January 13, 2022 | macro-economic research report

The Last Wave: Tempered Expectations Amidst Virus Uncertainty

BY: Richard Croft
In chaos theory, the butterfly effect refers to how minor changes in an initial assumption can alter the future in unimaginable ways. It was based on the work of mathematician and meteorologist Edward Lorenz who used the example of a tornado being influenced by minor perturbations such as a distant butterfly flapping its wings weeks earlier.



In chaos theory, the butterfly effect refers to how minor changes in an initial assumption can alter the future in unimaginable ways. It was based on the work of mathematician and meteorologist Edward Lorenz who used the example of a tornado being influenced by minor perturbations such as a distant butterfly flapping its wings weeks earlier.

Interestingly, Lorenz’s original thesis brought into play the impact from a seagulls’ wings altering the trajectory of a storm. He was persuaded to make it more poetic with the use of butterfly and tornado in 1972.

Lorenz discovered the effect when he observed runs of his weather model after rounding conditional data in a seemingly inconsequential manner. He noted that the weather model would fail to reproduce the results of runs with the unrounded initial condition data. Minor adjustments to the initial conditions created significantly different outcomes.

In 2004 Hollywood released a science fiction thriller entitled The Butterfly Effect starring Ashton Kutcher. The premise of the story centered around Kutcher’s character, who suffered blackouts as a child that seriously impacted his friends and family. In an effort to reverse these outcomes, he went back in time and changed the conditions of his blackouts in a way that would not harm his friends and family. However, the changes he makes lead to unintended consequences that had far reaching implications.

Slight changes in one’s assumptions affect everyday life… every day! A family Christmas dinner cancelled because of exposure to the children of a friend whose mother tested positive for COVID. A December 31st wedding cancelled for the second year in a row due to renewed government restrictions.

During the current overwhelming Omicron surge, we are witnessing firsthand the most extreme version of Murphy’s Law. To wit: “if you perceive four possible ways in which something can go wrong, and circumvent these, then a fifth way, unprepared for, will promptly develop.”

On the positive side, allow me to paraphrase a quote attributed to Thomas Fuller (theologian and historian), “it is always darkest before the dawn!” While not scientifically accurate (it is typically darkest at midnight), it offers hope of better things to come.

While, psychologically, the rise of Omicron has inflicted immeasurable damage, in terms of its impact on the economy… not likely so much. One main reason seems to be fewer unfavourable outcomes from Omicron infections. One study conducted by the Imperial College London COVID-19 response team analyzed outcomes of Omicron versus Delta.

Their analysis showed that people infected with the Omicron variant were 20% less likely to go to the hospital, and those that did, were 40% less likely to remain hospitalized for more than one night. Another study in Scotland had similar findings with a 66% reduction in Omicron hospitalizations compared with Delta.

There is also mounting evidence that Omicron burns out as fast as it infects. The South African Omicron wave crested in late December, the UK has plateaued, and based on the surge in North American cases it seems logical to assume that the Omicron wave decline will be a mirror image of its incline.

If scientists are right in this assessment, then Omicron may be the first of a series of variants that will usher in the endemic era of COVID-19. Shifting away from pandemic status will allow for a more normal existence without fear of lockdowns, where we live with COVID-19 in much the way we live with the flu.

That backdrop may explain why the financial markets’ reaction to Omicron has been ‘meh’! Aside from the impact Omicron may have on the labour market, the pandemic has taken a back seat to more pressing financial issues – issues such as the persistence of supply chain bottlenecks and inflation, plus central banks’ tighter monetary policies (i.e., reversals from quantitative easing), which are all precursors to how much higher interest rates rise and how quickly.

Central banks are trying to thread a very narrow needle. The goal is to tamp down inflation expectations without pushing the economy into a recession. However, how bankers define inflation depends in large part on the degree to which price increases are transitory (see Economic Outlook).

These headline risks have led to choppy action during the first few trading days in 2022 with the bulk of the damage hitting the tech-laden Nasdaq. That is not surprising because we would expect central bank tightening to have a more profound impact on growth stocks, which is why we have been seeing a shift from growth and momentum stocks to value names. Banks have been major beneficiaries of this shift in market sentiment.

As for the highlighted issues, the general view among economists is that the U.S. Federal Reserve might raise rates three or four times in 2022, depending on the trajectory of inflation. However, may see fewer rate hikes than consensus if we get relief in consumer prices as supply chain frictions ease. Which, coming full circle, will depend on how quickly the Omicron wave subsides.


