Big Picture Market Outlook
Base Case: Global growth in 2022 is likely to remain positive but will decelerate from 2021. Real GDP in 2021 will likely come in at a 5.6% growth rate and estimates for 2022 are 3.9%. The unemployment rate was 6.6% entering 2021 and will likely end the year near 4% with further small improvements in 2022. While economic growth is likely to remain positive in 2022, we are seeing a large withdrawal in market liquidity coming from several sources: Fed QE is ending, REPO facility is exploding to nearly $2T, and the US Treasury will be increasing its reserve balance at the Fed (see images below). The loss in liquidity should bring down market multiples and possibly lead to a correction in H1 2022. A correction would help provide cover for the Fed to take a more accommodative stance and set the stage for a relief rally in the back half of 2022.
- Unwinding of COVID lockdown should produce tailwinds for global growth. The reopening story was a US story in 2021 but could turn into a global story in 2022 should we get closer to herd immunity after our 4th wave of infections.
- The Fed could pivot to a more accommodative stance once inflation peaks and risk assets come back down to earth.
- If the Republicans take back one or both houses of Congress, a political stalemate would remove political uncertainty for the remainder of the Biden administration.
- We could be hit with a new, more virulent COVID strain that could lead to more stringent lockdowns and hurt global growth and risk assets.
- Should inflation prove stubborn, the Fed may have to accelerate its tapering process which would hurt risk assets.
- There is a real risk of an energy crisis this winter as coal and natural gas storage levels in the UK, Europe, India, and China are low and could lead to continued price spikes in energy prices.
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Recent Market Developments
1. The Fed has moved from easing to tightening. The shadow fed funds rate (expressing QE as an interest rate) has now turned positive after bottoming entering 2021, indicating the Fed is now in a tightening posture.
2. The US Treasury needs to replenish is emergency reserves by roughly $250B. This will effectively remove cash from the system as market participants swap their cash for USTs. In 2021 we had the opposite as the USTs cash account was drained from over $1.7T down to nearly zero by the end of 2021.
3. Fed's REPO facility has drained nearly $2T from the financial markets. The large decline in the US Treasuries' cash account at the Fed has helped offset the nearly $2T drained through the REPO facility, but with the UST needing to replenish its coffers, this offset is now adding more fuel to the loss in liquidity.
4. The bulk of market corrections occur when liquidity is decelerating. The bulk of pullbacks/corrections since the Great Financial Crisis have occurred when global money supply was decelerating. We've seen a sizeable loss in liquidity growth and yet the markets have continued to rally. Until liquidity turns up, the risk of a correction remains high.
5. A correction may be just around the corner. The market's new highs are being supported/led by a small number of technology stocks and defensives like utilities, REITS, and consumer staples.
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