Financial markets defied expectations as fears of a sharp and imminent recession failed to materialize. The S&P 500 index gained 16.9% in the first half of 2023. The Nasdaq 100 index soared 39.4% to lead the stock market rally. And even the lagging Russell 2000 index of small company stocks showed belated signs of life and rose 8.1%. As the economy showed unexpected signs of strength, the 10-year Treasury bond yield rose above 3.8% after trading below 3.3% in early April.

Headline inflation also surprised investors with a more rapid rate of decline than expected. The Consumer Price Index (CPI) stands at 4.0% year-over-year as of May 2023 … well below its June 2022 high of 9.1%. The Fed’s preferred inflation gauge based on Personal Consumption Expenditures (PCE) is also significantly lower at 3.8% through May. Core inflation measures remain sticky for the moment but are expected to decline meaningfully in coming months.

The impact of this progress on inflation has been felt in many different areas. The Fed stopped its string of 10 consecutive rate hikes in June. It has also signaled that the skip in rate hikes could eventually lead to a longer pause in the tightening cycle. The Fed’s shift in monetary policy from rapid tightening also spilled over into other markets.

The prospects of eventually lower policy rates along with unexpected economic resilience triggered the stock market rally. And more importantly for our discussion here, it continued to extend the recent bout of U.S. dollar weakness. The direction of the dollar has recently become a topic of intense debate as a number of threats have emerged to its status as the world’s reserve currency.

We assess the outlook for the U.S. dollar in light of the recent trend towards de-dollarization. We focus specifically on the following topics.

  • Recent catalysts for de-dollarization
  • Viable alternatives to the dollar
  • Fundamental drivers of dollar strength

Let’s begin with a brief history of events that have led to the hegemony of the dollar so far.

A Brief History

We can think of a reserve currency as one that is held by central banks in significant quantities. It also tends to play a prominent role in global trade and international investments. The last couple of centuries have essentially seen two primary reserve currencies.

The British pound sterling was the dominant reserve currency in the 19th century and the early part of the 20th century. The United Kingdom was the major exporter of manufactured goods and services at that time, and a large share of global trade was settled in pounds. The decline of the British Empire and the incidence of two World Wars and a Great Depression in between forced a realignment of the world financial order.

The dollar began to replace the pound as the dominant reserve currency after World War II. A new international monetary system emerged under the 1944 Bretton Woods Agreement, which centered on the U.S. dollar. Countries agreed to settle international balances in dollars with an understanding that the U.S. would ensure the convertibility of dollars to gold at a fixed price of $35 per ounce.

The Bretton Woods system remained in place until 1971, when President Nixon ended the dollar’s convertibility to gold. As we are well aware today, the U.S. typically runs a balance-of-payments deficit in global trade by importing more than it exports. In this setting, it became hard for the U.S. to redeem dollars for gold at a fixed price as foreign-held dollars began to exceed the U.S. gold stock.

The dollar continued to maintain its dominant role even after the end of the gold standard. Its position was further bolstered in 1974 when the U.S. came to an agreement with Saudi Arabia to denominate the oil trade in dollars. Since most countries import oil, it made sense for them to build up dollar reserves to guard against oil shocks. The dollar reserves also became a useful hedge for less developed economies against sudden domestic collapses.

The dollar’s hegemonic status is important to the U.S. economy and capital markets and their continued dominance in the global economic order. The U.S. is unique in that it also runs a fiscal deficit where the government spends more than it collects in revenues. The U.S. dollar hegemony is central to this rare ability of the U.S. to run twin deficits on both the fiscal and trade fronts.

The virtuous cycle begins with a willingness by other countries to accept dollars as payment for their exports. As they accumulate surpluses denominated in dollars, the attractiveness of the U.S. economy and the faith in U.S. institutions then bring those same dollars back into Treasury bonds to fund our deficit and into other U.S. assets to promote growth.

The dominance of the dollar in the world’s currency markets is truly remarkable. Our research indicates that the dollar currently accounts for more than 80% of foreign exchange trading, almost 60% of global central bank reserves and over 50% of global trade invoicing.

The importance of dollar hegemony cannot be overstated. At the same time, its dominance in perpetuity also cannot be taken for granted. In fact, the constant assault on the dollar has already seen its share of foreign exchange reserves decline from over 70% in 1999 to just below 60% now.

A number of new threats to the dollar have emerged within the last year or so. These developments have triggered renewed fears of de-dollarization and are worthy of discussion.

Recent De-Dollarization Catalysts

The main impetus for de-dollarization in recent months stems from a rise in geopolitical tensions. The war in Ukraine has played a meaningful role in the escalation of these risks. The U.S. and its Western allies have retaliated against Russia with a number of sanctions since the war began. On the other hand, Russia’s traditional allies in the East have been conspicuously silent in their condemnation of its actions in Ukraine. This misalignment on the geopolitical front has led the BRICS bloc (Brazil, Russia, India, China and South Africa) to decouple from the U.S.

We highlight a number of catalysts that may sustain this trend to reduce global reliance on the dollar. Our discussion attempts to steer clear of any political ideology and focuses solely on the likely economic impact of actual or potential policy actions.

Preserving Monetary Sovereignty

The mere premise of trading a country’s basic goods and services in a foreign currency presents a certain level of risk to that country’s monetary sovereignty. The domestic economy now becomes more vulnerable to currency and inflation shocks as well as foreign monetary policy. This proved to be particularly true for Russia whose commodity exports are largely dollarized.

As the BRICS bloc increases its global impact and ramps up its strategic rivalry with the West, it is mindful of the need, and opportunities, to become more independent in an increasingly multipolar world.

Security of Currency Reserves

The immediate and punitive sanctions on Russia also highlighted the reach and influence of Western institutions on emerging market economies.

As an example, the freezing of Russia’s foreign exchange reserves held abroad impaired its central bank’s ability to support the ruble, fight domestic inflation and provide liquidity to the private sector as external funding dried up. The actions of the U.S. and its Western allies were a reminder of how the dollar, and other currencies, can get politically weaponized.

Russia had already started its de-dollarization in 2014 after the Crimean invasion. Russia’s central bank has since cut its share of dollar-denominated reserves by more than half. It has also announced plans to eliminate all dollar-denominated assets from its sovereign wealth fund.

Shifts in Trade Invoicing

The efforts to de-dollarize have been most intense in this area. China has been a key force behind this trend, especially after the onset of its trade war with the U.S. in 2018. In a major threat to petrodollar hegemony, China is currently negotiating with Saudi Arabia to settle oil trades in Chinese yuan. On a recent state visit to China, French President Macron announced yuan-denominated bilateral trade in shipbuilding and liquefied natural gas.

Russia has also been active in shifting away from the use of dollars in foreign trade. It has steadily reduced its share of dollar settlements from 80% to 50% in the last ten years. India has been paying for deeply discounted Russian oil with Indian rupees for several months. India has also announced bilateral arrangements with several countries like Malaysia and Tanzania to settle trades in rupees. And in an unusual development, Pakistan recently paid for cheap Russian oil in Chinese yuan.

A desire on the part of the BRICS bloc to further extend membership to Iran and Saudi Arabia later in 2023 is another sign of petrodollar diversification and divestment.

Alternate Payment Systems

The lifeblood of international finance is its payment system. The gold standard for international money and security transfers is the Society for Worldwide Interbank Financial Telecommunications (SWIFT). SWIFT does not actually move funds; it is instead a secure messaging system that allows banks to communicate quickly, efficiently and cheaply. China and Russia are now building international payment systems that can actually clear and settle cross-border transactions in their currencies.

These new trends will play a meaningful role in the eventual increased polarity of the currency world.

Reserve Currency Alternatives

We have already highlighted strong economic growth and institutional governance as important factors for ascendancy in global currency markets. The dollar has benefitted from those attributes among others for several decades now.

As the chatter on de-dollarization picks up, we take a quick look at how viable other currencies are to replace the dollar as the world’s reserve currency. We examine the current mix of global currency reserves to identify some candidates.

Figure 1 shows the composition of central bank reserves over time. Even with the steady decline in the dollar’s share this century, it is still almost three times as large as the second-largest currency in foreign exchange reserves.

Figure 1 - MI Q3

Source: International Monetary Fund (IMF) COFER. As of Q1 2023, share is % of allocated reserves

The euro is the second largest currency within global central bank reserves with a share of around 20%. The share of other currencies tapers off rapidly thereafter with the Japanese yen and the British pound at 5% apiece and the Chinese yuan at 3%.

The broad-based malaise in their local economies and markets work against both the U.K. and Japan. The U.K. is adrift and directionless post-Brexit, and the pound has been in a steady decline for many years. The Japanese economy has been in the doldrums for several years now. The Japanese stock market peaked more than 30 years ago, and the Japanese yen is heavily influenced by the Bank of Japan. We rule out the pound and the yen as viable alternatives to the dollar.

This leaves us with three potential alternatives for the next reserve currency of the world.

  • Euro
  • Chinese yuan
  • Basket of multiple currencies

We defer a discussion on central bank digital currencies to a later date based on their sheer nascence and lack of practicality. We also exclude monetary gold, which is not part of the foreign exchange reserves reported by the IMF.


The euro is the official currency of 20 out of the 27 members of the European Union. This currency union is commonly referred to as the Eurozone. The euro has a number of advantages that make it a viable contender for a more prominent role in the global currency market.

The Eurozone is one of the largest economic blocs in the world. It is also a major player in global trade. The euro is the second-largest currency today within each of the categories of global reserves, foreign exchange transactions and global debt outstanding. It is easily convertible and is supported by generally sound macroeconomic policies.

However, we highlight a couple of key disadvantages that may impede its rise to the status of the world’s reserve currency.

Fragmentation Risks – While the Eurozone has successfully maintained its currency union for more than 20 years, it still remains fragmented in a couple of key areas. The Eurozone does not have a common sovereign bond market and also lacks fiscal integration within the region. This heterogeneity disadvantages the euro in ways that simply do not affect the dollar; the stability of the dollar is reliant on one single central bank and one single central government.

We illustrate this with a simple example. The divergence in bond yields and national fiscal policies was at the heart of the Eurozone sovereign debt crisis around 2010. Several countries such as Greece, Portugal, Ireland and Spain were unable to repay or refinance their own government debt or help their own troubled banks. The bailout from other Eurozone countries required a level of fiscal austerity in terms of spending limits that proved politically challenging to implement. The euro came under considerable selling pressure at that time, which also saw a decline in its share of global foreign exchange reserves.

Lack of Political Diversification – The Eurozone is politically aligned with the U.S. on many geopolitical topics. Their unity came to the fore again during the imposition of Russian sanctions. If the main impetus to de-dollarize comes from the goal of political diversification in reserve holdings, the euro is not much of a substitute to the dollar in that regard.

Chinese Yuan

China has the second largest economy in the world and is invariably one of the top trading partners for many countries. In light of this, it may seem surprising that the yuan’s share of global trade invoicing is low at around 5%, and its share of global currency reserves is even smaller at around 3%.

While the Chinese yuan may aspire to play a bigger role in world currency markets, there are a number of hurdles that it may be unable or unwilling to overcome.

Lack of Convertibility and Liquidity – The Chinese yuan is not freely traded; it is pegged to the dollar and cannot be easily converted into other currencies or foreign assets.

Capital Controls – China imposes restrictions on the outflow of both capital and currency. It does so to limit the drawdown of its foreign exchange reserves and to keep the value of the yuan stable.

There has been a stark divergence between global and Chinese monetary policies in recent months. Global central banks have tightened aggressively to fight inflation; China has been reluctant to do so to protect its still-fragile, post-Covid recovery. This divergence in rates has exerted downward pressure on the yuan. China does not wish to deplete its foreign currency reserves by buying yuan. It also doesn’t want to see the yuan weaken further. Capital controls are the only way for it to achieve both goals.

Inherent Incompatibility – China enjoys a significant cost and competitive advantage in global markets through a relatively weak currency. The more it exports, the greater its incentive to limit currency appreciation. If the yuan succeeds in becoming the world’s reserve currency, the resulting demand for yuan will cause it to appreciate. In a perverse feedback loop, a stronger yuan will make China less competitive in global markets. This inherent incompatibility creates a strong disincentive for the yuan to overtake the dollar.

Basket of Currencies

It has also been proposed that a basket of currencies be designated to fulfill the role of a reserve currency. Any combination of currencies will have similar fragmentation risks to those listed above for the euro. In addition, hedging costs will be higher for a reserve currency basket because of asset-liability mismatches and liquidity differentials across constituent currencies.

A G-7 basket of currencies with high political solidarity will suffer from the same limitations in terms of lack of political diversification. On the other hand, a BRICS or any other Emerging Markets (EM) reserve currency basket will suffer from familiar issues of misalignment of common interests, lack of market depth, risk of political intervention and inherent incompatibility in balancing export competitiveness with currency strength.

We are, however, intrigued by the growing role of smaller currencies such as the Australian and Canadian dollars, the Swedish krona and the South Korean won within central bank reserves. In fact, these currencies account for more than two-thirds of the shift away from the U.S. dollar in recent years. We expect that their virtues of higher returns, lower volatility and fin-tech innovation will help them further increase their share in global reserves.

We come full circle and close out our discussion by highlighting the numerous advantages of the U.S. dollar in the global currency markets.

Fundamental Dollar Advantages

Even as its hegemony diminishes at the margin, we believe that the dollar will remain the world’s reserve currency for several decades. Our optimism is based on both the limitations of competing alternatives and the significant fundamental advantages of the dollar.

It is actually remarkable that the dollar has remained steady even in the face of lower demand from a declining share of foreign exchange reserves. We see this divergence in Figure 2.

Source: IMF COFER. As of Q1 2023, share is % of allocated reserves, dollar price is for DXY trade-weighted dollar

The green line in Figure 2 represents the price stability of the dollar even as its share of reserves fell from 1999 to 2022.

