We closed 2021 on an optimistic note, looking for a “backdrop of overall progress towards more normal conditions” in the economy in the new year. We knew 2022 was always going to be a year of transitions: from government-fueled spending boosting GDP to a more normal consumer-led economy, from restrictive Covid policies to an endemic state of the virus, from pandemic distortions of supply chains to a more balanced market for goods and services, and from crisis-era central bank policy to more normal monetary conditions. What we didn’t foresee was a war in Eastern Europe that would provide a shock to the global economy and impact the outlooks for both growth and inflation, as well as supply chains and monetary policy. While the current situation is highly fluid, here is how we see these transitions playing out for the balance of the year.

Government to Consumer Spending

The policy response to the pandemic was forceful, with governments unleashing spending programs, labor market subsidies, and debt guarantees to provide bridge loans to the economy in order to support a faster recovery.  That fiscal action, coupled with the sharp contraction in growth in 2020, fueled above trend economic growth in 2021.  As the chart below shows, as we ended last year, expectations were for a slowing of growth this year.

The expected slowing of growth represented a return to more normal economic conditions.  2020 and 2021 were a period that, due to public health regulations and fears of the unknown (see more on Covid below), consumers were not allowed to spend as they normally would.  As we look forward, we expect government spending to slow, contracting in no small part due to the public’s opinion around inflation (see more on this topic below as well). 

 In place of government spending, the consumer will take over as the main driver of the growth outlook, especially in the U.S. The good news is, at least through the latest available data for the month of February, consumer spending is healthy and running almost 4% above pre-Covid trends.

This strong consumption behavior is notable in the face of survey data showing that consumer confidence is in a steep decline; by one popular measure compiled by the University of Michigan, today’s consumer is feeling worse today than they were in the dark days of March and April of 2020.  This is an odd dichotomy that we will be paying close attention to in the coming months.  The consumer may decide to retrench for whatever reason, but based on the amount of spending power in the economy and years of pent-up demand for experiences, our expectation is that the consumer will keep spending, no matter what they say in surveys.

Evolving Response to Covid

Despite a record surge in new Covid cases in late December and early January of this year, the policy response in the U.S. was much different than we have seen since the pandemic began in the first quarter of 2020.  Shutdowns were much more targeted than before, and much of the country went about their daily business, a reflection of experience with the virus, available protection for the most vulnerable, and a high degree of natural immunity.  Controversial issues like schooling and travel restrictions were quickly phased out as cases dropped, even in some of the most Covid-conservative parts of the country, while official recommendations from the CDC and other bodies were relaxed.  All of this is indicative of a transition to the endemic stage of the virus and a sign that more normal economic times are ahead.

Outside of the U.S., the response to this latest wave of the virus largely followed the same contours of our policies.  Europe and much of the emerging world appear to be treating Covid as if it has reached its endemic state, auguring more normal economic behavior in the future.  One notable exception to this is China.  For various reasons, including less effective vaccines, much less natural population immunity, and political calculations of the Chinese Communist Party, we have seen very little relaxation to the “zero-Covid” policies that the world’s second largest economy has been burdened with for over two years.  

Supply Chains and What we are Buying

The last two years have provided a crash course in just how long and complicated the supply chains that crisscross the global economy are.  This experience has also been humbling for economists, policy makers, and business leaders.  We are approaching the rest of this year with that same humility, noting that some of the issues that we have been dealing with on the supply front are improving, while others are not.  The New York Fed maintains a measure of supply chain stress, and while it has declined over the past few months, it remains very elevated versus normal conditions.

Two issues continue to frustrate progress on supply chains.  The first is China – more relaxed policies toward Covid outbreaks by their government would go a long way to easing the stress in global supply routes.  The second is consumer behavior.  In short, consumers are still not spending the way they did pre-Covid, binging more on goods (cars, houses, appliances) and less on services (travel, leisure).  We expect the elevated demand for goods to subside in the coming quarters, while demand for services should accelerate as we become more comfortable with the endemic state of Covid in the U.S.

