Introduction

The Covid-19 disruption led to a 3.4% decline in US GDP over 2020. This was the largest annual fall since an 11.6% collapse at the end of WWII in 1946. Like many other countries, growth rebounded strongly in 2021, up by 5.7% in 2021, more than offseting the Covid-induced decline.

2022 will be another year of recovery from the pandemic as services spending normalises. But, the tailwinds of growth that drove the strong US economic recovery over late 2020/21 are starting to fade. US GDP growth is set to slow down in coming years. We expect GDP growth of just over 4% in 2022, followed by 2% in 2023. In this Econosights we go through the four reasons for why we are expecting a slowdown in the US economy.

1/ Inflation is too high

Before the pandemic started, the US had spent a large part of the prior decade with consumer price inflation undershooting the Fed’s 2% target. Covid-19 led to a massive loosening of fiscal policy, more monetary stimulus, huge demand for consumer goods (both durable and non-durable) and disruptions in the global supply chain (the unanticpated surge in goods demand alongside temporary factory closures and changes in transport of goods). As a result, inflation has surged on all measures. Core consumer price inflation is at 6% while the core personal consumption expenditure index is at 4.9%, both at multi-decade highs. While wages have responded with average hourly earnings are up 5.7% over the year to January, continuous high inflation will be negative for economic activity because it eats into the spending power for businesses and consumers. One potential offset for conusmers from high inflation is the large build-up in excess savings since the start of the pandemic which is worth $2.4tn or ~10% of annual GDP.

High inflation means that the US Fed will need to raise rates relatively swifly in 2022.

2/ Interest rates set to rise quickly in 2022

In response to the inflation outbreak, the Fed will need to raise the fed funds rate faster than anticipated just a few months ago. The market is pricing in six or seven 25 basis point interest rate rises over the next 12 months. This is an aggressive rate hike profile (compared to the recent years of low interest rates) and it assumes a rate rise at nearly every meeting in 2022. We think the current market pricing looks fair year which means that the fed funds raise is likely be be around 1.7% in a year from now (from the current level of 0-0.25%), around 150 basis points worth of hikes. While this seems steep, it isn’t compared to prior interest rate hike cycles, given the current level of inflation. The chart below demonstrates this well, showing that at inflation levels well below the current headline figures, the Fed has lifted interest rates by 200-300 basis points in one year. So, the risk is that the Fed is behind the curve in tackling the high level of inflation (compared to historical rate hike cycles) and will need to do more hikes if inflation proves sticky.

Interest rate hikes will lift mortgage rates, with the US 30-year mortgage rate already up at 3.4% (from 2% a year ago), its highest level since mid-2019. And financial conditions are tightening.

In this rate hike cycle, the fed funds rate can probably get to a peak of 2.5%, our estimate of the US “neutral” interest rate.

3/ The Fed will reduce the size of its balance sheet

The value of the Fed’s balance sheet has more than doubled since the start of the pandemic, currently standing at 36% of GDP. This is probably the peak in the Fed’s balance sheet, with quantiative tightening (QT) expected to start around mid-year. QT will be done through allowing assets (bonds and mortgage-backed securities) to roll-off the Fed’s balance sheet and not re-investing the proceeds and/or actively selling assets before they mature. Quantitative tightening is likely to place further upwards pressure on bond yields and be negative for asset prices. The Fed has reduced the size of its balance sheet before, but the upcoming QT process will occur at a faster rate compared to history so there are still some risks to the process. However, the Fed can readily increase its balance sheet again if it needs to, once its starts the QT process. So it’s unlikely that QT, on its own, will cause a big upwards shift in yields or a bear market in equities. We expect the Fed’s balance sheet to decline to around 30% of GDP in a year’s time.

4/ Fiscal policy is tightening

Fiscal policy is tightening or becoming less stimulatory after the pandemic spending binge. “Fiscal thrust” is a measure of the change in the budget as a share of GDP to gauge the degree of tightness in fiscal policy. The US is currently running a budget deficit. So, as fiscal policy loosens (or becomes stimulatory), the budget deficit rises and fiscal thrust rises (see the chart below). As the budget deficit has been narrowing over 2021 (and will continue to narrow into 2022) since its explosion in 2020, fiscal thrust has been turning negative. This already occurred in 2021 and will continue in 2022, despite the potential passage of Build Back Better (and if it does get passed it will be a much smaller package, or potentially a few small packages).

One positive is that the worst of the fiscal drag may have already occurred in 2021. In the past year, the budget deficit has already narrowed by $2.4tn – 10% of GDP.

The midterms in November are likely to result in the Democrats loosing their majority in the House of Representatives and also potentially in the Senate, so any major policies that increase the deficit are unlikely to be agreed on after November.

Earnings growth has peaked

These 4 factors that will slow US economic growth in 2022 will also weigh on earnings. Exceptionally strong US earnings growth in 2021 (see the chart below) reflects the rebound in the economy from stimulus measures and the huge run-up in technology/large consumer discretionary profits, which massively benefited from the pandemic (lower bond yields, shift to working from home and lift in consumer goods demand). While earnings growth is expected to be positive over the next year (we expect ~10-15%), the pace of growth is slowing as interest rate hikes and higher bond yields threaten long-term profits from large technology companies.

But, while earnings growth remains positive it is hard to become too bearish on US shares. Risks for a serious bear market would result from negative profit growth, but we are not there yet.

Conclusion

US economic and profit growth is set to slow in 2022. The main downside risk to growth is a central bank tightening into a slowing economy. While the Fed needs to bring inflation down, it should still tread carefully in raising interest rates. But it’s hard to get too pessimistic on the US economy. There are still plenty of positives. Large pent-up consumer savings provide an offset to high inflation and interest rate rises, a strong labour market will keep the unemployment rate low and wages growth elevated, services spending will rise further in 2022 as it is now just getting back to its pre-Covid levels and business investment is rising, which is also positive for future productivity growth. Recession risks are low for now. We think the risk of a major growth slowdown or a recession is more of a risk from 2024 as interest rates rise further.

Slowing profit growth alongside slower economic growth and the rise in interest rate rates means we expect lower equity returns in the US market in 2022 compared to recent years. We think non-US shares can outperform in an environment of rising global bond yields which will weigh on tech stocks (which the US share market has a high exposure to compared to other global share markets).