We turn to basic currency fundamentals to explain this steady historical performance and also to argue in favor of the dollar going forward. In the long term, currency performance is determined by differentials in inflation, economic growth, real income and productivity gains. The U.S. offers significant advantages on these and many other fronts.

  • Strong economic growth and incomes driven by sound macroeconomic policies
  • Low inflation from independent and credible monetary policy
  • Technological innovation that contributes to both productivity growth and disinflation
  • High domestic consumption which reduces reliance on trade and currency effects
  • Convertibility, stability and liquidity of the dollar
  • Deep and liquid bond market
  • Fundamental attractiveness of U.S. risk assets such as stocks, real estate and private investments
  • Well-regulated capital markets
  • Government and institutional adherence to the rule of law
  • Strong and credible military presence

We do not see a credible threat to the dollar’s status as the world’s reserve currency in the foreseeable future.


We expect dollar hegemony to be preserved, and only modestly diminished, over the next several years. The following trends summarize our outlook for the composition of central bank reserves and the currency markets overall.

a. The dollar’s share of world reserves will continue to decline gradually but still remain above 50%.

b. The share of the euro, Australian dollar, Canadian dollar, Swedish krona, Swiss franc and South Korean won will inch higher.

c. The share of the Chinese yuan and other BRICS / EM currencies will rise less than what is currently expected.

We chose to focus exclusively on the current dedollarization debate in this quarter’s publication. At the same time, we are well aware of the deeply divided views on inflation, recession and the stock and bond markets. We are also closely watching the progression of any credit crunch from the March banking crisis.

In the brief space here at the end, we will simply observe that we are more constructive on the economy and markets than the worst-case scenarios. Our pro-growth positioning in portfolios has paid off handsomely so far in 2023. We remain careful and vigilant during these uncertain times.

The main impetus for de-dollarization in recent months stems from a rise in geopolitical tensions. 


We expect dollar hegemony to be preserved, and only modestly diminished, for the next several years.


Our optimism is based on both the limitations of competing alternatives and the fundamental advantages of the dollar.

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A Bump in the Road?

2023 began on a positive note. Prospects of a resilient economy and moderating inflation raised hopes for a soft landing and propelled stocks higher. Consumer spending was robust and GDP growth seemed to be in line with levels seen in a normal economy.

But much like the experience of the last several months, investor sentiment continued to fluctuate between extremes of optimism and pessimism. An exceptionally strong jobs report for January re-ignited fears that the economy may be running too hot for the Fed to pause. Bond yields rose sharply in February and stocks sold off as investors expected the Fed to continue tightening.

As eventful as the bear market has been so far, one of its momentous milestones took place in early March. It has been long feared that the rapid pace of monetary tightening would eventually lead to a financial accident and a subsequent crisis. Those fears came true as two regional banks, Silicon Valley Bank (SVB) and Signature Bank (SB), collapsed on March 10 and 12, respectively.

Bank failures are rare and they are almost unheard of outside of recessions. SVB and SB became the two largest banks to fail since the Global Financial Crisis. Their demise was swift as they unraveled in just a few business days. Fears of contagion spread across the globe and eventually claimed Credit Suisse a week later on March 19 as it was bought by UBS with assistance from the Swiss government.

We examine the short and long term implications of recent developments in our analysis.

At this stage, the banking crisis appears to be more of a bump in the road rather than a crippling pothole or crater.


Let’s take a look at the macroeconomic backdrop that led to this recent bank crisis.

The massive stimulus put in place to fight off the pandemic led to a significant growth in bank deposits and loans. The large regional banks were at the forefront of this surge in loan growth. While their share of the total U.S. loan book was less than 20% in 2019, they accounted for almost 40% of subsequent loan growth. Deposits also grew more rapidly in comparison to their normal pre-Covid levels.

This rapid increase in bank balance sheets came about in an era of easy money and abundant liquidity. As we all know now, those factors also caused a sharp spike in inflation and abruptly triggered the most rapid monetary tightening cycle ever.

Regional banks are less regulated than the systemically important large banks. Their governance oversight, risk management practices and capital resilience eventually proved inadequate to withstand the dramatic rise in interest rates and the unprecedented speed of a run on deposits.

Here is a look at how this banking crisis may be different from previous ones and some of its short and long term implications.

Comparisons to 2008

How does the current banking crisis compare to the Global Financial Crisis (GFC) in 2008? Will the events of March unleash a tidal wave of losses and bankruptcies and a deep global recession?

At this point, we do not believe that the current banking crisis will be nearly as severe or protracted as the GFC. Our optimism is based largely on the different origin of this crisis and the swift policy response that has limited its contagion so far.

Different Causes and Scope

Virtually all banking crises in the past can be traced to large loan losses stemming from bad credit. These losses typically arise from aggressive lending and poor underwriting. Borrowers turn out to be less creditworthy than believed and become progressively weaker as the crisis unfolds.

The transmission of a banking crisis into the broad economy follows a typical playbook. Loan losses diminish bank capital and inhibit the ability to lend in the future. The decline in loan growth then slows consumer spending and capital investments. The intensity and duration of this contagion eventually drives the depth of the ensuing recession.

However, the trigger for this banking crisis in March was not related to credit. It was instead a duration effect related to the rapid rise in interest rates. We know the basic bank business model is to borrow short and lend long. Bank deposits are short-term liabilities and bank loans are long-term assets. Bank balance sheets have an intrinsic duration mismatch where assets are more sensitive to interest rates than liabilities.

The rapid rise in interest rates triggered this duration risk and created unrealized losses in the long term bonds and loans within bank portfolios. The same rapid rise in rates also made money market funds at non-banks more attractive than bank deposits. Even as bank deposits were declining in a flight to money market funds, regional banks became vulnerable to another unusual risk.

Bank deposits are insured by the FDIC up to $250,000. Regional banks generally work more closely with small businesses. With a corporate clientele that typically maintains large balances, regional banks ended up with a high proportion of uninsured deposits in excess of $250,000.

Silicon Valley Bank catered predominantly to the venture capital community within its geographic reach. Given its client base, SVB ended up with one of the highest proportions of uninsured deposits among all banks at over 90%.

The decline of bank deposits at SVB was initially driven by the liquidity needs of its clientele as venture capital funding dried up. As SVB sold off assets and incurred losses to offset the initial decline in deposits, things quickly snowballed out of control as depositors feared for the safety of their remaining uninsured deposits.

In a brave new world of digital banking and social media, depositors pulled out a record $42 billion in deposits in one single day on March 9.

In an unprecedented bank run in terms of speed, SVB collapsed in two business days.

Unlike prior banking crises, this one was triggered by the unique confluence of a concentrated customer base in one single industry and geography, inadequate liquidity provisions and a lack of proactive regulatory oversight.

While a credit crunch may yet develop in the coming months, this banking crisis so far is different in that it has not seen large credit losses from defaults or bankruptcies. The SVB failure was not credit-driven, but rather a classic run on the bank created by a crisis of confidence and the ease of digital banking.

And finally, a quick word on the likely scope of this crisis in the coming months. This banking crisis is likely to be far less severe and systemic than the GFC because of one key difference – the health of the U.S. consumer.

The consumer, who drives 70% of the U.S. economy, is far more resilient today than was the case in 2008. The consumer balance sheet is healthy with no signs of excessive leverage. In a still-strong jobs market, consumer incomes are robust. While showing welcome signs of slowing down from an inflation point of view, consumer spending is still solid.

Timely Policy Response

The potential contagion from the failures of SVB and SB in one single weekend was controlled when the U.S. government announced that it would backstop all deposits at the two failed banks. In a similar vein, global contagion was contained the following weekend as the Swiss government intervened to prevent a potential chaotic failure of Credit Suisse.

The Fed also stepped up its liquidity provisions in the wake of the SVB and SB failures. The Fed’s Discount Window borrowing shot past $150 billion in the week ending March 15. The Fed also opened up a Bank Term Funding Program to offer loans of up to one year to depository institutions pledging qualified assets as collateral.

The Fed’s actions have caused its balance sheet to expand in recent weeks as shown in Figure 1.

Source: Federal Reserve

The Fed balance sheet grew to almost $9 trillion in 2022 and had fallen to a low of $8.3 trillion on March 8. The liquidity provisions to mitigate the March banking crisis saw its balance sheet grow again by more than $400 billion.

We believe that the Fed will further expand its balance sheet as needed to ward off a larger scale banking crisis. The additional liquidity will be aimed at stabilization as opposed to an intentional and stimulative increase of the money supply. These funds will help banks preserve or replenish bank capital. They are less likely to be deployed into the real economy in the form of new loans and add to the velocity of money through the multiplier effect.

Banks and Commercial Real Estate

One of the biggest concerns about the current banking situation is the refinancing of commercial real estate (CRE) debt in the near term. The fear of defaults and more bank losses is especially acute for the office segment as excess supply overwhelms lower demand in the new era of remote work.

We know that commercial real estate will be hampered by the higher cost of refinancing as rates have gone higher. We focus on the risks for the sector from the lack of availability of capital, not just the higher cost of capital.

Here are some salient details of the commercial real estate debt market.

  • Total commercial real estate debt is around $4.5 trillion
  • 38% of this debt is held by banks and thrifts
  • However, all commercial real estate debt makes up only 12% of total bank domestic loans

The commercial real estate debt coming due in the next 3 years is almost $1.5 trillion. The office debt maturing in the next 3 years is 12% of that amount or about $180 billion. We observe that both the low share of office debt as a % of total CRE debt and the low share of total CRE debt as a % of all bank loans may limit the impact of office debt defaults more than investors currently fear.

We also point to a more subtle positive observation in the composition of office loans maturing in 2023 and 2024. This is shown in Figure 2.

Source: RCA, Cushman & Wakefield Research

Each bar in Figure 2 breaks down office loans maturing in any given year by the original term loan.It tells us how many of the loans maturing in any year were originated recently (in the last 3 years) and how many loans are more seasoned (over 5 years old).

Let’s take a closer look at just the shaded box in Figure 2 above which highlights office loans maturing in 2023 and 2024. We can see here that most of these maturing loans are seasoned with an original loan term of 5 years or longer.

We believe the original term of loans maturing in the next two years is relevant for the following reason. From the time that these more seasoned loans were originated, the underlying properties had a greater chance to appreciate in value before the onset of higher interest rates. This accrued value appreciation will make refinancing easier even if bank lending standards tighten and loan-to-value ratios come down.

By the same token, the loans most at risk of default would be those that originated recently in the last 3 years. These properties have likely lost value both from non-performance and higher cap rates. On a positive note, they make up a smaller percentage of all office loans maturing in 2023 and 2024.

The cascading impact of the rise in interest rates so far will play out in the commercial real estate market over several months. A likely pause in the Fed tightening cycle will provide welcome relief for all segments of the real estate market.

At this point, we do not see a dire debt crisis stemming from commercial real estate.

Secular Implications

It is inevitable that the end of easy money and the banking crisis of 2023 will leave us with long-term shifts in bank regulations and business models. Here are some quick thoughts on secular changes in regulatory oversight, profitability and valuations.

It is quite likely that we will see greater regulation of regional banks with at least $100 billion in assets. The key lesson from SVB is how to incorporate unrealized losses in banks’ securities portfolios into regulatory capital.

It would also make sense to apply “enhanced prudential standards” to regional banks with assets of more than $100 billion. These standards will subject smaller banks to new stress tests and liquidity rules. We expect bank oversight and scrutiny will become more stringent to assess funding sources and concentration risks. Regulators may also act to deter a run on deposits with additional protection at a greater cost to the banking sector.

The greater burden of regulatory oversight and compliance is likely to bring down profitability and valuations for most financial institutions. The ones who can fundamentally restructure and organize their business models around specific customer needs may be able to avoid this adverse fate.

Economic Impact

Let’s take a step back to see how this micro banking crisis fits into the bigger macro picture for the economy and markets. In that context, it is helpful to recap the latest trends in inflation, jobs and overall growth.

Even as headline inflation continues to decline at a meaningful clip, core inflation has remained largely unchanged in recent months. Unlike the skeptics on this front, we expect shelter costs and wages to also decline gradually in the coming months.

Job growth has slowed down in recent months but still remains healthy with more than 200,000 new jobs created in March. Other metrics of economic activity continue to show a gradual deceleration. We see evidence of an orderly economic slowdown, but no signs of a precipitous and chaotic fall into a deep recession.

At the time of this writing, the contagion from the regional bank crisis in March to the broader U.S. economy seems to be contained. The recent bank failures will likely slow credit growth through tighter lending standards in the coming months. At the margin, this will further slow economic growth.

On the other hand, the “tightening” from slower loan growth will help the Fed pause sooner and pivot to rate cuts earlier than expected. We believe these two effects will offset one another and may well rule out significant changes in the economic outlook.

At this early stage, we do not expect the banking crisis to materially add to the depth of any impending recession.


The risks which triggered the recent bank failures were unusual and different than those seen in previous crises. We summarize our key takeaways and insights on the topic as follows.

  • The current bank crisis arose from duration and liquidity risks which were triggered by a historically rapid run on deposits, not from the more adverse risk of negative credit exposure.
  • Timely policy responses have so far contained the regional bank crisis without any material side effects.
  • We believe bank regulators and the Fed also have enough policy flexibility going forward to stave off a major systemic shock to the U.S. economy.
  • The disinflationary effects of slower loan growth may help the Fed pause and pivot sooner than expected.
  • We believe that any potential recession will likely remain short and shallow.

As uncertain as the last few years have been, the events from March add a new dimension of risk to the economic and market outlook. We are even more vigilant, careful and prudent in managing portfolios during these volatile times.

Timely policy responses have so far contained the regional bank crisis.


At this stage, the banking crisis appears to be more of a bump in the road rather than a crippling pothole or crater.


The disinflationary effects of slower loan growth may help the Fed pause and pivot sooner than expected.

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Focus on Recession ... or Recovery?

The market turmoil of 2022 couldn’t have been in sharper contrast to the benign conditions of low inflation, easy money and high growth seen in 2021. Persistently high inflation in recent months has led to tighter monetary policy and slower growth.