In the early- to mid-1980s retailers reassessed how they managed inventory. Using improved logistics, retailers were able to transition away from holding sizeable inventory to “just in time” delivery. The main impetus for this shift was the cost of financing huge inventories. High interest rates forced retailers to speed up inventory turnover by cutting prices which caused profit margins to shrink.

The pandemic has made companies re-think that strategy. Supply chain issues have upended the “just in time” model, frustrating consumers as delivery times increase exponentially. With ultra low interest rates reducing the cost of carry companies may reset their inventory away from “just in time” to “just in case.”

We suspect retailers stocked up for Christmas and are carrying significant inventory into 2022. If we are correct, that should ease supply chain pressures and inflation expectations, which is the nexus of the transitory debate.

The broader U.S. economy has recovered from pre-pandemic levels as U.S. GDP topped U.S.  $23 trillion by the end of 2021.

We expect that trend to continue throughout 2022 supported by  consumers with excess disposable income and a desire to spend.

The record low unemployment rate (3.9%) plus unfilled jobs that dwarf the total number of people looking for work should add fuel to the growth trajectory.

That said, the job market remains a two-edged sword – particularly in terms of the number of job openings versus the number of people looking for work. Part of that gap is the result of 2.4 million excess retirements that occurred during the pandemic. Early retirement is one factor in the lower-than-expected labour participation rate which declined from 63.2% in the fourth quarter of 2019 (pre-pandemic) to 61.9% at the end of 2021. That translates into approximately 4.5 million workers having left the labour force in 2021.

There are any number of explanations for the diminishing labour force. Changing one’s retirement timeline because of health reasons or fear of getting COVID-19 in the workplace, rising asset values (i.e., real estate and stocks) making retirement suddenly a viable option, or the appeal of a healthier work / life balance.

Currently, retirees make up just under 20% of the U.S. population. That percentage has been increasing since 1995, especially so a decade later as baby boomers (those born between 1946 and 1964) began to retire. This demographic exodus of a large cohort from the work force was to be expected. More concerning, however, is the recent number of ‘excess’ retirements beyond what one would predict based on demographics.

In one study conducted for the St. Louis Federal Reserve, author Faria-e-Castro compared the predicted percentage of baby boomer retirements from 2008 to February 2020 (i.e., normal retirements) with the actual percentage of retirements. The difference, which he calculated as 0.92% (about 2.4 million workers), would be considered “excess” retirements. For some perspective, the number of excess retirements accounted for about 50% of all retirements during the COVID-19 pandemic.

These ‘excess retirees’ tended to be older people, and they may have left the labour force because of the serious risk of COVID-19 infection and death for that age group. The wealth effect resulting from higher asset prices (notably principal residences) and the booming stock market, probably made retirement a feasible option for many.

The main issue from our perspective is whether any of those ‘retirees’ find their way back into the work force. And they may come back depending on personal circumstances and a more hospitable labour market. However, if they do not return, we are looking at a labour market with excess slack, which will eventually translate into higher wages as companies compete for a limited number of workers.

Leading Economic Indicators

There is no way to predict how COVID-19 will impact financial markets through 2022. We can hope for the best that the pandemic will transition to an endemic virus. Beyond that, the best we can do is use the tools that have, historically, been the most useful in providing good direction. The principal arrow in this quiver is the Index of Leading Economic Indicators (LEI), which is a basket of statistics that, historically, have been reasonable proxies for the future state of the economy. The index components include:

  • Labour statistics: the monthly unemployment rate and average earnings as well as initial claims for State unemployment insurance
  • Output spending, which includes consumer and business expenditures
  • Building permits and the change in housing stock
  • The spread between 10-year Treasury Bill interest rates and the federal funds rate
  • The Fed’s inflation-adjusted measure of the M2 money supply
  • The ISM manufacturing index
  • The S&P 500 index
  • Sentiment indicators, such as ones that measure consumer expectations

The upward slope in the LEI implies a strong U.S. economy with output well above pre-pandemic levels. Economists get concerned when the LEI peaks, which typically occurs twelve months prior to a recession (gray bars). So far… so good! With the caveat that a new COVID-19 variant, or a misstep by central banks could threaten this outlook.

Consumers Trends

When we talk about the GDP it is important to examine the components that make it up. To that point, we must recognize that consumer spending drives 70% of overall U.S. real GDP with the remainder coming from government spending and business investment.

