If 2020 was the year of the pandemic-induced recession and policy-led V-shaped recovery, and 2021 was the year of inflation, courtesy of relentless fiscal and monetary steroids as well as unprecedented supply bottlenecks, then I posit that 2022 will be the year of the Great Transition.
We will transition from pandemic to endemic, from policy tailwinds to headwinds, and away from this current burst of inflation to renewed disinflation. That last point is contentious, but the inflation everyone is consumed with is overplayed and hardly likely to be long-lasting even if “transitory” is no longer applicable. The primary risk is that all the central bank “barking” turns to “biting” and that the U.S. Federal Reserve and Bank of Canada overtighten and tip the economies back into recession. The flat shape to the yield curve, the woeful underperformance of small cap stocks, and the recent weakness in industrial commodity prices (albeit from lofty levels), are flashing the exact same signal.
It simply is not well appreciated as to how government stimulus, both fiscal and monetary, juiced up the Canadian and U.S. economies and financial assets this past year. It is even more powerful than the “reopening trade,” which is now in the rear-view mirror, at least south of the border. The view that households are sitting on a ton of savings is misplaced. Only 3 per cent of the time, historically, have consumers drawn down their cash balances to fund spending; virtually all expenditures are derived from current (and expected) income. That is just basic economics. What comes next, and the dominant theme for 2022, is the withdrawal of all these gobs of stimulus. How will the markets respond to the policy vacuum?
The Fed is now moving much more quickly to exit its quantitative easing program, which it knows has outlasted its usefulness and may actually have ended up doing more harm than good. This is not really about consumer inflation at all, but rather the central bank’s concern, evident in the minutes of recent Federal Open Market Committee meetings, about asset inflation. We head into the New Year with price bubbles having been created in virtually every asset class with a modicum of risk and cyclicality.
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Now, if the futures markets are correct, and the Fed funds rate goes to a 1.75-per-cent peak by 2023, it would mean the possibility of a 20-per-cent decline in U.S. home values and a 30-per-cent slide in equity prices. That’s also assuming we see a reversion to the mean in price-to-income ratios for both asset classes.
As things stand now, our work shows that both equity and residential real estate markets, in aggregate, are nearly 15 per cent overvalued relative to their underlying income fundamentals, even with today’s interest rate structure. I mean, the cyclically adjusted price-to-earnings ratio (CAPE) on the S&P 500 is 40 times. It was last this high in November, 2000, and in the next year, the market was down 18 per cent.
For U.S. housing, the price of a single-family home now absorbs more than eight years of wages, which is right back to where we were during the last bubble peak in the mid-2000s. If equities, relative to earnings, and housing, relative to personal income, were to mean revert with no help from higher interest rates, we would still be talking about a 15-per-cent correction from here. And, as I showed above, if the Fed ends up doing what the futures markets have priced in, we are talking about something much bigger. Tracing the impact of a diminishing “wealth effect” – consumers feeling poorer as their asset values decline – will end up acting as a considerable drag on demand. I estimate a 4-per-cent hit, and that, my friends, is going to be the story that replaces broken supply chains on the front pages of the morning papers in the months and quarters ahead.
Bubbles always go further than you think, which was the financial market story for 2021; but they never correct by going sideways, and as policy stimulus is withdrawn we believe the effects of this withdrawal will emerge as the dominant feature in 2022. Hence our recommendation to de-risk portfolios, shift up in quality and move toward a more defensive and lower-beta investment strategy in general.
David Rosenberg is founder of Rosenberg Research, and author of the daily economic report, Breakfast with Dave.
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