The Fed has raised rates by more than 400 basis points and reduced its balance sheet by almost $400 billion ... with more to come on both fronts. Inflationary pressures have come from both pent-up demand and supply side shocks. The war in Ukraine has lasted longer than most expected and China’s zero-Covid policy further disrupted supply chain logistics.

These factors conspired to push back the peak in inflation and created a hostile environment for risk assets. Investors were left with no place to hide ... even bonds did not provide a safe haven in 2022.

Very rarely do both stocks and bonds deliver negative returns in a single year. Over the last almost 100 years, this has only happened twice and 2022 was by far the worst outcome in this regard. Stocks were down almost -20% and bonds were down around -10%.

All of this brings us to an interesting juncture in this bear market. The calls for a recession in 2023 have become virtually universal in recent weeks. The arguments in favor of that view appear well-justified. Growth is clearly slowing, the housing market is falling under the weight of rising rates, the entire yield curve is now inverted, the Fed is far removed from rate cuts and the global economy is in even more dire straits.

These macroeconomic views in turn support the characterization that the current stock market rebound is just another bear market rally. The consensus believes that this rally will only flatter to deceive and stocks are then inevitably headed to new lows. The skeptics further observe that stocks have never bottomed before the onset of a recession and worry specifically about three potentially negative outcomes.

  • Services inflation may yet prove to be uncomfortably sticky.
  • The Fed may have virtually no flexibility in its policy path forward.
  • Earnings, and stock valuations as a result, may continue to slide lower.

We address these concerns specifically in developing our more contrarian and constructive outlook for 2023.

Trends in Components of Inflation

Inflation was clearly the headline story in 2022. But as headline inflation peaks, investors are now switching their focus to economic growth as well.

While the Fed’s preferred inflation gauge is based on Personal Consumption Expenditures, we use the more comprehensive Consumer Price Index (CPI) for ease of discussion here.

Headline CPI inflation peaked at 9.1% in June and has since declined to 6.5% in December. However, core CPI inflation, which excludes the volatile food and energy components, seems to be uncomfortably stuck at an elevated level. Core CPI inflation was 5.7% in December and has been largely unchanged in a narrow band around 6% for several months.

Investors now worry that core inflation will remain stubborn, sticky and elevated for quite a while.

Let’s decompose inflation into its goods and services components and study their underlying trends. Much like the overall U.S. economy, inflation is also more dominated by services than it is by goods.

It turns out that goods inflation has actually declined rapidly in recent months. Supply chain pressures have eased significantly, gasoline prices have fallen sharply and the price of almost all commodities from wheat to lumber has declined dramatically. Unfortunately, since goods are a smaller component of inflation, they have played a smaller role in bringing inflation down.

Services inflation is made up mainly of two components – rents and wages. Both are notorious for being sticky. We look at each of them separately.

The dark blue line in Figure 1 shows CPI shelter inflation, which has been rising steadily for several months and now stands at 7.5%.

       Source: Federal Reserve, Zillow, Apartment List

At first glance, this increase in shelter inflation contradicts the growing weakness in the housing market. But the counter-trend is actually not much of a surprise at all.

Rents are typically negotiated over a 12-month lease. It, therefore, takes 12 months for the entire stock of leases to get re-priced. Even as rents on new leases begin to come down, older leases at previously higher rents slow down the measured decline in rents. This lagged measurement effect does not capture real-time fundamentals because of the delayed discovery of new rent prices.

The good news in Figure 1 is that rents on new leases are indeed coming down. We can see that clearly in the two downward parabolas. Both these lines show rents for new listings and offer a more timely indicator of rent inflation. Rent growth on new leases is declining rapidly. The Dallas Fed projects that rent inflation will likely peak in the second quarter, which means that rent relief is in sight.

Let’s see if wage inflation is also likely to abate by using average hourly earnings as our proxy for wages. The year-over-year change in average hourly earnings was 4.7% in December. This is clearly too high to achieve the Fed’s target of 2% inflation overall.

But again, recent data brings some good news. Wage inflation peaked over a year ago and has since been declining. At its peak, wage inflation was above 6%. In contrast, the annualized pace of wage gains in the fourth quarter of 2022 was less than 4%.

We believe wage inflation will continue to trend lower as the job market begins to cool off. But how far can wage inflation decline? Can it go back to pre-pandemic levels?

Unfortunately, we believe the answer is No, not quite. We believe two reasons may drive a secular uptick in wages – one related to demographics and the other to the pandemic.

As we know, the labor force participation rate is the proportion of the working-age population that is either working or actively looking for work. It represents the available resources for the production of goods and services. An aging population has been a major driver of labor shortages in recent years. As the baby boomers age, the labor force participation rate has been declining for the last 20 years.

We show this demographic trend in Figure 2.

Source: Haver, Jeffries Economics

The labor force participation rate is shown as the dark green line and its trendline is in light green.

The steadily declining labor force participation rate trendline will continue to constrain labor resources. As a result, even as wage inflation comes down, it is unlikely to subside to pre-pandemic levels.

And beyond demographics, there is another factor at play here related to the pandemic.

It turns out that we have more than 2 million fewer workers today than we did prior to Covid. Interestingly, the largest cohort of these missing workers, almost 1 million of them, is in the age group of 65 and above. We can only surmise that these workers embraced full retirement over the vagaries of a Covid-ravaged workplace. They are unlikely to re-enter the labor force.

This pandemic effect is incrementally additive to the broad demographic trend. Absent any major policy reform on immigration, we believe that both wages and overall inflation will eventually settle in at a slightly higher level in the next cycle.

Inflation averaged about 3% between the 1970s and the Global Financial Crisis (GFC). We believe that the abnormally low 2% post-GFC inflation was enabled by a long deleveraging cycle and is unrealistic in this post-covid recovery.

We believe inflation will be less sticky than feared and will continue to decline in coming months. However, we feel it will eventually settle in above the Fed’s target of 2% ... somewhere in the 2.5% to 3% range. We also believe that this slightly higher range of inflation will still be benign to stock and bond valuations.

Flexibility of The Fed

The U.S. job market was remarkably strong in 2022 and, as a result, the U.S. consumer was remarkably resilient. However, cracks are beginning to emerge in both the labor market and the overall economy. Layoffs and job losses are mounting, retail sales are falling and economic activity as measured by the Purchasing Managers Index and Leading Economic Indicators is beginning to drop off materially.

The growing evidence of a slowing economy and cooling inflation gives the Fed more flexibility on policy.

As of mid-January, the Fed expects 3 more rate hikes of 25 bps each for a terminal Fed funds rate of 5.1%. It then expects to hold rates steady for the rest of the year. The market, on the other hand, expects only 2 more rate hikes, not 3.

And more importantly, it expects 2 rate cuts in November and December.

Should the Fed pause and pivot sooner than they anticipate? The market believes they should ... and so do we.

To the extent that this upcoming recession will be induced by Fed tightening, we believe that the Fed will also have the flexibility to mitigate it before it becomes entrenched.

2023 will offer up a set of binary outcomes. In one scenario, growth slows all the way into a recession. In this setting, inflation comes down and the Fed no longer needs to be restrictive because the inflation war has been won. If inflation instead doesn’t subside, it will likely be on the heels of a fairly strong economy in which case a recession becomes moot.

We, therefore, believe that any potential recession will be short and shallow.

We assign a low probability to the two scenarios that work against our view – high inflation in the midst of a recession or a Fed mistake wherein they remain restrictive for several months into a recession.

Earnings and Stock Valuations

Earnings estimates for 2023 have been declining steadily in the last few months. Despite this downtrend, earnings in 2023 are still projected to grow modestly. Investors worry that these earnings projections are unrealistically high.

Many fear that earnings may fall by levels that have historically been seen during prior recessions. In the four recessionary years of this century (2001, 2008, 2009 and 2020), earnings fell by an average of -15%. A similar decline in 2023 could push stocks to significant new lows.

We offer two counter perspectives.

We agree with the view that earnings are at risk and are more likely to decline from here. But we don’t expect any impending recession to be similar to the GFC or the Covid recessions in terms of its impact on earnings. We believe the upcoming “earnings recession” will also be short and shallow.

Our second observation should further allay concerns about negative earnings growth in general. Conventional wisdom suggests that price generally follows earnings. If earnings go up, price goes up; if earnings go down, price goes down.

But, counter to intuition and popular belief, it is actually possible for stocks to go up when earnings go down! Indeed, they do so more often than not.

We show this interesting anomaly in Figure 3.

          Source: Bloomberg, Evercore ISI Research

We show S&P 500 returns on the y-axis and earnings growth on the x-axis.

There have been 13 instances in the last 50 years when earnings have declined in a calendar year. Stocks were down in only 3 of those 13 years. These limited instances, which include 2008 and 2001, can be seen in the bottom left quadrant of negative earnings, negative returns.

However, in defiance of convention and heuristics, stocks actually go up about 70% of the time when earnings are down. We see that in the top left quadrant of negative earnings, positive returns.

On further reflection, this stock market outcome is not all that surprising. We know that the core function of the stock market is to anticipate and discount future events. It is always looking ahead and often by almost a year.

At pivot points in the economy when a recession might transition to a recovery, stocks can become disconnected from the current reality of weakness and get connected to a new future reality of strength.

We demonstrate this discounting mechanism both visually and empirically in Figure 4.

Source: Bloomberg, Evercore ISI Research

Figure 4 plots three S&P 500 variables – prices, price-to-earnings multiples and aggregate earnings. It traces the trajectory for Price (P), Price/Earnings (PE) and Earnings (E) during recessionary bear markets.

Time t = 0 coincides with the low point of the bear market seen during a recession. P, PE and E are all indexed to 100 at t = 0. All data points to the left of t = 0 are prior to the market bottom. All observations to the right of t = 0 are after the market has bottomed out.

In this framework, the trajectory for P is hardly surprising. Prices decline before they hit bottom and then rise thereafter. This V-shape trajectory for P is merely a truism. Stock valuations or PE follow a similar trajectory. The trough in P and PE is marked by a red circle.

Now here is the interesting observation from Figure 4. The solid black line traces the trajectory for Earnings (E) during a recession. As expected, earnings decline as the recession unfolds. E eventually bottoms out as marked by the red oval, but it does so well after P and PE have bottomed out.

So here is the answer to the seemingly confounding earnings conundrum. The trough in prices and P/E multiples leads the trough in earnings. Stock prices anticipate the eventual low point of earnings well before it happens.

How far in advance do stocks bottom out before earnings do? The readings on the x-axis suggest that this lead time can be around a year or so.

If the earnings recession of 2023 ends up being short and shallow as we expect, it is conceivable that the October 2022 low in S&P 500 price and P/E multiple was in anticipation of trough earnings in 2023.

If that were the case, then we could be in the zone between the red circle and red oval in Figure 4 where stock prices and valuations go up even as earnings go down.

We assign a lower probability to a deep economic or earnings recession than the consensus. We believe the market may well have priced any remaining economic or earnings weakness for 2023 through its discounting mechanism.


Bear markets, especially ones that are accompanied by a recession, can be long, painful and a true litmus test of patience and endurance. So here is our economic and market outlook for 2023 and beyond to help investors navigate the second year of this difficult bear market. We believe:

  • Services inflation will be less sticky than feared and gradually abate
    • Rent inflation will decline in the coming months as lagged effects roll over
    • Wage inflation will subside but not all the way down to its pre-Covid levels
  • Overall inflation will likely normalize at 2.5% – 3.0% in 18 to 24 months
  • A slowing economy and cooling inflation will give the Fed more flexibility than it anticipates
  • Greater Fed flexibility will prevent any potential recession from becoming deep and protracted
  • The earnings recession will also be short and shallow, in line with a potential economic recession
  • Stock prices and price/earnings multiples may have bottomed ahead of the trough in earnings
  • Stocks may be impervious to further declines in earnings
  • Stocks and bonds will deliver a decent equity risk premium and term premium
  • Bonds will provide better diversification than they have in the past

In the midst of high uncertainty, we remain vigilant but also cautiously optimistic. We continue to emphasize portfolio diversification, risk management and high quality investments.

Services inflation may be less sticky than feared and gradually abate.


A slowing economy and cooling inflation may give the Fed more flexibility than it anticipates.


Stock prices and price/earnings multiples generally bottom well ahead of the trough in earnings.

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With the 2021 tax filings behind us and the 2022 tax year drawing to a close, it’s already time for tax updates coming in 2023. The IRS released its 2023 tax year annual inflation adjustments covering updates to more than 60 tax provisions. The 2023 tax year adjustments will effect tax returns filed in 2024. For 2022 tax year filings due in 2023, certain tax due dates fall on a weekend. The actual due date is the following Monday. A list of 2023 federal tax due dates can be found in the attached PDF.


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The 2022 holiday spending forecast and why this year will be different than last

It’s that time of year when Americans are making their lists and checking them twice, but for the 2022 holiday season, many will be slimming down their spending. “I don't think there's any question that holiday spending will be slower this year,” says Whittier Trust Senior Vice President and Senior Portfolio Manager Teague Sanders, a phenomenon that will impact every socio economic segment. Here are some of the reasons why we’re likely to see a chilling effect on holiday spending for the 2022 season. 

Most consumers have already made their sizeable pandemic purchases 

Late 2020 and 2021 were big years for consumers making durable goods purchases such as new washers, dryers and other appliances, as well as automobiles. “These one-time, large expenses have all mostly been bought,” Sanders explains. “Once you’ve made such a purchase, you don’t have to buy it again anytime soon.” There was somewhat frenzied buying activity around these categories due to supply chain disruptions and the early part of the pandemic when many consumers were saving money thanks to stores being shut down. 

“That wealth effect has begun to diminish. We have also seen some slowdown in home prices, amid higher interest rates, higher borrowing costs and depletion of a lot of the excess savings that was sitting in people's bank accounts for the last 18 months,” Sanders says. “There’s simply less of an inclination, across all demographics, right now for people to go out and spend.” 

