In their first walk in the new year, Hugo and Olga dissect the economic slowdown that must follow the exceptionally strong growth of last year. 2022 is shaping up to be an unusually exciting year for active investment, as we will need to unbundle the structural changes that the pandemic wielded on our economies from the seemingly more familiar cyclical pressures.
Hugo Scott-Gall: Happy New Year! Let’s talk about the slowdown. Where and why are we expecting it? A slowdown to what?
Olga Bitel: As we start 2022, a discussion of slowing economic growth is probably a good place to begin. Let’s set the stage with a couple of observations.
Despite extraordinarily robust GDP growth in 2021—both the U.S. and euro area economies are likely to have expanded by more than 5%—neither has reached its pre-COVID output growth trajectory yet. In other words, both sides of the Atlantic have yet to recover to levels of output that their respective economies would have generated in the absence of the COVID pandemic.
Given the policy response and the medical rather than economic nature of the 2020 output decline, I see little reason to assume that GDP cannot recover to pre-COVID levels in either the United States or the Euro Area. Yet, current consensus forecasts for the largest economies within the Euro Area imply a permanently lower output trajectory post-COVID.
At the same time, as these developed economies approach their respective pre-COVID output trajectories, GDP growth will most likely decelerate to a structural trend growth rate of about 2% per year. So, your question, Hugo, boils down to how a slowdown from 5%-plus GDP growth to 2% unfolds.
Since the U.S. economy has already recovered much ground, we expect it to reach its pre-COVID path by this summer, with economic growth slowing sequentially as the year progresses. The principal European economies suffered a much more severe contraction, and so have more room to grow before reaching their pre-pandemic output trajectory. We expect Germany, France, and Italy to get there by the end of this year, with growth beginning to slow into 2023.
Hugo: If I understood you correctly, the largest DM economies are still running below capacity. Why, then, has inflation risen more rapidly and been more persistent than anyone anticipated? How do you expect it to play out this year?
COVID exposed the weakness of pairing global supply chains with purely national responses to medical challenges: China pursues zero-tolerance of infections, while the U.S. and most others embraced economic activity while minimizing severe illness outcomes.
Olga: In a way, COVID exposed the weakness of pairing global supply chains with purely national responses to medical challenges: China pursues zero-tolerance of infections, while the U.S. and most others embraced economic activity while minimizing severe illness outcomes. This divergence in national response translates into impossible-to-anticipate, sporadic, highly disruptive closures of plants and ports located in China, while the United States and Europe remain open for business. The supply of goods has become a victim to the rolling supply disruptions, as they reverberate throughout the world economy for months after the initial disruption. Imagine a container ship heading to a Chinese port, and within days of docking, the port terminal suddenly closes because someone tested positive for COVID. This ship is re-routed to a different port. There is a sudden mismatch between ground transport logistics and the location of cargo, as container ships get re-routed to a different port.
This is precisely what has been happening. In the last week of May 2021, the port of Yantian—fourth-largest globally, processing 90% of exports of electronics—was partly shut down after five crew members aboard a docked container ship tested positive for COVID. The closed port terminal serves over 100 ships weekly, and it remained shut well into the second half of June.
The Meishan terminal of Ningbo-Zhoushan port, the world’s third busiest, ceased operations for much of August after one worker tested positive on August 11. Simultaneously, the cargo terminal at Shanghai’s Pudong International Airport closed when five airport workers tested positive, with 80%-90% capacity cuts. August and September are traditionally busy times for holiday shipping to the United States and Europe. Little wonder that inflation spiked in October and November.
China’s ports process nearly 50% of global container volumes, so the disruption is massive. Shipping and logistics veterans have emphasized that these sudden port closures are far more disruptive than the pileup in the Suez Canal in March 2021. The rolling production and transport facilities closures largely explain why goods prices are rising at a 12% rate, a sharp and temporary reversal of multidecade price deflation. Temporary in the sense that it should end once pandemic-related disruptions subside and end-to-end supply chains normalize.
On top of this, U.S. consumers feel the price squeeze on cars, as the current annualized supply is running 3 million to 4 million vehicles short of the pre-pandemic rate. In the dreary days of pandemic lockdowns, many car producers underestimated the strength of demand resumption and canceled semiconductor orders. A lack of new cars, in turn, elevates the prices of used vehicles, which is evident in the U.S. monthly consumer price inflation data. As the supply of semiconductors normalizes and new cars roll off the assembly lines, pricing pressures here, too, are likely to subside.
Importantly, purchasing patterns suggest that consumers do not expect pricing pressures and scarcity to persist: there are no signs of hoarding. In fact, the supply-demand adjustment is occurring as expected: consumers are postponing purchases in response to higher prices. Overall demand is down more than 10% since the reopening peak, with much of the deceleration concentrated in motor vehicles.
The current bout of inflation should dissipate with declining COVID infections.
Hugo: OK, I hear you on the COVID-related disruptions, though the U.S. Fed seems to have taken a different view recently. In December, the FOMC dropped the term “transitory” when describing current inflation and committed to faster withdrawal of pandemic monetary stimulus. This stance seems contrary to your assessment that the current bout of inflation should dissipate with declining COVID infections.
Olga: I actually do not see a contradiction. Current inflationary pressures may be transitory in the sense of lasting as long as the pandemic does. But they still make monetary policy de facto more expansionary by lowering real, as in inflation-adjusted, interest rates. In effect, the Fed recalibrated its monetary policy stance to where it was last summer.
So, we still have a highly expansionary monetary policy, very supportive of growth. No action from the Fed would have made de facto monetary policy stance even more expansionary at a time when economic recovery is proceeding so well that the U.S. GDP is on track to close the gap with the pre-pandemic output trajectory by this summer.
Hugo: So, we are projecting economic growth to decelerate sequentially over the course of 2022 from the current, breakneck pace; for inflation to remain high, at least until COVID infections are relegated to the past; and for monetary policy to tighten as a result. This is a tough backdrop for equities. Are we about to replace “beat and raise” guidance from companies with misses and downgrades to earnings estimates instead? How do we think about a fair market multiple against what seems to be a rapidly changing backdrop?
Olga: At a minimum, market multiples must relate—inversely—to the prevailing interest rates. If our expectations for the U.S. economy to reach the pre-pandemic output trajectory prove to be directionally correct, then we must expect interest rates to begin to rise toward levels prevailing in 2015-2019.
Beyond the superficial averages, I suspect investors will have to reassess prospective earnings growth and trends in cash flow margins not only relative to strong growth in 2021 but also relative to the pre-pandemic economy. For better or worse, COVID changed how we shop, work, and live. The pandemic brought forward demand in some cases, and there will be a pullback. But, elsewhere, the demand curve experienced a permanent shift.
At the same time, companies large and small were forced to rethink the resilience of their supply chains and the way they deliver value to their customers. Digitally enabled businesses proved more resilient. It is already notable that private investment recovered within two quarters. How companies invest moving forward will help shape the U.S. economy for much of the decade.
Hugo: Yes, the assessment of the impact of this COVID pandemic is just now beginning. I see lots of conversations on this topic in the near future.