Economists typically breakdown consumer expenditures in percentage terms to services (i.e., restaurants, travel and leisure, entertainment) versus capital goods (i.e., new vehicle, appliances). Normally we would expect to see 70% allocated to services and 30% allocated to capital goods. At present, we are seeing consumers shift their emphasis away from services towards capital goods (see chart) likely because early lockdowns limited their ability to spend on services.

That juxtaposition may be a factor in the inflationary surge we have been experiencing. Supply chain bottlenecks have caused prices to surge for goods such as used vehicles, appliances and of course, new home purchases. Supply chain friction during a period of robust demand is the foundation underpinning the transitory argument. We may see inflation subside as supply chains normalize and consumers begin spending more on services and less on capital goods.

Consumer Sentiment

Consumers are not feeling good about the economy. Not at all surprising, given the surge in Omicron and general exhaustion of having to deal with the virus. Add to the mix the surge in core inflation – including food and energy – that has a visible impact on family budgets.

There are two associated concerns that we will monitor: 1) is it likely we will experience a more severe deterioration in expectations for the future; which hinges on 2) whether this decay in confidence is related to virus malaise or a more permanent reflection of unknown concerns?

Inflation Expectations

There has been some talk about the similarities between the 1970s’ era of stagflation and the current economic sensitivity to inflation. We do not agree! The most influential driver in the 1970’s was the impact spiralling wages had on corporate profit margins. In the 1970s’ profit margins moved in lockstep with labour costs. Today, thanks to technology and globalization, not so much!

Profit margins have remained intact despite a recent decline in productivity. We suspect that is attributable to lower corporate tax rates and, to a lesser extent, the decline in labour costs and capital expenditures during the depths of the pandemic. Our base case would see a convergence of the two lines by the third or fourth quarter of 2022. Much will depend on how quickly and, more importantly, how significantly wages rise, and as to whether companies will have the pricing power to pass those costs through to the consumer.

Earnings Outlook

When we look at earnings, we are focusing on trends rather than specific datapoints. So far, the trend has been our friend as above average expectations created the euphoria that pushed U.S.  and Canadian stock prices to record highs. Not surprising, as there is a strong correlation between the performance of stocks and the trend in earnings (see chart to right).

We are anticipating a slowdown in the earning growth trajectory through 2022. Not a reason for panic, but we want to temper expectations around future equity returns. In short, do not expect financial markets to repeat the performance of 2021.


Whether central banks bump rates two or four times, it is clear we will face higher interest rates in 2022. But a higher rate environment does not necessarily translate into lower equity prices. Two considerations come to kind: 1) sentiment can drive stocks higher than the fundamentals would suggest; and 2) efforts to sell this market will feel like being side swiped by a truck that hits a brick wall a mile down the road.

A more likely scenario is that 2022 will be a more moderate version of 2021. The main theme will be sector rotation as investors move away from smaller momentum driven stay at home stocks (i.e., Zoom, Peloton and the like) towards mega-tech names (i.e., Amazon, Apple, Microsoft) and value stocks (i.e., banks and consumer discretionary).

This ebb and flow between sectors and style had negligible impact on the broader markets in 2021. That may change in 2022. If the weakness broadens, it could push the major indices lower, much as we have seen with the Nasdaq in the early trading sessions of 2022. Obviously, we prefer to see rotational corrections rather than a broad sell-off. We can diversify rotation shifts by adjusting the percentage weight applied to value and growth stocks at any particular point in time.

That strategy worked through 2021. For 2022, we will be laser focused on the interplay among the broader market indices. An upswing in the correlation between the three major indices (i.e., S&P 500 Index, Dow Jones Industrial Average, Nasdaq 100) would infer that sector and style metrics percolating below the surface are beginning to influence the broader market. In that scenario, simply shifting allocations between growth and value will not provide the same risk reduction benefits.

To address that possibility, we can use option strategies for risk mitigation and enhanced cash flow. It may be that 2022 will see the rise of covered call writing as the preferred strategy.

Finally, it is important to remember that trying to time moves into and out of the market is not an investment strategy. Like rolling the dice at a craps table, it is gambling on market direction and returns at particular moments in time.

A successful investment discipline relies on established, well-thought-out themes that include a diversified approach across asset classes, geographic regions, sectors, and investment styles, built on the back of quality companies that can survive black swan events, with the fortitude to power through periods of above average portfolio variability.

Happy New Year!

Richard croft signature

Richard Croft, Chairman & CIO

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