Luxury travel and goods might be somewhat exempt from the downturn

However, for the top echelon of income earners in the United States, some categories of holiday spending might be less impacted by lower spending. The pandemic era saw the introduction of a trend called “revenge travel”—essentially where consumers were taking their bucket list trips (often more than one) as a reaction to being cooped up at home for months on end. While this spending trend is slowing some, certain segments of the population are still booking high-end, luxury trips to faraway destinations. 

“Two areas that are proving to be more resilient are ultra-high-end luxury goods and airline prices,” Sanders says. “While portfolios of these consumers are down perhaps 18 to 20%, demand continues to remain robust owing to an increased wealth effect and supply demand imbalances respectively.” 

Plan to spend wisely 

No matter how much money you have, it pays to be wise with it. “Even when people have a larger pool of funds to pull from, they tend to still be rational in their purchasing decisions. They're just rational in slightly different ways,” Sanders says. When the vast majority of the country thinks about a large purchase, it might be a home appliance, but when ultra-high-net-worth individuals consider a sizable purchase, the scale is much larger. 

While most Whittier Trust clients have a strong understanding of how wealth works, advisors make it a point to keep an eye on every facet of their clients’ portfolios. “We’re not doing our job if we're not counseling people on the direction of borrowing costs and where expenses are likely to run,” says Sanders. With higher interest rates and increased costs of just about every good and service, everything is pricier in 2022. 

While those things may not immediately impact someone’s lifestyle, the Whittier team realizes that wealth is just one important facet of a person’s overall peace of mind, and it can be emotionally charged. “When we counsel people, we take their thoughts and emotions into account as we make our recommendations,” Sanders says. “That approach is really helpful because our clients see what's going on in the world around them. No matter how wealthy someone is, it’s important to be empathetic and realize that what’s going on in the world at large is impacting them too.” 

Practical implications for this holiday season and beyond

Some people might be thinking about whether the gifts they’ll receive this holiday season will change, but more broadly, decreased spending can have significant implications for markets overall. 

“Consumer spending is 60 to 70% of GDP growth in the United States, so consumer sentiment matters quite a bit,” says Sanders, who notes that recent Google Trends reports—a predictor of what’s on people’s minds—have seen a sharp increase in searches for the word “inflation.” Higher prices on everything from gas to groceries tends to dampen consumer spending. “It really impacts your emotional state because those sharp price hikes are disconcerting,” he explains. 

His advice? Take a deep breath and keep an eye on the long game you’ve agreed with your wealth management advisor. “Adjusting to the new normal is going to take a little bit of time, because there's been an entire generation of spenders who have really known nothing besides zero interest rates,” Sanders says. Markets are fluid by nature, and the right advisors and advocates can help you weather the storm.  

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Foreign Contagion Risks and the Policy Path 

The U.S. economy continues to show remarkable resilience in the face of stubbornly high inflation and tighter financial conditions. Core inflation, which is more influenced by the sticky components of rents and wages, remains elevated even as headline inflation recedes at a glacial pace. The Fed has already raised short rates from zero to 3% and remains steadfast in its commitment to more rate hikes.

The fallout from persistent inflation and a hawkish Fed has led to several adverse outcomes. The U.S. dollar and long-term bond yields continue to soar higher. And stock prices continue their downward trajectory as they discount rising risks of a global recession.

Despite the Fed’s efforts to cool the economy down, the jobs market remains surprisingly strong. The unemployment rate is still at its all-time low of 3.5% and weekly unemployment claims are close to historical lows. There are still 10 million job openings, which far exceed the available pool of 6 million unemployed workers.

Healthy job creation and steady wage gains have supported consumer incomes and spending. As a result, real GDP growth for the third quarter is projected to rebound from negative levels in the first two quarters to above +2%.

On the policy front, the Fed has repeatedly communicated that restoring price stability now is crucial for achieving sustainable growth and full employment in the long run. In this context, the Fed has made it abundantly clear that it is willing to accept “short-term pain for long-term gain”.

The current economic backdrop in the U.S. will likely encourage the Fed to continue tightening aggressively. After all, why worry about the possibility of breaking something in a big way or unleashing systemic risk from a financial crisis when we haven’t even slowed the economy materially?

With investor focus squarely on U.S. inflation and Fed policy, it may be worthwhile at this juncture to take a closer look at the broad global economic landscape. The U.S. has enjoyed strong growth fundamentals through both the Covid crisis and this latest inflation shock. The rest of the world has not been so fortunate. The inflation problem is significantly worse and growth is materially weaker outside the U.S.

In a still tightly integrated global economy, we examine the impact of U.S. policy actions on global growth. To what extent has the rapid pace of Fed tightening contributed to global economic stress?

At a more relevant level, we also assess the risks of contagion back to the U.S. from ailing foreign economies. We focus on two themes:

  • Can the U.S. remain an oasis in an increasingly barren global growth landscape and avoid cross-border contagion?
  • Can U.S. policy responses better mitigate global systemic risk and minimize contagion risks?

We look at recent developments in key foreign economies. We identify the strong dollar as a potential driver of future U.S. and global weakness. Finally, we offer some thoughts on the Fed’s optimal policy path forward within a broader global context.

Foreign Economic Risks

We begin our brief tour of foreign economies with a quick look at recent volatility in the U.K. bond market and its global fallout.

On September 23, the new administration in the U.K. announced a new fiscal plan to spur growth from supply-side reform and tax cuts. However, this focus on fiscal stimulus was at odds with restrictive monetary policy from the Bank of England and risked a further escalation of already-high inflation.

The lack of any funding details also raised concerns about an unsustainably higher debt burden and sent U.K. bond yields soaring. This upward spiral in bond yields was further exacerbated by forced liquidation of U.K. long-term bonds, also known as gilts, by local pension funds.

The unexpected rise in U.K. bond yields spread through the global bond and currency markets. This contagion is seen clearly in Figure 1.

Source: FactSet as of October 12, 2022

Immediately after the initial announcement, the 30-year U.K. gilt bond yield (shown in green) rose by more than 100 basis points to almost 5%. The spike in U.K bond yields reverberated across the globe. The 10-year U.S. bond yield (dark blue) moved higher by 50 basis points to almost 4% and the U.S. dollar strengthened against the British pound (light blue) by more than 5%. Higher bond yields and the strong dollar, in turn, sent U.S. stocks significantly lower at the end of September.

The rise in U.K. bond interest rates also highlighted another vulnerability for the global economy. As much as higher interest rates crowd out consumer spending in any economy, the problem is particularly severe in foreign economies.

The U.S. consumer is unique, and fortunate, in being able to access fixed rate long-term mortgages ranging in term from 15 to 30 years. For example, think about a U.S. household that refinanced its long-term mortgage during the period of low interest rates prior to 2022. With a low interest rate locked in for many years, that household is now immune to higher housing costs from rising mortgage rates.

Our readers may find it interesting to note that few mortgages overseas are at a fixed rate over long terms. Figure 2 provides a glimpse of how mortgages vary across countries by the term over which the interest rate is fixed.

Source: European Mortgage Federation

More than 90% of mortgages in the U.S. have a fixed rate over a long term in excess of 10 years. In Germany and Spain, that proportion drops to just around 50%. The impact of rising rates on housing costs is even worse in the U.K., where long-term fixed rate mortgages simply don’t exist.

More than 90% of mortgages in the U.K. offer a fixed rate for only 1-5 years. In a country already hit hard by high inflation, the greater proportion of mortgages resetting to a higher rate and higher payments significantly add to the odds of a U.K. recession.

The situation is also grim in Europe, but for a different set of reasons. Europe’s historical dependence on Russian energy is well known. Prior to the war with Ukraine, roughly 40% of Europe’s natural gas imports came from Russia. Since the invasion, Europe has looked for new sources of supply and Russia has retaliated by shutting off some of its existing supply of gas.

The resulting energy shortfall in Europe has led to sky-high energy prices, high inflation and significantly weaker growth. We show the outsized impact of energy costs on Eurozone inflation in Figure 3.

Source: European Central Bank

The nearly ten-fold increase in natural gas prices in Europe has led to a mega-spike in energy inflation and double-digit headline inflation in Europe. While energy inflation in the U.S. has started to decline, it shows no signs of abating in Europe. And things are likely to get worse during the dark winter months as Europe contemplates reduced energy consumption. Any cutbacks in production within energy-intensive sectors will likely lead to more layoffs and lower economic growth.

European policymakers are particularly hamstrung in balancing inflation and growth considerations at this point. The inflation problem in Europe emanates from a true supply shock, which cannot be remedied simply by raising interest rates. Any fiscal stimulus to counter lower industrial production and employment runs the risk of driving already-high inflation even higher.

Our baseline outcomes for Europe are listed below.

  • The European Central Bank is unlikely to hike rates as aggressively as the Fed.
  • A weak Euro will likely contribute to higher energy prices and more persistent headline inflation.
  • Europe may be forced to consider fiscal stimulus at some point to soften the recessionary hit.

Finally, we touch briefly on growth challenges in China. For a long time, China’s high growth trajectory was achieved by investment and trade. It has recently tried to shift growth more towards domestic consumption, but with limited success. China’s two key drivers of growth are now under significant pressure.

China’s investment share of GDP is almost twice the global average and has come at the expense of an unsustainable surge in debt. As an example, the heavily indebted real estate sector is now slowing dramatically. A zero-Covid policy has reduced mobility of people, goods and services, increased supply chain problems and decreased global trade. China’s trade and competitiveness have been further compromised by the new U.S. export controls on semiconductor chips and machinery.

We note in summary that foreign economies are far more fragile than the U.S. and remain quite vulnerable to policy missteps and exogenous shocks.

Pitfalls of a Strong Dollar

The U.S. economy is stronger than any foreign economy for a number of reasons. The recent monetary and fiscal stimulus in the U.S. was the largest in the world. As a result, the U.S. consumer is still resilient and its jobs market is still strong. U.S. inflation is, therefore, as much a demand issue as it is a supply-side shock.

As we have discussed above, this is not the case in the rest of the world. Foreign central banks are unable to raise rates aggressively because of weaker demand. Foreign inflation is also far less of a demand issue than it is a true supply-side shock.

This divergence between growth and policy dynamics in the U.S. and the rest of the world argues for continued dollar strength. We highlight two key risks from a persistently strong U.S. dollar.

First, a strong dollar reduces earnings for U.S. multinational companies from a simple currency translation effect. Revenues booked in foreign countries get translated back to lower dollar levels at a higher exchange rate. Figure 4 shows this intuitive strong-dollar / weak-earnings relationship.

Source: Bloomberg

The blue line in Figure 4 shows the year-over-year change in the U.S. dollar on an inverted scale on the right axis. A downward sloping line, therefore, denotes dollar strength. The green line shows the year-over-year growth in S&P 500 earnings estimates for the next twelve months (NTM) on the left axis.

We can clearly see here that S&P 500 earnings go down as the dollar goes up. A sustained rally in the U.S. dollar going forward could further reduce corporate profits and potentially trigger a dangerous self-reinforcing spiral of more layoffs, lower consumer spending, weaker economic growth, lower company revenues, back to lower profits … and so on.

And second, a strong dollar poses risks to foreign economies as well. A strong U.S. dollar raises the cost of their imports and drives up their inflation. Supply-side energy inflation is already high overseas; a strong dollar only makes this bad situation worse. Currency fluctuations affect trade balances and foreign exchange reserves. And emerging market economies find it increasingly difficult to service their dollar-denominated debt.

The strength of the U.S. dollar remains an important conduit for global contagion of economic weakness.

Possibilities for the Policy Path

The Fed has repeatedly reiterated its relentless pursuit of monetary tightening to quell inflation. It has so far been unmoved by the prospects of a U.S. or global recession.

We have recently suggested that the Fed may be well served from a shift in positioning where it becomes less rigid and more data-dependent. Our view is based on the observation that real-time U.S. inflation is likely coming down even as lagged measures of inflation such as shelter CPI continue to rise. We believe that the downward trajectory in upstream and coincident inflation will eventually bring overall inflation below policy rates.

Our focus on the fragility of foreign economies bolsters the argument for a more flexible approach to Fed policy. There is now an increasing chance that a central bank or government misstep is an accident waiting to happen. The calamitous fallout from the U.K. mini-budget crisis is just one small example.

We also believe that it is premature for the Fed to pause right now and a grave mistake for it to pivot towards rate cuts. We support the notion of continued rate hikes in 2022 to keep inflation expectations in check.

However, the Fed will likely have done enough and the U.S. and global economies will likely have weakened enough for the Fed to signal a pause in early 2023. A prescriptive upward march in U.S. policy rates in 2023 may very well lead to an unexpected and dire financial crisis somewhere in the world.


We are still in the midst of unprecedented economic and market uncertainty. U.S. core inflation remains sticky even as more timely measures of inflation appear to be declining in real time. Foreign inflation is less influenced by demand and largely remains a supply-side shock.

Against this backdrop, foreign economies are fragile and especially vulnerable to policy missteps. We believe that a pause in rate hikes by the Fed in 2023 will mitigate the risks of unexpected financial crises.

We continue to emphasize our strong regional preference for the U.S. over foreign markets. We also continue to target sufficient liquidity reserves to help our clients weather this storm. More so than ever, we remain vigilant and prudent in diversifying risk within client portfolios.


Foreign economies are fragile and remain vulnerable to policy missteps and exogenous shocks.


The strength of the U.S. dollar remains an important conduit for global contagion of economic weakness.


A pause in rate hikes by the Fed in 2023 will mitigate the risks of unexpected financial crises.

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The End of Easy Money


The market turmoil in 2022 so far is in sharp contrast to the heady mix of stimulative policy and low volatility in 2021. In 2022, persistently high inflation has led to tighter monetary policy and slower growth.

