monthly purchase of mortgage-backed securities, home prices have appreciated by 30.3% since pre pandemic levels and prospective buyers are priced out of the market, which is boosting the demand for rental units. With interest rates going up, this will not get any better. Owner’s equivalent rent, which is a concocted calculation thought up by some career bureaucrat, represents about one third of the consumer price index, CPI, and is intended to calculate what a homeowner would pay himself to rent his own home. It usually lags the actual housing market price action by about one year and is currently running at 3.5%. With pressure on rental rates, this homeowner’s equivalent is likely to remain under upward pressure.

Our third secular concern is energy and is based on an ill-conceived transition process from fossil fuels to renewables. Between political pressures and environmentalists, our energy security and economic progress could be in jeopardy. World crude oil production remains 8.4% below 2019 year end levels and US supplies are still almost 2.0 million barrels per day short of where they were pre-pandemic. Oil and gas discoveries are on track to hit the lowest levels in 75 years while exploration is inhibited by the banks’ reluctance to lend to the industry due to political risk. Yet China and other growing economies will see their consumption of oil continue to grow for decades to come. Furthermore, coal which is the primary fuel used to generate electricity is expected to reach record levels of consumption this year in China, India and the US. Transitioning to renewables is not likely to be smooth and could result in economic disruptions and/ or more inflation, not to mention security threats as the US loses self-sufficiency and once again becomes reliant on the Arabs and Russia.

Bottom line, we don’t see how Federal Reserve policy can affect these trends unless it wants to restrict the economy and demand.

Federal Reserve

Our other big theme centers on liquidity. When there is more of it around than the economy can absorb, it goes into the stock market. As inventories get rebuilt and the economy expands, there will be greater demand for those surplus dollars. However, the supply of that liquidity is also under re-assessment. The Fed has been focused on employment first and inflation second in reaching its twin mandated goals. With unemployment at 3.5% and inflation running at 7% they seem to be in a position to declare a victory and possibly be labeled as over achievers. So, how do they back off without triggering some unintended consequences? We all know they have to reduce liquidity and eventually raise interest rates. What remains unknown is how fast and how far. The minutes of their meetings give us some insights and suggest they are incrementally moving from accommodation to normalization much quicker than what was assumed. They also show that their ability to forecast, even given all the resources that they have, isn’t much better than average. In their December 2020 meeting, they predicted that inflation would be 1.8% for 2021. By March, that projection had risen to 2.4%; by June to 3.4% and 4.2% in September. But they continued to project 2.2% for both 2022 and 2023. Meanwhile real yields, the difference between interest rates and inflation, have gone to record negative lows, which would suggest that either rates are too low or inflation has to come down. We’ve already given you our opinion on inflation. To adjust for this, we now have all 18 members of the Fed Open Market Committee expecting at least one rate hike in 2022 up from nine in September. Furthermore, 12 of them think there will be as many as three, one quarter point, hikes and two think there could be four increases. In 2023, three more increases could be in the offering which would bring the policy rate to 2.1% by 2024 compared to 2.25%-2.50% in 2018, the previous cycle high. In response to these quickly changing realities, the Fed has decided to accelerate its tapering program. It sounds like a reduction, but it isn’t. The new policy will in fact still stimulate the economy with added liquidity, just less of it until it ends in April with no new additional bond purchases.

So, Fed policy is still accommodative until then. Beyond this spring, things are less certain. The Fed suggested that rates could start to rise once accommodation ends and they threw in a new twist suggesting that they could allow for balance sheet run off, meaning that they would actually reduce liquidity at some point after the first hike. This is the first time run off has been mentioned. As we said, this is the stuff of bull markets so the antenna goes up pretty quickly, especially since the Fed seems to be behind the curve and recent actions suggest they’re trying to catch up.

Since the pandemic started, the Fed’s balance sheet has expanded by almost $5.0 Trillion to $8.7 trillion. It was used to fund government spending which resulted in checks going out to the public, some of which made it back to the banks and show up in deposits which are part of M2. M2 is up $6.0 trillion since February, 2020 and about $3-$4 trillion above trend at $21.4 trillion. About the size of the entire US economy and is the most liquid since March 1975. How much of this liquidity is surplus is open to conjecture, but the guess is around $3.0 trillion. The government needs to borrow about $1.0 trillion next year plus whatever the economy requires. The Fed’s balance sheet is concentrated in short maturities which would result in a $1.0 trillion run off this year and an additional $1.0 tn in 2023. Things may get tight sooner than expected.

So this addresses quantity or availability of money. The other variable is price, or the cost of money, which is measured by the interest rate. If the Fed governors are correct, we get to a .75% official rate by the end of this year which doesn’t seem very high in absolute terms. Nothing that would seem to threaten the economy. Even the projected rate of just over 2% in 2023 seems consistent with what we have seen before.