Monetary Policy Pulls Back from Crisis Posture

Expectations for central bank policy have been moving toward a more normal stance for months now.  Because of weaker institutions and less robust economies, emerging market countries (outside of China and parts of Asia) led this trend last year.  Rate hikes will likely continue from EM central banks in 2022, but the more important trend is toward  the normalization of monetary policy in the developed world.  As of the end of the first quarter, both the Fed and the Bank of England have raised interest rates, as well as various other smaller developed economies such as Norway and New Zealand.  The chart below shows global short-term rates, illustrating that  their move toward a more normal stance of monetary policy is well underway.

Some economists and market commentators are concerned about this normalization, but in the context of a strongly recovering global economy and elevated inflation pressures, we welcome a move toward more neutral global monetary conditions. 

The below chart makes clear that, when weighing both sides of the Fed’s mandate (full employment and stable prices), the greater risk today is around inflation, not the labor market.

A more neutral stance of monetary policy will afford central bankers the flexibility to act as needed to deal with evolving economic conditions, especially important in light of what is occurring on the eastern edge of the European continent at the moment.  

War in Europe

The above transitions were well underway when the global economy was dealt an unexpected and severe shock: a fighting war in Eastern Europe.  The Russian invasion of Ukraine elicited swift and punishing sanctions from the West on their economy, weaponizing the financial system to inflict severe pressure on the Russian economy.  Putting aside the tragic humanitarian cost, we think of this shock as impacting the global economy across two dimensions: inflation and growth.  

On the inflation front, Russia and Ukraine are major exporters of commodities, including oil, gas, wheat, and many industrial metals.  As a result, many of these commodities, whose prices were already rising due to the expected economic recovery this year, skyrocketed in value in February and March, driving the broadest measure of commodity prices, the Bloomberg Commodity Index, up about 25% in the first quarter of 2022.  Consensus inflation forecasts for 2022 shot up as a result, led higher by Europe, the most directly impacted region due to their reliance on Russian energy.  In the U.S., this inflationary shock will prolong today’s elevated inflation readings through the summer, forcing the Fed to raise rates faster than they were planning before the war.

The growth impact of the war in Ukraine is also most heavily felt in Europe.  Below is the same chart from earlier, showing consensus expectations for GDP in 2022, but updated with expectations as of the end of this quarter.

Higher inflation and slower growth are a pernicious combination for Europe and are likely to pose headwinds for the remainder of the year.  Importantly, however, the other main engines of growth in the global economy, including the U.S. and China, are expected to be less heavily impacted.  The situation remains highly fluid, and we expect greater divergences between growth and inflation across countries and regions in 2022 than we saw in the prior year.

Conclusion

2022 was always going to be a year of transition, and the shock of the war in Europe has likely accelerated that process across multiple dimensions.  This economic cycle has been extraordinarily compressed; our analysis has had to be more nimble as a result.  It remains one of the more exciting and dynamic times in terms of economic trends, and we look forward to cutting through the noise in the coming quarters and discerning where we are headed.  In confusing times such as this, whether it is in markets, the economy, politics, or any other field of human endeavor, it is often helpful to think deeply about what is important in order to focus one’s attention.  Undertaking this exercise today in reference to the outlook for the global economy has us squarely focused on the behavior of the U.S. consumer.

DISCLOSURES

The commentary in this report is not a complete analysis of every material fact in respect to any company, industry or security. The opinions expressed here are not investment recommendations, but rather opinions that reflect the judgment of Horizon as of the date of the report and are subject to change without notice. Any forecasts, figures, opinions or investment techniques and strategies set out are for informational purposes only, based on certain assumptions and current market conditions, and are subject to change without notice. Forward looking statements cannot be guaranteed.

We do not intend and will not endeavor to provide notice if and when our opinions or actions change. Horizon Investments is not soliciting any action based on this document. This document does not constitute an offer to sell or a solicitation of an offer to buy any security or product and may not be relied upon in connection with the purchase or sale of any security or device.

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