The Fed has raised rates from 0 to 2.25%. It is on track to reduce its balance sheet ... perhaps by as much as $500 billion by December. Long term interest rates have moved dramatically in response to inflation and proposed Fed policy. Along the way, the war in Ukraine and lockdowns in China have further pushed back the potential peak in inflation.

These events have conspired to create a hostile market environment for risky assets. At their low point, stocks were down by more than -20% and bonds had declined by over -10%.

As a long cycle of easy money draws to an end, we discuss several implications of a more normalized regime of inflation, interest rates and valuations.

In the short term ...

  • Have we just seen that elusive peak in inflation or will the data “flatter to deceive”?
  • How far behind is the Fed in its tightening cycle and how far does it need to go from here?
  • Are we in a recession now? If not, when will it arrive and how long will it last?
  • How severe and protracted will the bear market be for stocks and other risky assets?

There are even more intriguing questions on the other side of this economic slowdown.

In the longer run ...

  • Where will inflation and interest rates eventually settle?
  • What will stock and bond returns look like?

These are extraordinary times of change, challenge and chaos. We hope these insights help our readers navigate this unusually high market volatility.

Inflation and The Fed

We know inflation has been rising steadily. It is now remarkably high, pervasive and ubiquitous. However, there are clear signs in recent weeks that inflation may have peaked in June.

Headline and core CPI inflation (Consumer Price Index) for July came in below the June highs and also below consensus expectations. The downside surprise to July inflation has now raised hopes that inflation may have started its descent from June’s lofty 9.1% perch.

It is still feared that wage inflation, which tends to be more sticky and stubborn, will be a key impediment to a swift reversal in inflation. For example, average hourly earnings grew by 5.2% in July on a year-over-year basis.

But a closer look at monthly changes in average hourly earnings others some hints of deceleration. In the last 6 months, average hourly earnings have increased at a slower pace of just around 4%. In contrast, wage gains in the prior twelve months were in the range of 5-6%.

A potential diminution in wage pressures is corroborated with a decline of over a million job openings in recent months and an increase in corporate layoffs.

As inflation and stagflation fears have given way to recession concerns in recent weeks, we have seen other compelling signs of disinflation and demand destruction.

  • Longer-term inflation expectations have come down dramatically. As an example, 5-year inflation expectations have fallen from a high of about 3.7% to around 2.6%.
  • Gasoline futures are off their highs by over 20%. And the average price of gas at the pump has declined steadily by over $1/gallon since mid-June.
  • The price of most commodities including copper, nickel, lumber, wheat and corn has also declined by more than 20% in recent weeks.
  • Supply chain pressures continue to decline even as demand seems to be getting weaker.

And finally, at the risk of re-igniting a controversial debate, our last argument in favor of subsiding future inflation comes from monetary theory instead of empirical evidence.

We have previously observed that the relationship between money supply growth and inflation seemed to have broken down after the 1980s. This was borne out by the data between 1990 and 2020.

We believe that this relationship was meaningfully restored over the last couple of years. The recent surge in money supply had a bigger impact on inflation than in prior years because of its sheer size and origin. The colossal $10 trillion of monetary and fiscal stimulus was unprecedented in magnitude. And stimulus checks literally took the form of inflationary “helicopter” money.

As a result, we have seen a revival of Milton Friedman’s well-known thesis that inflation is always and everywhere a monetary phenomenon. As goes money supply, so goes inflation. We believe this played out in a material way in 2021 and 2022. We also acknowledge that the pandemic effects of supply chain disruptions and pent-up demand further exacerbated inflationary pressures.

We show year-over-year changes in money supply and inflation in Figure 1.

Figure 1: Money Supply Growth and Inflation

Source: St. Louis Federal Reserve

Our measure of money supply is M2 which typically includes checking, savings and money market accounts. It is shown above in blue. The green line shows the year-over-year change in CPI inflation.

We see two effects playing out in this relationship. One, fiscal stimulus tends to have a bigger impact on inflation than monetary stimulus. And two, monetary stimulus generally works on a lagged basis ... typically after 6 to 12 months.

Money supply shot up and peaked at over 25% in early 2021. We believe it contributed to the spike in inflation a year later.

But from that peak, money supply growth has declined dramatically in the last year or so. There are no more stimulus checks and the Fed is now tightening.

We believe that the recent decline in money supply growth has not yet fully impacted inflation. On the same lagged basis, it will likely reduce inflation in the coming months.

We close with a final word of caution on the outlook for inflation. We do not expect inflation to abate nearly as quickly as the rate at which it shot up.

The ongoing war in Ukraine will continue to dislocate commodity prices and supply chains. And even as energy and goods inflation tails off, services inflation which includes rents and wages will likely be stickier and more persistent.

As a result, while inflation will likely recede, it will do so slowly and remain above target in 2022 and 2023. We expect core PCE inflation (Personal Consumption Expenditures) at around 4% by the end of 2022 and at about 3% by the end of 2023.

So, where does all this leave the Fed? And what do they need to do next?

The misguided belief on the Fed’s part last year that inflation would be transient leaves it in a difficult spot in 2022 – fight inflation and risk a recession or avoid a recession and risk a long inflationary spiral.

Its dilemma is further compounded at this point. The Fed finds itself at peak hawkishness with consecutive 75 basis point hikes even as inflation may be peaking.

We begin our discussion on the Fed with a quick recap of their policy responses so far. Yes, the Fed was hopelessly late in beginning its tightening cycle. But we believe they are not as far behind as the current gap between a Fed funds rate of 2.25% and July’s headline CPI print of 8.5% may suggest.

While the Fed was late to raise rates, they did use their policy tool of forward guidance to good effect in engineering a slowdown.

The Fed has clearly communicated in recent months what they expect to do in the future. As a result, financial conditions have already tightened in the form of higher interest rates, a stronger dollar and lower stock prices.

We also anticipate a lower cap to the Fed funds rate than many may fear. We believe that today’s high inflation is not simply a demand problem, it is also a supply issue. In so far as this may be true, the Fed will get some help in the fight against inflation ... and it will come from the private sector as supply chains continue to get restored.

So, should the Fed continue on its policy path or consider a pause or a pivot if inflation does peak?

The 2y-10y portion of the yield curve is already steeply inverted. At its current projected pace, the Fed will invert the short end of the yield curve as well by November.

Does the Fed have any options but to invert the entire yield curve before the end of the year?


The Fed’s hawkish stance has so far succeeded in preventing current inflation from becoming anchored in inflation expectations. To keep inflation expectations muted and avoid an inflationary spiral, the Fed needs to continue hiking in the foreseeable future.

But at some point in the next several months, the Fed may have some flexibility. By then, it may be able to look back at a clearly visible peak in inflation. If June proves to be that peak, the Fed may then have enough evidence of falling inflation to consider a shift in policy.

We believe a pivot to rate cuts anytime soon would be a mistake; it runs the risk of prolonging the inflationary cycle much like it did in the 1970s. We believe, however, that a “no-promises” pause in 4 to 6 months may not be as unlikely as many believe... especially if the incoming data shows a clear and convincing trend of disinflation.

We focus next on the depth and duration of a potential recession and the current bear market.

Recession and Bear Market

Investors have agonized about a long list of concerns for several months now. There is one common theme across all these sources of anxiety. Just how severe will this current bear market or a potential recession be?

We look at several factors to answer this question and conclude that the worst fears on this front may be unfounded.

We first assess the impact of higher interest rates on the broad economy. And we do so through two potential transmission mechanisms – its impact on the housing market and corporate profits.

We have addressed concerns about the housing market in our prior writings. It is true that higher mortgage rates have combined with high home prices to push mortgage costs to their highest level since 2008.

But we still refute concerns of a dire housing situation or parallels to the 2008 Financial Crisis for a number of fundamental reasons. These include a limited supply and inventory of homes, greater credit-worthiness of borrowers and a significantly lower household debt to income ratio.

We also uncover an interesting and less-understood observation related to interest expenses and corporate profits.

Corporate debt is typically laddered across a wide range of maturities. On this spectrum, variable rate and short-term debt resets almost immediately to higher interest rates; longer-term debt does not. As a result, short-lived exogenous shocks in corporate bond yields simply don’t transmit as quickly or materially to interest expenses.

We saw this phenomenon during the Global Financial Crisis and we are likely to see it this time around as well. With the abundance of easy money until last year, corporations were quick to refinance most of their debt to much longer maturities.

Less than 15% of corporate debt today is in short-term and variable rate debt. More than 30% of corporate debt has a maturity of 10 years or longer. Based on this distribution, overall interest expenses are unlikely to rise sharply any time soon.

We offer one final observation in support of our belief that any potential recession is less likely to be deep and protracted.

The strength of the U.S. economy at the beginning of the year was based on a strong U.S. consumer. The strength of the consumer in large part is derived from the health of the labor market.

Figure 2 shows that the labor market has held up surprisingly well through the turmoil this year. Cumulative job growth has handily outstripped GDP growth in 2022.

Figure 2: Employment and GDP

Untitled design (77)

Source: St. Louis Federal Reserve

Figure 2 shows two consecutive quarters of negative real GDP growth which suggests that we may be in a recession right now. However, it is hard to square that up with the health of the labor market. We see in Figure 2 that employment has been strong – more than 3 million new jobs have been created in 2022 through July and the unemployment rate is at 3.5%. In the same period, Gross Domestic Income (GDI) has also been positive and divergent from GDP.

The National Bureau of Economic Research (NBER) determines the beginning and end of recessions using several metrics. GDI and employment are two of the more important factors in their assessment. It will be curious to see if the NBER eventually labels the first half of 2022 as an official recession or not. We wouldn’t be surprised if the answer turns out be No.

We believe that the economy is strong enough where any potential recession, should it unfold, will be short and shallow.

And how about the current bear market in stocks? Could it become more severe and protracted? Is the recent uptick in stock prices the beginning of a new bull market or simply a bear market rally?

The outlook for stocks depends on how resilient corporate earnings turn out to be in the coming months. Earnings have held up remarkably well through the first half of 2022. In the first two quarters, earnings came in well above consensus expectations. 2022 earnings growth for the S&P 500 is still on track to match its 9% estimate from the beginning of the year.

While earnings estimates for 2023 have declined a bit in recent weeks, they also remain surprisingly robust. Earnings for the S&P 500 in 2023 were projected to be around 250 at their high point; they are now estimated to be 2% lower at 245.

It was widely expected that high inflation and a strong dollar in the second quarter would take a bigger toll on corporate profits. Those fears have not yet been realized. In fact, if inflation peaks in June, inflation and currency headwinds will only diminish from this point on.

In order for stocks to retrace their recent gains and create new lows, we estimate that 2023 earnings need to fall by another 10-15% to the 210-220 level. We deem this to be less likely than feared. If the devasting second quarter could dent 2023 earnings by only 2%, then subsequent quarters with weaker head-winds are unlikely to inflict greater damage.

We believe that the underlying strength of the U.S. economy and company fundamentals will allow earnings to withstand adverse inflation and currency effects.

There is still a dominant view in the investment community that the recent rebound in stock prices is simply a bear market rally that will eventually give way to new lows. We assign a greater probability to the counter view that this may be the start of a new bull market.

In summary, we do not expect the current growth scare to degenerate into a prolonged recession or a lengthy bear market.

We also look further out into the next decade and offer the following perspectives on the economy and the markets.

Longer Term Outlook

Here is a brief look at the longer term outlook for inflation, interest rates, and stock and bond returns.

The last five decades have seen 3 distinct inflation regimes. We show them in Figure 3.

Figure 3: CPI Inflation in the Last Five Decades

Source: St. Louis Federal Reserve, 2022 – year-over-year change as of July

Figure 3 shows that inflation was about 8% on average during the 1970s. It then declined to around 3% from the 1980s to the Global Financial Crisis (GFC) and fell even lower to around 2% after the GFC. Which of these 3 regimes are we likely to see over the next decade?

We have already argued against a prolonged 1970s type of recessionary spiral. We also believe that the 2% post-GFC inflation represents a cyclical low which may be difficult to reach in the next cycle.

The GFC was a severe financial crisis which then led to an even more pronounced deleveraging cycle in its aftermath. Absent such a strong disinflationary force and in the face of potential de-globalization, we believe inflation in the coming decade is more likely to be around 3% than around 2%.

In this setting, we expect the neutral long-term Fed funds rate to remain around 2.5-3.0%. At these levels, it will keep pace with realized inflation.

The post-GFC and post-Covid periods were characterized by low, and even negative, long term interest rates across the globe. Real interest rates, net of inflation, were significantly more negative.

We believe that this era of easy money is now over and expect interest rates to be higher in the next decade. U.S. Treasury bond yields will likely be in the 3-4% range and, as a result, real long term rates will also be positive.

We believe real GDP will settle in at a more normal level of around 1.5-2% in the next decade. This should still allow earnings to grow in the range of 6-8%.

We next assess what a fair Price/Earnings (P/E) multiple might be for stocks going forward.

We draw on historical precedent in Figure 4 to answer the question.

Figure 4: P/E Multiples by Inflation Regime.

Screen Shot 2022-08-25 at 6.50.30 PM

Source: Strategas

Figure 4 shows trailing 12-month P/Es across different inflation regimes. Stocks perform best when inflation is low and between 0 and 4%. At either extreme, both deflation and high inflation tend to destroy profit margins and compress P/E multiples.

Based on the data shown in Figure 4, our expectations of inflation around 3% and our view on interest rates, we believe that the fair P/E multiple for the S&P 500 index in the next cycle is likely to be 18-19 times trailing 12-month earnings.

We expect this economic backdrop will lead to more traditional returns for stocks, bonds and cash. It is likely that cash generates returns in the 2-3% range, bond returns are around 3-5% depending on credit exposure and stock returns are between 7-9%.

Within these ranges, investors can expect normal levels of risk premiums for bearing the risk of investing in stocks and bond over the next decade.


The sheer breadth and depth of economic uncertainty so far in 2022 has been truly unprecedented. We have rarely, if ever, seen such divergent economic and market forecasts in the past.

