Maturing Economy Could Prove Bumpy For U.S. Equity Markets

As the economic cycle enters a new phase, investors learn to live with the pandemic and fiscal stimulus winds down, U.S. equity markets should be increasingly volatile and offer lower returns. While likely to get worse over the next few months, inflation should improve later in 2022. Longer-term inflation expectations are muted while recession fears remain minimal.

With real gross domestic product (GDP) growth and job creation coming off a boil from 2021 peak levels, the maturation of the economy from early to mid-cycle may be a little bumpy. It is expected to move toward its pre-pandemic trend in 2023, with GDP growth slowing to 2.5% and job creation poised to fall toward the 175,000 per month range.

Growth is expected to decline, but the still-robust consensus forecast in real GDP of a 3.9% increase is a level better than any single year in the decade following the global financial crisis.

Slack is being absorbed much faster than usual, however. The time it took this cycle for earnings per share (EPS) to recover to its prior peak was much shorter than in the last several recessions. The length of the EPS recovery and the overall economic expansion appear to be related, so the current expansion could be shorter than the 8.5-year average seen over the last four cycles.

Despite omicron outbreaks, the potential exists for a more truncated and hotter economic cycle. Near-term recession risks remain low. The Atlanta Fed’s GDPNow is tracking to 6.8% real GDP growth for the fourth quarter of 2022, much higher than at any point during the third quarter delta-related disruption.

Omicron may bend the economy, but it is unlikely to break it. It appears more contagious but less deadly than previous coronavirus variants, which could be important in transitioning from pandemic to endemic. This shift will not be costless, but it should be positive for risk assets as the necessity diminishes for additional social distancing restrictions.

For financial markets, the key macro debate over the past 18 months has focused on inflation. As consumer preferences normalize and supply chain pressures abate, so should inflation.

The core Consumer Price Index (CPI) has run at 4.9% over the last year — 3.1% above the average 1.8% pace from 2010 to 2019. Much of the excess inflation has come from used cars and other goods, largely driven by shifting consumer preferences during the pandemic (services to goods). Four categories of goods make up only 14% of the overall CPI basket but accounted for almost two-thirds of the increase: new cars, used cars/trucks, apparel and household furnishings.

Since the turn of the century, more than 100% of core…