Slowdown Ahead

by | March 21, 2022

A year ago, ahead of the consensus, we argued that inflation was underestimated. Now it is time to warn about the coming slowdown.

Like then, our view is unfashionable. Indeed, this past week equity markets staged a strong comeback, a sign that investor spirits are recovering from their soggy start to 2022. As we note below, that bounce back isn’t entirely without justification. But it isn’t likely to enjoy much follow through, either.

Several factors have underpinned the most recent recovery of risk assets. Federal Reserve Chairman Powell assuaged fears by offering an unusual degree of clarity about the Fed’s first quarter point rate hike, ruling out in advance a more aggressive half-point increase. Reports that Russia and Ukraine might find a diplomatic solution to the war is also reason for hope, despite the absence of tangible progress in their talks. Finally, despite a widening of the latest Covid outbreak in China, investors took heart from comments by Vice Premier Liu that China would take measures to ‘invigorate’ its economy.

Those factors, alongside expectations that Europe will significantly boost spending on defense and re-orient its energy dependency away from Russia have helped to re-kindle investor sentiment.

So far, so good. But in our opinion, investors continue to underestimate global GDP and earnings growth risks. 

Let’s begin with corporate profits. According to FactSet, US earnings growth is set to decelerate to 4.8% year-on-year in the current quarter, its slowest pace since the final quarter of 2020. Moreover, earnings growth has been revised down by nearly a percentage point since the start of the year. Of the twelve reporting sectors, only two—utilities and energy—are forecasted to have higher net profit margins relative to consensus estimates three months ago. That reflects ongoing supply chain challenges, as well as rising costs for many inputs. Four sectors, including financials and consumer discretionary, are now expected to record negative year-on-year profits growth. The percentage of companies issuing negative quarterly profits’ guidance is 69%, above the five-year norm of 60%.

Double digit profits growth is a thing of the past. Excluding energy, basic materials, and utilities, US S&P500 Q1 earnings may fall below 4%. Simply put, US corporate earnings are one mid-sized shock away from a profits’ recession. With valuations (price-to-earnings basis) some 20% above long-term norms, the US equity market appears to have limited upside potential over the remainder of 2022. 

At the same time, global economic activity has probably peaked. In country after country – advanced, emerging, and lesser developed – real wages are plunging. In Western Europe, nominal wages are lagging headline inflation by over five percentage points. While some investors predict that falling real incomes will unleash a powerful surge in wages, the evidence is thus far more mixed. US wages, as compiled by the Federal Reserve Bank of Atlanta, are rising at a 5.8% annual clip, their fastest pace on record (dating to 1997). Even so, US wages are lagging consumer price inflation, which is up 7.9%.

In Germany, meanwhile, wage inflation is subdued and as Bundesbank President Nagel recently noted, there are ‘no signs’ of a sharp wage acceleration. According to a recent YouGuv poll, most workers in all advanced economies (with the sole exception of Sweden) are unlikely to ask for a pay increase. And of those asking for higher pay, the median expected increase is below the current rate of inflation.

Various reasons account for the reticence of workers to recoup lost purchasing power. Two sharp jumps in unemployment in the past dozen years (during the global financial crisis and then again during the pandemic) are powerful reminders of job insecurity. Rates of unionization have fallen in many countries. The increased pace of technological change is a further form of worker uncertainty.

Workers also face the prospect that central banks will block their efforts to restore lost purchasing power resulting from surging prices. The Federal Reserve, the Bank of England and even the European Central Bank are taking steps to ensure that inflation is quickly curbed. The result is likely to be a period of below trend growth that increases the rate of unemployment, undermining labor’s bargaining position.

It is a mystery why central banks are so convinced that aggressive tightening is now required. After all, there is precious little evidence that today’s inflation is the result of monetary policy excess. Bank lending, as well as consumer and business borrowing, have not surged in response to low interest rates and increased liquidity of recent years. 

Indeed, if one poses the question, ‘what happened in the past two years that accounts for higher prices?’ the answer is unlikely to be monetary. Rather, the pandemic produced an adverse supply shock and prompted a massive fiscal demand impulse. Those factors, alone, account for the greatest part of the macroeconomic imbalance between aggregate demand and aggregate supply.

The actions of central banks, on the other hand, were more preventative, including helping to contain credit and financial risk. Monetary policy also boosted asset prices on everything from houses to stocks and bonds, but there is very little data to suggest that wealth effects and balance-sheet effects have significant impacts on consumer and business spending.

In short, some removal of emergency monetary policy measures is surely warranted as growth returns to trend, fuller employment is restored, and pandemic risks recede. But if monetary policy was not the primary cause of inflation, it is questionable as to whether it should assume responsibility for curbing it.