In an effort to filter some signals from all the noise, we summarize our key observations at this crucial juncture.

We believe:

  • Inflation will moderate from here and recede gradually
  • Short and long Treasury rates are less likely to exceed 4%
  • Any potential recession, should it unfold, is less likely to be deep and protracted
  • The bear market in stocks may well be shorter than most investors expect
  • Stocks offer more upside than downside over the intermediate term

We are mindful of the broad range of unknowns at this point and the even greater need to invest with care and prudence. We remain firmly committed to the basic principles of portfolio diversification, risk management and investing in high quality companies.

We do not expect to see a lengthy recession, should it even unfold, nor a prolonged bear market. 


We also expect to see a more normalized regime of inflation, interest rates and valuations in the next decade.

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Inflation And The Yield Curve


The market turmoil of 2022 stands in sharp contrast to the Utopian backdrop of stimulative policy, low volatility and high returns seen in 2021. Persistently high inflation has caused an abrupt pivot in monetary policy. Fiscal stimulus is poised to disappear in 2022 and a couple of new global risks have recently emerged to spark fears of a recession.

The Fed announced its trifecta of hawkish policy actions in the form of tapering, rate hikes and quantitative tightening in early 2022. It has now completed tapering, implemented one 25 basis point rate hike in March and signaled the beginning of balance sheet reduction from May onwards.

The Russian invasion of Ukraine on February 24th triggered another upward spiral in inflation through a rise in food and energy prices. More than two months later, the war shows no signs of abating.

And finally, China has responded to its most recent outbreak of Covid cases with sustained lockdowns in major cities and ports. The curtailment of manufacturing and shipping activity will likely prolong supply chain disruptions and sustain inflationary pressures.

U.S. interest rates have moved dramatically in response to proposed Fed policy actions. Shorter-term interest rates rose significantly towards the end of the first quarter and even inverted the yield curve in early April.

Inflation has now become even more conspicuous as the main economic and market risk. High inflation can act as a tax and slow growth by itself. It also increases the risk of a policy misstep, where overly aggressive tightening by the Fed may trigger a recession.

Both of these possibilities were potentially reflected in the recent inversion of the yield curve. Yield curve inversions have historically been useful recessionary indicators. We focus on the key topics of inflation and the yield curve to reassess the outlook for growth. Along the way, we pose and answer the following questions.

  • Can the Fed alone bring inflation down to target levels at this point?
  • Could inflation roll over on its own? If so, when and to what extent?
  • What is the typical lead time from the inversion of the yield curve to the onset of a recession?
  • Has extraordinary central bank policy distorted the information content of the yield curve?
  • What other factors may be driving the recent decline in the term premium?
  • Does a low term premium make yield curve inversions statistically more likely?


High inflation is now pervasive and ubiquitous. It has become a global phenomenon for several reasons. The coronavirus pandemic was a global crisis. The war in Ukraine has increased commodity prices worldwide. And rising Covid cases in China will affect global supply chains. Figure 1 shows how high inflation is in excess of levels targeted by domestic central banks.

Figure 1: Global Inflation in Excess of Target (%)

A chart of inflation in exchange of target (%).

Source: Whittier, FactSet, Federal Reserve Board, ECB, Bank of Canada, Reserve Bank of India, Bank of Korea, BoJ, PIMCO

Figure 1 shows that the 8.5% U.S. CPI inflation in March was 6.5% above the Fed’s target level of 2% inflation. The experience is similar across both developed and emerging economies with Japan and China being the notable exceptions.

A closer look at U.S. CPI inflation reveals some interesting trends. The post-pandemic spike in inflation has been bookended by abnormal increases in vehicle prices early on and then energy prices most recently. In a curious case of symmetry, energy prices declined last year when vehicle prices shot up in April 2021. A year later, vehicle prices declined as energy prices skyrocketed in March 2022.

In fact, energy and vehicle prices account for almost 45% of CPI inflation over the last 12 months.

One may reasonably expect their outsized impact on inflation to diminish once supply chains and energy markets are restored to some level of normalcy.

Investors have focused increasingly on the adverse impact of higher food and energy prices on overall consumer spending and economic growth.

We examine this thesis in Figure 2 which shows domestic spending on food and energy as a percent of total personal consumption expenditures.

Figure 2: Consumer Spending on Food and Energy (%)

A chart of a consumer spending on food and energy (%).

Source: J.P. Morgan Asset Management

It is encouraging to note that spending on Energy today is only 4% of the total and less than half of what it used to be in the 1980s. Combined spending on Food and Energy today is also less than half of what it used to be in the 1960s.

We offer the counter perspective that higher spending on Food and Energy may have a smaller impact on overall consumer spending than many may believe.

We finally turn to the important question of whether U.S. inflation may roll over by itself in the coming months. We pose the question not out of fond hope, but based instead on the cumulative rebalancing of global supply and demand that has taken place over the last several months.

We look for signs of a natural deceleration in core CPI in Figure 3.

Figure 3: Month-over-Month Change in Core CPI (%)

A chart of a month-over-month change in core CPI (%).

Source: St. Louis Federal Reserve

Figure 3 shows an encouraging decline in the levels of monthly change in core CPI.

Core CPI has increased at a slower pace in each of the last two months compared to the prior four months. Monthly changes from April to June 2021 were also a lot higher than those registered in recent months.

Figure 3 shows that the first big increase in the post-pandemic bout of inflation came in April 2021. Starting next month in April 2022, it is likely that favorable “base effect” comparisons from a year ago may now mitigate annual inflation measurements.

We observe separately that a number of recent inflation drivers like gasoline futures, used car prices and freight rates have all rolled over in recent weeks.

We believe that inflation will likely plateau in the coming months. However, the ongoing war in Ukraine and China’s lockdowns to combat Covid will continue to dislocate commodity, manufacturing and shipping supply chains. As a result, inflation will recede slowly and remain above target in 2022 and 2023.


The misguided belief on the Fed’s part last year that inflation would be transitory leaves it in a difficult spot now.

The war in Ukraine and China’s recent lockdowns have exacerbated inflationary pressures in the near term even as global growth slows under the weight of higher inflation and rising interest rates.

The Fed is now left to pick between the lesser of two evils. Try to control inflation and risk a recession or try to avoid a recession and risk a long inflationary spiral.

We believe that the Fed cannot afford to back off from its tightening agenda. They are already late in the process and simply cannot fall any further behind.

Having said that, it is highly unlikely that Fed policy by itself can bring inflation all the way down to target levels.

Our view is based on the simple arithmetic of monetary policy. The latest core PCE inflation reading is 5.4%. Assume for a moment that inflation doesn’t naturally roll over or supply chains don’t heal any further. In this setting, the Fed funds rate would have to go to 6% or 7% for monetary policy alone to push inflation all the way down to the target 2% level.

We do not expect the Fed to engage in such Draconian tightening. It will, nonetheless, push forward aggressively to achieve another outcome which is more modest and realistic.

We know how actual inflation can spiral out of control when inflationary fears get embedded into inflation expectations. The Fed’s recent rhetoric is aimed squarely at preventing current inflation from becoming anchored into inflation expectations.

In a sign of some modest success, longer-term inflation expectations rate still remain fairly low at around 2.5% as of mid-April.

We conclude this section with two key takeaways. At this point, the Fed needs help from the real economy to bring inflation gradually down to target. In the meantime, it seeks to establish enough credibility to manage long-term inflation expectations.


The recent inversion along most of the U.S. yield curve has sparked fears of a recession in the near term. The spread between the 10-year U.S. Treasury yield and the 2, 3, 5 and 7-year bond yields became negative at the beginning of April.

The 2-10 inversion is generally considered a reliable recessionary indicator. Inversions are generally observed when tight monetary policy leads to fears of a subsequent economic slowdown. In this setting, long-term interest rates begin to decline and end up below short-term rates.

Each of the last seven recessions was preceded by a 2-10 inversion. It is important to note that while every recession has been preceded by a 2-10 inversion, not every inversion has led to a recession.

We note that the yield curve inversions of early April lasted just a few days and have since reversed out at the time of writing.

We, nonetheless, explore the topic in light of renewed recessionary fears and in the event they re-appear in the bond market.

Lead Times and Alternate Measures

The 2-10 inversion is a leading indicator of recessions. Historical data suggests that a negative 2-10 yield spread tends to be quite early and leads an eventual recession by about 20 months on average. This lead time has ranged between 10 and 35 months at either extreme.

It is interesting to note that stock market peaks are observed closer to the onset of recessions. In other words, the 2-10 inversion typically leads the peak in stock prices as well, e.g. stock prices can go higher after the 2-10 spread inverts.

The slope of the yield curve can also be measured by the spread between the 10-year and 3-month Treasury yields. We designate this as the 3m-10y spread from here on and contrast it to the 2-10 spread discussed above.

The 3m-10y is also a reliable recession indicator. Its historical track record suggests that a recession ensues about a year after the 3m-10y spread stays inverted for about two months.

Even as the 2-10 spread became inverted, the 3m-10y spread has remained steeply positive. Proponents of a continued expansion in the cycle point to the 3m-10y spread as a rebuttal of the recession thesis.

We look at one more variation of the 3-month Treasury yield before interpreting these divergent signals.

Near-Term Forward Spread

Fed researchers have pointed out that an even more useful recessionary indicator from the yield curve is derived from the 3-month Treasury yield. The near-term forward spread is defined as the difference between the implied forward rate on 3-month Treasury bills six quarters from now and the current yield on the 3-month Treasury bill.

When this spread becomes negative, the market expects monetary policy to ease in response to the likelihood of a recession. However, the near-term forward spread is also steeply positive at this point.

Both the positive 3m-10y spread and positive near-term forward spread simply reflect the reality of a new Fed tightening cycle, e.g. the Fed plans to hike aggressively in the coming months.

How should one reconcile a flat or slightly negative 2-10 spread with a steeply positive 3m-10y spread and a steeply positive near-term forward spread?

The two 3-month indicators tend to assess the odds of a recession in the next twelve months or so. The 2-10 spread tends to have a longer lead time, which is closer to two years.

We believe the market is suggesting that a recession is less likely in the next one year than it may be in later years.

Inversions and Low Term Premium

We close out our yield curve discussion by examining an unconventional link between inversions and the level of term premium.

Treasury yields are derived from two components – expectations of the future path of short-term Treasury bonds plus a Treasury term premium.

Simply stated, the term premium is the compensation that investors demand to bear interest rate risk in holding long-term bonds. While intuitive to grasp, the term premium is not easy to measure. It is unobservable and must be estimated from the yield curve.

Figure 4 shows a popular measure of the term premium compiled by researchers at the Federal Reserve Bank of New York.

Figure 4: 10-Year Treasury Term Premium

A chart of a 10-Year Treasury Term Premium.

Source: Adrian, Crump and Moench, Federal Reserve Bank of New York

The secular decline in the term premium shown above has now become a topic of great interest and debate.

Figure 4 shows that the average term premium since 1985 has been around 150 basis points. In contrast, the average term premium over the last 10 years has been close to 0.

A number of reasons have been advanced to explain this decline in the U.S. term premium.

  • Central bank asset purchases
  • Glut of global savings
  • Interest in dollar-denominated assets from foreign investors
  • Demand for longer-dated assets to hedge long duration institutional liabilities
  • Disinflationary pre-pandemic pressures and forward guidance

It is easy to understand how asset purchases (quantitative easing) by the Fed for over a decade may well have distorted the bond market. It is possible that unrelenting demand from a large price-insensitive buyer can dislocate prices from fundamental values.

U.S. Treasuries are also a preferred destination for a glut of global savings, foreign investors and institutions such as pension funds who need to hedge long duration liabilities. And finally, from a sheer risk premium perspective, the long trend of disinflation prior to the pandemic along with enhanced Fed signaling and forward guidance have reduced interest rate volatility.

The topic of term premiums becomes relevant in the following context.

Fed researchers have also studied the impact of this decline in term premium on the likelihood of yield curve inversions.* They conclude that inversions are 4 to 5 times more likely statistically at today’s low level of the term premium than they are at their historically higher levels.

Yield curve inversions in a regime of low term premium may, therefore, carry less fundamental information about growth and may prove to be less reliable as a recessionary indicator.


We have so far addressed several recent concerns related to a potentially higher risk of recession. We comment briefly on some of the continued tailwinds to the U.S. economy to balance out our growth outlook.

We begin with some brief comments on the housing sector. There are growing concerns that rising mortgage rates and falling affordability will soon make housing a headwind for the U.S. economy.

We allay those concerns at least partially by drawing the following comparisons to the Financial Crisis.

  • Adjustable rate mortgages are a smaller percent of mortgage applications now (< 10% vs. > 30%)
  • Home inventory in terms of months of supply is lower now (< 2 vs. > 10)
  • Household debt to income ratios are lower now (~ 100% vs. > 130%)

In addition, the labor market is strong and close to full employment. Consumer balance sheets are healthy. Consumer net worth is more than $30 trillion higher than it was prior to the pandemic. Consumer incomes are high. The U.S. consumer is still strong.

Credit spreads have also remained fairly narrow so far. And S&P 500 earnings estimates for calendar years 2022 and 2023 have continued to rise through April.

In light of these strong fundamentals in the U.S. economy, we believe a soft landing is more likely than a recession in 2022.


We examine the latest developments on inflation, Fed policy and interest rates to reassess our economic outlook. Our views are summarized below.

We believe:

Inflation and the Fed

  • Inflation remains the biggest economic and market risk
  • Inflation may peak soon, but will remain above target in 2022 and 2023
  • War in Ukraine and Covid cases in China will impede the recovery of supply chains
  • Fed policy alone cannot lower inflation to target
  • Fed signaling is key to managing longer-term inflation expectations

Yield Curve

  • Term premium in the last decade has been unusually low and close to zero
  • Yield curve inversions are statistically more likely when the term premium is low
  • Yield curve indicators may now be a less reliable recessionary signal


  • A strong labor market and U.S. consumer bode well for the U.S. economy
  • Low credit spreads and rising earnings estimates do not signal any major concerns
  • Recession risks may not be as elevated as many fear

We, nonetheless, live in complicated times. We acknowledge that there are a number of complex forces at play in the current macroeconomic backdrop. We are constantly monitoring new information for any signs that may refute our constructive view on the economy.