Our fear is that the current rates, especially the 10 year U.S. Treasury may be giving us some false comfort. It hasn’t gone up as much as many had expected. A number of things could be causing this, which will now start to reverse allowing a realistic rate to evolve. First, a lot of the Fed bond purchases provided liquidity to the banks which then bought bonds to get it invested. The banks have also seen a lot of deposits come in with no offsetting loans resulting in bond purchases. And lastly, the US has been running enormous trade deficits from all the goods they have been importing. Traditionally, foreigners receiving payment for those goods exchange the funds and their country’s central bank buys treasuries. Trade deficits get recycled into the treasury. Both of these sources of bond purchases which push interest rates down are expected to reverse as savers buy a car and withdraw the funds, auto dealers need loans to finance their inventories and satisfied pent-up demand reduces spending on imported goods. If so, over the next few months, we’ll see the true yields on Treasuries and if inflation is still elevated so will yields. Availability of funds declining while the cost goes up may prove problematic.


In the near term, conditions probably support an optimistic market outlook. The Fed, despite its rhetoric, is still providing liquidity and interest rates remain at their lows. The Omicron variant is expected to be mild and short-lived while bottlenecks and shortages should get resolved allowing the economy to resume its recovery. So, the market backdrop for the next few months still looks constructive. However, below the surface I still have my concerns. Concentration is extreme. The FAANG group has now been expanded to the Magnificent 8, Alphabet (Google), Amazon, Apple, Meta (Facebook), Microsoft, Netflix, Nvidia and Tesla. Their collective market cap is $12.1 trillion, about 25.7% of the S&P 500 total market cap and they trade at a collective 33.8X forward earnings. This compares to the S&P 500 at 21.3X and the S&P500 ex the Mag 8 of 18.6X. Apple alone is worth more than Walmart, Disney, Netflix, Nike, XON, Coke, McDonalds, AT&T, Goldman Sachs, Boeing, IBM, and Ford combined. They’re great companies and will continue to grow but their valuations are far from cheap.

We’re also seeing a diversion in breadth in the NASDAQ where roughly 36% of the stocks are down over 50%, while the averages are only about 7% below their peak. Moderating this concern is that the vast majority of these companies are small caps and may be overstating the issue. Nonetheless, the advance/decline ratio on the N.Y. Stock Exchange also peaked last June.

Overall valuation is also high but mostly due to the concentration issue. Ex the Mag 8, the S&P is not cheap but trading at a more reasonable 18.6X forward earnings. The nuances of the market are further apparent when comparing growth to value. The S&P 500 Growth index trades at 28.3X while the Value component trades at a more modest 17.1X. The growth versus value argument has been an ongoing debate, but the most predictive variable has been interest rates. Value performed well through the first five months of the year while rates were rising and lost ground when rates declined in the summer. But, if the Fed is on the verge of a tightening cycle, value might be able to show a more sustained outperformance. What might lend some further support to this is the analogy I see between today’s market and what happened at the end on the dot com era in 2000. Back then the Tech stocks were hyped by the corporate spending to prepare for Y2K. But it wasn’t sustained the following year. Last year the market darlings were those that benefited from the pandemic. But will there be a follow up for the Zooms and Pelotons or is it over? It was a defining event in 2000 when market sentiment shifted dramatically from growth to value. There are also many signs of speculation from record-high levels of M & A activity to the participation rate of the public which are concerning.

However, as we move beyond this last economic recovery phase and the Central Bankers begin to normalize interest rates the outlook becomes less promising. Earnings can continue to grow, but valuations are already high. Liquidity will diminish and economic growth by the end of the year will be headed towards a trend line 2% as comparisons become more difficult. Mistakes by the Fed or an unexpected slowdown in the economy would probably be unwelcome news. According to Alpine Macro, there have been 8 stock market shakeouts that exceeded 15% since 1990. However, there were only four recessions. The others were valuation contractions. One was induced in 2018 when the Fed then also raised interest rates and shrank the Banks balance sheet. Chairman Powell had to quickly reverse his direction. Will there be a repeat or has Powell learned a lesson and won’t go far enough to fight inflation?


The Omicron story likely gets pushed off the front page by the end of January in favour of the economy recovering as shortages get resolved and the inventory cycle plays out. Inflation will remain a stubborn issue for secular reasons that defy the Fed’s efforts to resolve it and potentially set it up to overreact. Slowing economic growth, high valuations in certain sectors and declining liquidity will likely make for a more challenging market environment in the second half of the year, if not sooner as the market anticipates these changes.

The by-word for the year is likely to be Normalization. Normalization for the economy as it comes off a fiscal and monetary stimulus high. And, Normalization for monetary policy as we move away from zero and negative interest rates to something more realistic.

If this results in an economy growing at 2%, a policy interest rate around 2% and inflation moderating towards 3%, the market can probably live with that.

Just don’t count on it being a smooth glide path. There are likely to be some air pockets or bumps along the way.

Gerald Connor

Yardeni Research
Ned Davis
John Atkins TD Bank
Alpine Macro


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