That question is even more important considering that global demand drivers are already slowing. In the US, for instance, real household disposable income is falling, courtesy of negative real wages. Unsurprisingly, consumer confidence is falling sharply. And pent-up demand unleashed by economic re-opening is also likely to subside. After all, the personal savings rate has now fallen to its lowest level since 2014, suggesting that consumers are already outspending their incomes. 

Meanwhile, fiscal policy will exert a powerful drag on US 2022 growth. The Brookings Institution forecasts ‘fiscal drag of over 3% of US GDP this year. Lastly, net exports are apt to weaken as European and Chinese growth rates slow (owing to high food and energy prices worldwide as well as to Covid-lockdowns in China).

In sum, investors appear too ready to believe that war in Ukraine will fade away, that China can easily stimulate growth and that higher spending on defense and energy security will prop up European growth. That thinking may have some merit, but it overlooks the demand destruction of falling global household purchasing power, a negative US fiscal impulse and the risk of global monetary policy error.

A miscalculation would be fine if earnings growth were robust and valuations reasonable. But that is not the starting point—earnings growth is already weak and valuations are high. 

Just as investors were late to focus on the inflation risk a year ago, they seem equally unprepared for the coming global growth slowdown. It’s time to take notice.

About the Authors

Larry Hatheway

Larry Hatheway has over 25 years experience as an economist and multi-asset investment professional. He is co-founder, with Alexander Friedman, of Jackson Hole Economics, LLC, which offers commentary and analysis on the global economy, policy & politics, and their broad implications for capital markets. Prior to co-founding Jackson Hole Economics, LLC Larry worked at GAM Investments from 2015-2019 as Group Chief Economist and Global Head of Investment Solutions, where he was responsible for a team of 50 investment professionals managing over $10bn in assets. While at GAM, Larry authored numerous articles on the world economy, policy-making and multi-asset investment strategy. Larry was also the lead investment manager for various mandates, funds and an actively managed multi-asset index. Larry also served on the GAM Group Management Board, was Chairman of the GAM London Limited Board and served as member of the GAM Investment Management Limited Board. Larry was also Chairman of the GAM Diversity & Inclusion Committee. During his tenure at GAM, Larry was based in London, UK and Zurich, Switzerland. From 1992 until 2015 Larry worked at UBS Investment Bank as UBS Chief Economist (2005-2015), Head of Global Asset Allocation (2001-2012), Global Head of Fixed Income and Currency Strategy (1998-2001), Chief Economist, Asia (1995-1998) and Senior International Economist (1992-1995). During his tenure at UBS, Larry was also a standing member of the UBS Wealth Management Investment Committee. While at UBS, Larry worked in Zurich, Switzerland, London, UK (various occasions), Singapore and Stamford, CT. At both GAM Investments and UBS Investment Bank Larry was widely recognized for his appearances on Bloomberg TV, CNBC, the BBC, CNN and other media outlets. He frequently published articles and opinion pieces for Bloomberg, CNBC, Project Syndicate, and The Financial Times, among others. Before joining UBS in 1992, Larry held roles at the Federal Reserve (Board of Governors), Citibank and Manufacturers Hanover Trust. Larry Hatheway holds a PhD in Economics from the University of Texas, an MA in International Studies from the Johns Hopkins University, and a BA in History and German from Whitman College. Larry is married with four grown children and a loving Cairn Terrier, and resides in Wilson, WY.

Alex Friedman

Alex Friedman is the co-founder of Jackson Hole Economics, LLC, a private research organization which provides analysis on economics, politics, the environment and finance, and develops actionable ideas for how sustainable growth can be achieved. Friedman is a senior leader with two decades of experience growing and transforming organizations in the financial and non-profit industry. He was the CEO of GAM Investments in London and chairman of the firm’s executive board. Previously, he was the Global Chief Investment Officer of UBS Wealth Management in Zurich, chairman of the UBS global investment committee, and a member of the executive board of the private bank. Before moving to UBS, Alex Friedman served as the Chief Financial Officer of the Bill & Melinda Gates Foundation. He was a member of the foundation’s management committee, oversaw strategic planning, and managed a range of the day-to-day operating functions of the world’s largest philanthropic organization. Friedman also created the foundation’s program-related investments group, the largest impact investing philanthropic fund in the world. He started his career in corporate finance at Lazard. Friedman served as a White House Fellow in the Clinton administration and as an assistant to the U.S. Secretary of Defense. He is a member of the board of directors of Franklin Resources, Inc. (Franklin Templeton), a member of the Council on Foreign Relations, Chairman of the Advisory Board of Project Syndicate and a board member of the American Alpine Club. Friedman is a regular contributor to a range of newspapers and thought leadership groups and is also the author of Babu’s Bindi, and The Big Thing, both children’s books. He is an avid mountaineer and rock climber and led the first major climb to raise money for charity through an ascent of Mt. McKinley. Friedman holds a JD from Columbia Law School, where he was a Harlan Fiske Stone Scholar, an MBA from Columbia Business School, and a BA from Princeton University.

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