We continue to invest client portfolios with caution, vigilance and a focus on high quality securities.

 *Haltom, Wissuchek and Wolman, Federal Reserve Bank of Richmond

Inflation may peak soon, but will likely remain above target in 2022 and 2023.

In a regime of low term premium, yield curve inversions may prove to be a less reliable recessionary signal.

In light of strong fundamentals in the U.S. economy, we believe a soft landing is more likely than a recession in 2022.

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Above-trend Growth in 2022 


The remarkably short Covid recession of 2020 was followed by a rapid and powerful recovery in 2021. Bolstered by massive policy stimulus, global economies and markets were resilient enough to overcome uncertainty from virus variants and inflation spikes.

The U.S. economy grew by almost 6% in 2021 in real terms even as CPI inflation reached 7% by the end of the year. The S&P 500 index led global equity markets with a stunning total return of 28.7%. In an even more astonishing outcome, stock market volatility remained unusually low. The maximum drawdown from peak to trough in the S&P 500 index was only -5% in 2021.

The strength in the economy and the markets was based on solid fundamentals. Heading into 2022, the Purchasing Managers Index, which serves as a useful leading indicator of economic activity, still remains firmly at expansionary levels.

However, an increasingly hawkish stance from the Fed roiled the stock and bond markets early in the New Year. It wasn’t too long ago that the Fed had appeared overly sanguine about inflation. As recently as September, the Fed was projecting zero rate hikes in 2022. It has since changed its position in a number of ways.

The Fed has stepped up its pace of tapering which is now expected to end in March. It is also projecting 3 rate hikes in 2022 with more to follow in the next two years. These actions were initially met with enthusiasm in the markets as they dispelled fears that the Fed was falling behind the curve in fighting inflation.

However, what came as a shock to the markets on January 5, 2022 was the Fed’s consideration of a reduction in its balance sheet soon after the first rate hike. This trifecta of tapering, rate hikes and now quantitative tightening (QT) was deemed to be an insurmountable “triple threat” for both stocks and bonds.

>We have highlighted for a while now that we have reached an inflection point in policy stimulus and that growth will slow down from its 2021 peak. Our outlook for 2022 focuses on one key question.

Will the decline in growth be exacerbated by a policy mistake around inflation or will growth still come in above trend to sustain the economic cycle and bull market? We assess risks to the economy from the virus, inflation and the Fed. We balance these risks out against the continued tailwinds for growth from prior stimulus, easy financial conditions and a healthy U.S. consumer. Along the way, we also look more closely at earnings growth in light of historically elevated stock valuations.

Omicron, Inflation, and The Fed


We believe that Omicron will have limited economic impact despite its high rate of transmission. The current vaccines have been reasonably effective at preventing severe disease. They have also been successfully rolled out; the older, more vulnerable age groups have vaccination rates in excess of 90%.

The Omicron variant of the virus has also mutated significantly. While this makes it more transmissible, it may also make it less potent. The current data shows that a smaller percentage of all infected people have been hospitalized than before. And an even smaller percentage of hospitalized patients have been admitted to the ICU.


We do not expect inflation to spiral out of control like it did in the 1970s. That bout of inflation was triggered by a supply side shock in the oil market. We do not see a similar parallel in 2022. We agree with the Fed and the consensus forecast that inflation will peak in the first half of 2022.

Our reason for this view is simple. Prices became so elevated in 2021 from the immediate shock of the pandemic that future price increases are likely to be more muted as the intensity of that shock abates.

Our third observation on inflation is a departure from the consensus view. We expect that inflation will subside at a slower pace than most expectations.

We, therefore, expect inflation to remain higher than consensus or Fed forecasts in 2022 and 2023. Having said this, we do not expect inflation to adversely impact the economy or the markets. When inflation and interest rates go up from extremely low levels towards 3 to 4 percent, stocks generally do well in a robust economic recovery.

The Fed

We do not believe the Fed will commit a major policy mistake any time soon. The hallmark of its policy for over a decade has been an overly accommodative stance.

The Fed has constantly erred on the side of risking inflation from being dovish than on risking another recession from being hawkish. Its recent decision to allow inflation to run well above 2% before raising rates is another example of its desire to go slow instead of going fast.

The Fed can always be data-dependent and we expect it to alter course as necessary.

We move to the more promising drivers of growth in the next couple of sections.

Legacy Tailwind of Prior Stimulus

Investors have worried about the inflection of both monetary and fiscal stimulus for quite a while now. More central banks have raised rates globally than cut them. Fiscal stimulus going forward will be a tiny fraction of what was seen in 2020 and 2021.

We believe, however, that investors are underestimating the powerful legacy of prior stimulus as a tailwind for future growth. We discuss a few examples of how financial conditions are still accommodative on the heels of the Covid policy responses.

We begin with a look at just how massive global monetary stimulus was during the Covid crisis.

Figure 1 shows quantitative easing (QE) from the four major central banks of the world over the last 15 years.

Figure 1: G4 Central Bank Balance Sheets, $ Trillion and % of GDP

A chart showing the G4-Central Bank Balance Sheet.
Source: KKR Global Macro and Asset Allocation, as of 10/31/21

The G4 central banks expanded their balance sheets by more than $9 trillion in the Covid crisis. This injection of liquidity was a staggering 21% of GDP. It was also 3 times bigger than their policy response after the Global Financial Crisis (GFC).

The Fed alone grew its balance sheet by more than $4.5 trillion and is now ready to start reducing it. At what pace might that happen? We turn to the last tightening cycle for a precedent. In 2017, it took the Fed almost 2 years to reduce its balance sheet by about $700 billion. We believe that any quantitative tightening in 2022 will only be a small fraction of the existing stock of liquidity that the Fed created previously through QE.

We believe that the Fed’s balance sheet will still remain sizeable and provide sufficient support and stimulus to aid above-trend growth in 2022.

Global monetary stimulus during Covid also resulted in extremely low interest rates.

We show global real interest rates in Figure 2. Real rates are defined as nominal rates minus long-term inflation expectations.

Figure 2: Real 10-Year Government Bond Yields

A chart showing the Real 10-Year Government Bond Yields.
Source: Bloomberg, as of 11/30/21

As we can see in Figure 2, real rates are negative in most countries. They are also well below their trailing 10-year averages.

We fully expect real rates to rise as growth remains strong, the Fed starts to tighten and inflation begins to subside. But because real rates will rise from such historically low levels, we expect financial conditions to still remain easy and accommodative.

We can also see legacy tailwinds from fiscal stimulus. Savings rates shot up on the heels of the initial rounds of fiscal stimulus as consumers were unable to spend all of their stimulus checks. These excess savings were banked and have since grown into a sizeable pool of reserves for consumers.

By most calculations, cumulative excess savings are estimated to be over $2 trillion. At around 17% of Personal Consumption Expenditures and almost 10% of GDP, this cash on the sidelines bodes well for future consumer spending.

And the consumer is strong in many other ways. Household net worth has grown exponentially from the rapid Covid recovery, a booming stock market and a red-hot housing market. Debt payments as a percent of household income are at an all-time low. The jobs market has almost fully recovered now with the unemployment rate below 4%.

Strong economic fundamentals have sparked reflation and high nominal GDP growth. We expect nominal GDP growth to be around 8% in 2022. At these levels, economic growth will far exceed nominal GDP growth seen in the last 20 years.

The above-trend growth in nominal GDP also bodes well for corporate profits. We look at the outlook for earnings growth and its impact on stock prices in the next section.

Earnings Growth and Stock Returns

We first highlight an important inflection point in stock market leadership.

The initial phase of a new bull market is typically driven by abundant liquidity. Stock prices move higher in anticipation of an eventual recovery. However, this early move in prices can happen even as actual earnings decline or throughout. As a result, P/E multiples expand dramatically in this liquidity induced phase of the bull market. We saw this play out in 2020.

We transitioned to the next phase of the equity bull market in 2021. In this growth-driven phase, earnings growth becomes the main driver of stock prices and P/E multiples begin to decline.

Figure 3 shows this effect with visual intuition.

Figure 3: S&P 500 Return Contributions in 2021

A chart showing the S&P 500 Return Contributions in 2021.
Source: FactSet, as of 12/31/21

Earnings growth reflects change in forward earnings estimates

The green line in the chart shows the S&P 500 price return of 26.9% in 2021. The light blue line at the top shows earnings growth of 34.6%.

The only way to reconcile a lower return than the growth in earnings is through a decline in the P/E multiple. This multiple compression of -7.7% is shown in the dark blue line at the bottom of Figure 3.

We expect this pattern to repeat itself in 2022. The magnitude of the numbers, of course, will be different but we believe the pattern will be similar. We expect earnings growth will be strong enough to more than offset a continued decline in the P/E multiple.

Our optimism for earnings growth stems from a couple of fundamental factors e.g. revenue growth and margin growth.

Revenue growth tends to be highly correlated with nominal GDP growth and is also expected to be around 8% in 2022. At these levels, it will be significantly higher than revenue growth seen in the last two decades. We expect revenue growth to remain above trend in the foreseeable future.

We are even more intrigued by the continued contributions to earnings growth from high profitability. Profit margins for the S&P 500 index continue to rise. Net margins reached an important milestone in 2021 as they crossed the 12% threshold for the first time ever.

In fact, profit margins have grown steadily for the last 20 years from the mid-single digits to the low-double digits. Contrary to conventional wisdom, the trend suggests a structural shift upwards in profitability.

We take a closer look at profitability.

Figure 4 shows trends in profitability over time and across sectors.

Figure 4: Change in Profit Margins over Time by Sector

A chart showing the Change in Profit Margins over Time by Sector.
Source: FactSet, Whittier, as of 12/31/21

We show current profit margins in green and profit margins from 2011 in blue.

The breakdown of profitability by sector reveals several insights.

  • Profitability varies significantly across sectors. The most profitable sector is Technology and the least profitable sector is Consumer Staples.
  • Growth in profit margins over time also varies significantly by sectors.
    •  The most profitable sector, Technology, has also seen a big increase in profitability.
    • So has the Communications sector.
    • The Energy sector is the only sector to see a decline in profit margins.
  • These results are intuitive. Communications has become a more profitable sector after Google and Facebook were added to the sector. Technology includes high margin companies like Apple and Microsoft.
    • Growth in profit margins also helps explain sector and market valuations.
    • The Technology and Communications sectors are more valuable with a bigger market cap because they are more profitable.

Figure 5 highlights the base effects of margin growth over time and the mix effect of margin growth across sectors.

Figure 5: Mix Shift for High Margin Growth Sectors

A chart showing the Mix Shift for High Margin Growth Sectors.
Source: FactSet, Whittier, as of 12/31/21

Figure 5 shows base and mix effects for two sectors with high margin growth. The purple bars show Communications and the grey bars show Technology.

The first pair of bars shows how profit margins have increased for these two sectors in the last 10 years – by 12% for Communications and 9% for Technology. The next pair of bars shows that at the same time, their weight in the index has also increased – by 5% for Communications and 12% for Technology.

On the other hand, sectors with low margin growth, such as Energy and Consumer Staples, show the opposite outcome – no growth in profit margins and a decline in their index weight.

These observations help us understand the recent rise in profit margins.

We believe strong revenue and margin growth will drive above-trend earnings growth and create potential for upside surprises.

We use these insights to inform our economic and market outlook.

Outlook For 2022

We expect the post-Covid economic cycle and bull market to continue in 2022 but with several important distinctions.

This cycle is more likely to resemble the post-Internet Bubble recovery than the post-GFC one. A key characteristic of this cycle will likely be steady reflation instead of the sustained disinflation we saw in the previous cycle. And finally, we expect stock returns in 2022 will likely be lower and more volatile than they were in 2021.

We summarize the key tenets of our 2022 outlook below. We believe:


  • Virus variants will continue to have limited economic impact
  • Inflation will remain above consensus expectations in 2022 and 2023 but will not meaningfully impede growth or profit margins
  • Fed will avoid a major misstep in 2022
  • Above-trend nominal GDP growth in 2022 may exceed current expectations

Earnings, Revenues, Profits and Valuations

  • Earnings growth will remain significantly above trend in 2022
  • Revenue growth and profit margins will remain well above trend
  • P/E multiples will compress modestly as interest rates rise gradually
  • However, stock valuations will not revert to their long-term mean in the near future

Asset Classes

  • Stocks will handily outperform bonds and cash in 2022
    • Above-trend earnings growth will offset modest P/E compression
    • Equity returns will be in the mid to high single digits with upside potential
  • Select Real Estate is especially attractive at this stage of the cycle
    • Cash yields could exceed bond yields
    • Correlation with nominal GDP creates useful inflation hedge
  • Private market investments should outperform their public market counterparts

Sectors and Themes

  • Value and cyclical stocks will perform well in 2022 e.g. Energy, Financials, Industrials
  • Credit will outperform duration
    •  Credit spreads will remain lower for longer
    • Nominal rates will rise by 50 to 75 basis points
  • The following themes will attract investor interest
    • Pricing power
    • Real assets
    • Energy transition and ESG investing
    • Innovation and disruption

We recognize that inflation is now the main investment risk in 2022. We are mindful that the seismic dislocation of global supply chains may create some unexpected outcomes and pose risks to our views on inflation and the Fed.

Nonetheless, we remain optimistic on the economy and the market. We expect growth to remain above trend and stocks to perform well. At the same time, we exercise restraint and discipline in managing portfolio risk.

Inflation has now emerged as the biggest investment risk in 2022. Will inflation or a related Fed policy mistake exacerbate the deceleration of growth from its 2021 peak?


We believe growth will still come in above trend to sustain the economic cycle and bull market.

