Growth

Revised 3Q21 Real GDP shows the economy expanded at a 2.3% annual rate in 3Q21, lower than the 2.6% consensus estimate and a sharp slowdown from robust gains earlier in the year. Weakness was led by a marked deceleration in consumer spending, growing just 1.7%, along with slower home building and a wider trade deficit. Weaker auto sales alone detracted significantly from GDP, and the rotation to services continued at a slower pace. While supply chain issues may persist well into 2022, recent data has shown economic momentum recover in the fourth quarter. Most recently, December manufacturing ISM PMIs showed factory activity continued to expand, albeit at the slowest pace since January as continued supply chain disruptions hampered production.

Jobs

December nonfarm payrolls rose by just 199K, well below consensus expectations for a 400K gain. However, other aspects of the report show continued labor market tightening, with unemployment falling to 3.9% and overall wages rising a robust 0.6% m/m. In particular, wages for production and non-supervisory workers rose by 0.7%, suggesting lower-paid workers are benefiting from the labor squeeze. The Omicron variant is likely disrupting hiring in January and may do so into February. However, as the economy gets past the latest pandemic wave, the chronic excess demand for labor should continue to pressure inflation higher and keep the Federal Reserve in a more hawkish stance.

Profits

The 3Q21 earnings season was strong, with 502 companies reporting (99.9% of market cap). 81% of companies have beaten on earnings expectations and 68% have beaten on revenue expectations. Our current estimate for 3Q21 earnings is $52.06, which represents y/y EPS growth of 37.4% and a modest q/q growth of 0.1%. Earnings have held up better than we previously anticipated, as companies seem able to defend profit margins despite higher input prices. Oil (+73.4%) and the U.S. dollar (-1.4%) have also been decent tailwinds to earnings.

Inflation

Inflation has far surpassed the FOMC’s 2% target, with the headline PCE price index rising +0.6% m/m and +5.7% y/y in November. The core PCE deflator also rose to +0.5% m/m and +4.7% y/y. The December CPI report showed consumer prices rose at their fastest pace in 40 years as vehicle prices, owner’s equivalent rate and broad goods prices continued to accelerate. Headline CPI was in line with expectations at +0.5% m/m and +7.0% y/y, while Core CPI rose 0.6% m/m and 5.5% y/y. As we look to 2022, we should see a significant moderation in inflation as supply chain issues ease, energy prices cool and the reopening categories stabilize.

Rates

A rapidly improving labor market and persistent inflationary pressures have pushed the Fed to adopt a more hawkish stance toward monetary policy. At its December meeting, the FOMC officially announced its plans to accelerate the taper of its net asset purchases to $30bn per month, suggesting the FOMC will conclude tapering by March 2022 and pave the way for rate hikes next year. The Fed’s dot plot now implies three rate hikes in 2022 and 2023. In the statement, the Fed retired the word “transitory”, making clear that high inflation and a falling unemployment rate prompted the committee to hasten its tapering timeline.

Risks

• Further COVID-19 waves could continue to disrupt the global economic recovery.
• Inflation could remain at elevated levels in the medium term if supply shortages persist.
• The removal of policy support and stretched valuations could provide a challenging backdrop for equities.

Investment Themes

• U.S. equity investors may use earnings as a guide in a rising rate environment.
• Fixed income investors may want to underweight duration and explore alternative sources of income.
• Long-term growth prospects, a falling dollar and cyclicality support international equities.