Moving from stagflation to growth

Global overview – Big picture

Historically, when we construct a forecast for the year ahead, we begin by laying out a road map detailing how varying headwinds and tailwinds can affect the economy and try to work out which among them will dominate at different points in time. Once that’s done, we have these expectations incorporated into our economic forecasting models and firm up assumptions that we’ve made about policy responses.

As we set out to do this for 2022, our road map suggested a fairly stark year of two halves. A long list of
macro headwinds implies that the first half of 2022 looks problematic, particularly when compared with 2021: Price pressures look as though they might ease, but inflation could remain uncomfortably high for the first few months of the year—particularly in light of the emergence of the Omicron variant—while global growth looks like it could disappoint.

This is a continuation of the stagflationary narrative that persisted in the second half of last year; however,
prospects for the second half of 2022 look better, as we expect inventory rebuilds and the unwinding of supply chain disruptions to fuel a more sustainable recovery than the pent-up rebound of 2021. An improved growth picture and slower inflation should bring us back to a Goldilocks regime, which should be far better for market returns and general risk assets.

In our view, this year-of-two-halves scenario is a good base case for 2022 and will serve us well as a traditional macro year-ahead outlook. Yet, as we make assumptions about 2022, we find ourselves having to do far more guesswork than we’ve typically done in the past, even in 2021.

Many of the key questions central to our outlook—and, for that matter, almost everyone else’s—are new to us. Notably, many of these questions relate to policy choices that require less data analysis and more political insight, which isn’t exactly a quantifiable variable that economists can use in their modeling work.

While it isn’t particularly fashionable or click-worthy to admit that we have less confidence in our base-case projection than normal, we believe it’s important to acknowledge the highly uncertain environment that we’re in as we head into a year dominated by a very long list of known unknowns.

The four known unknowns

1 COVID-19 and associated global policy responses

In our base case, a fifth wave of coronavirus outbreak will primarily affect the global economy in the first quarter of the year, albeit in an uneven manner.

As of this writing, it remains unclear just how much more transmissible and/or severe this next wave will be, but when it comes to COVID-19 and the economy/financial markets, there are some basic tenets that have become clearer to us in the past 18 months.

COVID-19 can affect the global economy in two key ways. First, through resulting changes in household/
business behaviors (demand-side developments). There isn’t a strict formula for this—different economies have different demand-side responses, and vaccination rates may become increasingly relevant. In general, we assume that each subsequent wave will have a relatively smaller impact on these behaviors. However, the second channel of impact is at once more powerful and less predictable: government responses in the form of restrictions on economic activity, social mobility, or trade (supply-side developments).

Problematically, there isn’t really any robust way to forecast these responses—different leaders in different jurisdictions have reacted differently with varying results. While we can try to model a relationship between the severity of a COVID-19 variant and ensuing official responses, it isn’t a constant and, crucially, it wouldn’t be particularly reliable.

A fifth wave (or subsequent outbreaks) that’s less severe and leads to limited government responses and behavioral responses is consistent with our base-case outlook for 2022. But lockdowns, supply chain disruptions, and/or a pullback in activity from households and businesses will likely exacerbate the stagflationary environment that we experienced in the second half of 2021.

2 Global supply chain disruptions

In our base-case scenario, we’ve already endured the worst of the disruptions in global supply chains. Stresses around port activity appear to be easing, global trade pricing has improved, and companies have been reporting major improvements in supply chain bottlenecks. If we’re correct, then price pressures in the manufactured goods space should ease throughout the first half of the year, and global companies should be able to restore depleted inventories, thereby contributing to growth through inventory rebuilds and extended capital expenditures. In many ways, the ability to identify when global supply chain disruptions will ease is probably the most critical macro call for 2022, in terms of both growth and inflation.

Once again, our ability to model how quickly supply chain bottlenecks will dissipate and whether a new COVID-19 variant will produce additional supply disruptions through policy responses or other mechanisms is limited.

3 The return of U.S. labor force participation

In our base case, U.S. labor supply trickles back into the jobs market throughout 2022. We have a pretty good grasp of why the United States endured the biggest one-off drop in labor supply in modern history—it’s a potent mix of a myriad of issues: fear of contracting COVID-19, direct government assistance, pressures associated with virtual school (for working parents), slower immigration, and early retirement.
However, the U.S. labor force participation rate barely budged in the second half of 2021, even after several of those factors subsided (e.g., taking into account retirees who aren’t likely to return to the job market). Why is it taking so long for the U.S. labor supply to return to pre-pandemic levels? Are we missing the bigger picture? Like so many other economic questions of the past two years, we’re in uncharted waters, meaning there isn’t a robust forecasting model that we can turn to for a sense of how the labor force will behave in the coming year—we can assume, but we won’t know for sure.

A return of the U.S. labor force is key to not just the U.S. outlook, but also to global growth. If U.S. workers decide to stay home, wage pressure is likely to continue to rise—a development that’s likely to have an uncomfortable impact on businesses in some sectors. It could also translate into a more protracted period of elevated prices and fuel inflation expectations, which could, in turn, lead to a more hawkish U.S. Federal Reserve (Fed).

4 Policy responses to higher prices but lower growth

In our base case, the Fed and other major central banks will effectively undergo two phases in 2022. In the first instance, we expect them to pursue a tightening bias in the first few months of the year, when price pressures will remain high. In all likelihood, it will take a few months for the weak global macro environment to be reflected prominently in upcoming economic data, thereby providing some justification for central banks to withdraw support. This tightening bias is likely to produce a further flattening of global yield curves—a key investment theme for the first quarter of the year.

Once inflationary and growth pressures ease, however, we expect global central banks to make a dovish policy pivot, which should create conditions that will allow for an extension of the economic growth cycle.

Forecasting central bank policy is always a mix of art and science but, more often than not, the uncertainty usually has to do with the timing of a policy decision as opposed to its direction of travel. That’s less the case in 2022. First, while we expect uncomfortably high levels of inflation in the first half of the year, they’re likely to be driven by global supply issues, which aren’t particularly sensitive to interest-rate policy.

It’s also worth noting that different central banks have taken a different approach to managing inflation: The European Central Bank (ECB) has consistently downplayed its ability to effectively address supply-side driven inflation, while the Bank of Canada (BoC) has said it believes it can and will keep inflation under control. Same data, different responses.

Second, we expect that global labor markets will still have room for improvement throughout 2022, and central banks with dual mandates (such as the Fed) will have more subjectivity than those with other mandates (e.g., the Bank of England’s (BoE’s) mandate is price and financial stability).

Third, there will be compositional changes at central banks in 2022, particularly at the Fed, where three seats on the decision-making committee need to be filled. This makes it even more challenging to read central bank perspectives.

It’s entirely possible (although not our base case) that central banks worldwide will remain hawkish in 2022 and that the Fed will raise interest rates more than two times. Such a development will weaken the likelihood of a Goldilocks reemergence; however, at this point, that remains not to be our base-case scenario.