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September is a notoriously volatile month and it certainly held true to form in 2021. Stocks sold off during a seasonally weak period of the calendar as market uncertainty grew. The S&P 500 declined by more than -5% from its previous high while the Nasdaq index fell by more -7% from its prior peak.

We have long held the view that a couple of unusual factors would allow economic and earnings growth to surprise on the upside. Coming out of the Covid recession, we had an unusually strong U.S. consumer and we had unusually massive policy stimulus. In the first half of the year, they did propel growth higher than consensus expectations.

But the tide seems to have turned as the list of investor concerns has grown steadily in recent weeks.

There is a growing fear that supply chain constraints may keep inflation high and raise the specter of stagflation. The proposed reconciliation bill comes bundled with higher taxes that are generally restrictive for growth. Fiscal and monetary policy is approaching an inflection point and investors are now focusing on an anticipated deceleration of growth. Investors also worry that historically high stock valuations may be at risk if growth slows down dramatically.

We focus on the following discussion points to answer one key question.

  • Inflation
  • Spending and taxes
  • Inflection in stimulus
  • Deceleration and valuations

Are these potential headwinds likely to become major disruptors of growth in the coming months? Or will they merely be distractions on a bumpy road to recovery?

We begin our discussion with some brief remarks on a couple of other investor concerns that appear to be fading at the time of this writing. The Delta variant triggered a third wave of the coronavirus and stalled economic activity in the third quarter. However, we appear to have peaked in daily new cases, hospitalization rates and the incidence of deaths and a third round of re-opening may well lie ahead of us in the fourth quarter.

The perennial debate on the debt ceiling surfaced again in September and created angst and uncertainty among investors. At this moment of time, it appears that the Senate has reached an agreement to raise the debt ceiling through early December. We believe that a more permanent deal to resolve this manufactured crisis will also be negotiated in the coming weeks.


Inflationary pressures started to build up after vaccination rates gathered momentum in early 2021. The initial spike in inflation was attributed to two pandemic-related effects – pent-up demand and supply chain disruptions.

The U.S. consumer has remained strong through the Covid recession. Disposable incomes are higher as a result of fiscal stimulus. Consumer net worth has soared from higher savings, rising stock prices, a red-hot housing market and low interest rates. The inability to travel or even move freely inhibited spending during the pandemic. The ability to do so after reopening, along with higher savings and incomes, has unleashed significant pent-up demand for goods and services.

At the same time, global supply chains have been in disarray after being brutally disrupted during the pandemic. Lengthy factory shutdowns in Asia and snarled shipping traffic have created a constant shortage of key components for manufacturing. Labor has also remained in short supply and contributed to wage increases.

Many had expected these pandemic effects to be shortlived and, therefore, for inflation to remain transitory. It is now increasingly clear that “transitory” needs to be recalibrated as inflation is proving to be more persistent than initially expected.

As growth begins to decelerate at the same time that inflation remains stubbornly high, investors have now started to worry about stagflation. We will discuss the deceleration of growth in later sections. We set out here to assess the outlook for inflation in the short term and over the long run.

We first rule out the possibility of runaway inflation similar to the levels seen in the 1970s. We do not see any parallels to the types of supply side shocks that were experienced in the oil and food markets back then.

We narrow down our choices of likely inflation regimes to either stubborn or transient and conclude that the answer is both over a 3-year horizon. We explain the rationale and implications of our view.

We show the Fed’s revised outlook on inflation in Figure 1.

Figure 1: Fed Projections of Core PCE Inflation

Source: September Federal Open Markets Committee Minutes
Source: September Federal Open Markets Committee Minutes

The Fed uses the Personal Consumption Expenditures metric as its preferred inflation gauge. The left chart in Figure 1 shows how their forecast for core inflation in 2021 has risen in the last 3 months. It now stands at 3.7% in September … up from 3.0% in June.

On the other hand, their forecasts for the next 3 years in the right chart above show a significant decline. Core inflation is projected to be just above 2% in 2022, 2023 and 2024.

We believe that the Fed’s outlook for core inflation at 2.3% in 2022 is overly benign. We think instead that inflation will remain sticky and stubborn for more than just a few more months. We expect core inflation to be 3% or higher for the next 12 months or so.

Month-over-month inflation has come down in pandemic-affected sectors like cars, airfares and hotels in recent weeks. But that decrease has been offset by an uptick in wage and rent inflation. And any easing of supply-side constraints in the near term will likely be offset by greater demand as the Delta variant continues to recede.

We, therefore, believe that the decline in inflation will be more gradual than the rate at which it spiked up. We are also not troubled by core inflation levels of around 3% in the near term. We know empirically that Price to Earnings (PE) ratios for stocks do well when inflation rises to around 3% from disinflationary levels against a backdrop of higher growth.

Over a longer 3-year horizon, we believe that inflation will end up being transient and recede towards 2.5%. There are powerful secular forces related to technology, demographics and global competition that will inevitably contain inflation in the long run. We are aligned with the Fed over the longer term and the markets which are pricing in lower inflation expectations in the future.

Spending and Taxes

The proposed reconciliation bill for social welfare has generated both support and opposition. Proponents of the bill view it as a significant investment in human and environmental infrastructure with the longterm benefits of greater social equality and a more sustainable planet.

Critics, however, worry about the implications of both higher spending and higher taxes. Some fear that more spending will exacerbate an already significant debt burden and others fret that higher taxes will be restrictive to growth.

We address the topic with a very narrow focus.

We comment simply on the economic impact of higher taxes and higher spending without any adherence to a political or philosophical ideology. We also steer clear of any tax advice.

The $3.5 trillion reconciliation bill has funding for education, housing, child and elder care, healthcare and climate change. The green bars in Figure 2 below show proposed outlays for spending and tax cuts over each of the next ten years.

Figure 2: $3.5T Reconciliation Bill: Spending vs. Pay-Fors

Source: Moody’s Analytics
Source: Moody’s Analytics

These programs offer direct and indirect social, environmental and economic benefits. For example, there is research support for the notion that lower childcare costs can have positive employment effects especially among single and younger mothers. However, we focus more on the concern that the costs of these programs will raise interest rates as debt levels reach a tipping point.

We allay debt fears by pointing out that this spending won’t add materially to the debt burden. It is instead intended to be paid for in almost equal amount by higher taxes and other provisions.

The blue bars in Figure 2 show these pay-fors by each of the next ten years. Total pay-fors aggregate roughly $3 trillion and provide a neat offset to the $3.5 trillion cost of the reconciliation bill.

How onerous will higher taxes be and what impact will they have on growth? Higher taxes account for 70% of total pay-fors or roughly $2.2 trillion. Most of the tax increases are projected to come from higher rates for domestic and international corporate taxes and high-income individual taxes.

We also don’t expect this higher tax burden to weigh significantly on economic growth … for one simple reason.

The restrictive effect of $2.2 trillion in higher taxes is likely to get neutralized by the expansionary effect of $3.5 trillion in higher spending.

We believe that the similar magnitude and inverse impact of higher taxes and higher spending could well offset each other and, therefore, be neutral to growth.

Inflection in Stimulus

The rapid recovery from the Covid recession was driven in large part by unprecedented levels of monetary and fiscal stimulus. The Fed has kept short-term interest rates at zero and expanded its balance sheet by more than $4 trillion. Government spending has also been monumental at $5.8 trillion in the last year and a half.

We are now on the cusp of an inflection point in stimulus. The Fed has clearly signaled its intentions to gradually embark on a tapering and then tightening cycle. The Fed is ready to scale back on its bond purchases and then raise interest rates.

And even though there is future spending proposed in the infrastructure and reconciliation bills, its magnitude pales in comparison to the post-Covid fiscal stimulus. The withdrawal of fiscal stimulus in this magnitude will create a so-called fiscal cliff and reduce future growth.

We assess the likely impact and implications of this shift in monetary and fiscal policy.

We believe that this expected shift in policy comes as no surprise to most market participants. The economic landscape in 2021 is far different than what it was in 2020. Ultra-stimulative policies were appropriate as emergency measures in the throes of a pandemic. But they are likely misdirected today in the midst of a healthy economic recovery and persistent inflationary pressures.

The minutes of the September Fed meeting suggest that it will likely begin to reduce its monthly asset purchases before year-end. This tapering process could see an initial reduction of $15 billion per month in bond purchases from the current monthly pace of $120 billion. It is expected that the target date to end bond purchases altogether will be mid-2022.

We concur that tapering should begin in November or December and last 6 to 9 months. We disagree, however, with the Fed’s latest forecasts for its pace and timing of rate hikes. Based on September data, the Fed projects no rate hikes in 2022 and 4 rate hikes in 2023.

We believe that interest rates need to rise sooner than in 2023. We believe that the strength of the economy, the recovery in the labor market and the persistence of inflation all argue for a liftoff in interest rates in the third quarter of 2022. In this regard, we are more aligned with the market than with the Fed. We remain vigilant for a policy misstep by the Fed in terms of falling behind the curve.

The absence of any “taper tantrums” in the markets so far suggest that these changes in monetary policy have been anticipated and priced in. Long-term interest rates have started to rise ahead of the Fed’s tightening plans.

The impact of fiscal stimulus is generally less understood and is, therefore, worthy of more careful analysis. We measure the impact of fiscal policy on growth with a metric called Fiscal Impact Measure (FIM) developed by the Hutchins Center at Brookings Institution.

FIM is a more comprehensive metric than the federal deficit because it combines the impact of federal, state and local fiscal policy. It specifically measures the differential impact of fiscal policy beyond its normal level in an economy operating at potential GDP and full employment.

FIM is easy to interpret. By definition, it is zero and neutral to growth when government spending and taxes rise in line with potential GDP. When FIM is greater than 0, fiscal policy is expansionary … it pushes growth above potential GDP. Fiscal policy is contractionary when FIM is below 0.

We show the evolution of FIM in Figure 3.

Figure 3: Fiscal Impact Measure

Source: Hutchins Center at Brookings Institution
Source: Hutchins Center at Brookings Institution

Positive FIM levels are typically seen after recessions and they are particularly prominent on the right side of the chart in Figure 3. During the pandemic, fiscal policy was hugely expansionary and added between 4 to 6% to GDP growth.

By the same token, the end of that massive spending spree will create a negative impact on GDP growth in the next year or two. The red negative bars at the far right of Figure 3 show that growth will likely get reduced by a little more than -2%.

We expect that GDP growth will decelerate by -2 to -3% from the upcoming inflection in stimulus. However, we do not despair this drop-off in growth. At well above 3% in 2022, GDP growth will be considerably ahead of pre-Covid levels. In fact, we see these policy shifts as a reason to cheer and celebrate and not as a cause for concern. They simply mean that the U.S. economy is now self-sustaining and can be weaned off life-support measures.

We have already suggested that this upcoming deceleration of growth has been widely expected and is likely priced in. We lend credence to that notion by looking at the impact of decelerating growth on stock valuations.

Deceleration and Valuations

Many investors still worry that stock valuations are too high especially in the context of historical norms. A slowdown in growth is particularly troublesome to them because that would make valuations even less sustainable.

We allay those concerns by pointing out that this feared compression of PE multiples has already started to take place. Future earnings estimates have recently started to decelerate. But the markets had efficiently anticipated this deceleration well in advance of when it took place.

We show this vividly in Figure 4.

Figure 4: S&P 500 Earnings and PE

Source: FactSet
Source: FactSet

The green line in Figure 4 shows S&P 500 forward earnings and the blue line shows the S&P 500 forward PE multiple.

Forward earnings grew rapidly from the second quarter of 2020 and have recently started to grow at a slower pace. PE ratios have correctly anticipated both the initial burst of growth and then the subsequent deceleration … and well in advance by several months.

The current deceleration in earnings growth began to take shape in September 2021. It is remarkable that PE ratios began to price in this eventual deceleration one full year earlier in September 2020! The forward PE ratio peaked at that time at around 24 times. It has continued to compress even as earnings continued to rise but at a progressively slower pace. The forward PE ratio now stands at around 20 times.

We reiterate our belief that the impending slowdown in growth is not a new development and certainly not a surprise for the markets. We also believe that even though PE multiples have come down, they will continue to modestly compress further in the next year or two.

We believe that current stock valuations are reasonable in light of still-low interest rates and above-average growth. We believe that future earnings growth and dividend yields will offset this continued compression of PE multiples and generate positive equity returns.


We examined a number of concerns that are currently weighing on investors – Delta variant, debt ceiling, inflation, spending and taxes, inflection in stimulus, deceleration of growth and stock valuations.

We do not believe that these factors, individually or collectively, will conspire to significantly disrupt growth. We don’t dismiss them as trivial distractions either. Between the bookends of major disruptors and mere distractions, we position them as modest detractors of growth.

We summarize several beliefs, views and thoughts on this broad array of topics as follows.

  • The Delta variant and future virus strains will have limited economic impact
  • Inflation will remain stubbornly persistent over the next 12 months or so; it will eventually become transient as it drops below 3% by 2024
  • Higher taxes and spending will offset each other … and be neutral to growth
  • The Fed has signaled that tapering will begin by year-end and end in mid-2022
  • We expect the first rate hike to happen earlier than current Fed projections … we may see a liftoff in interest rates in Q3 2022
  • Fiscal and monetary inflections will cause growth to decelerate by -2 to -3%; however, growth will still be robust in 2022 and 2023
  • Inflection in stimulus is not new information and is likely priced in
  • Stock valuations have already compressed … and will do so in 2022 as well

We believe that this new economic cycle and bull market have longer to run. Our constructive outlook lends itself to a pro-growth, pro-cyclical tilt in our asset allocation and portfolio positioning.

We are also mindful that we have just come through some truly unprecedented times and uncertainty still abounds. We, therefore, remain respectfully vigilant and cautious in our optimism.

Investors are worried that stubborn inflation, higher taxes and the end of monetary and fiscal stimulus may become major disruptors of growth.

We believe that is unlikely to happen.

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