After a Volatile Start, How Will 2022 Play Out?

Three asset managers discuss the delicate balance this year between inflation and rate hikes, plus other factors impacting the economy.

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With 2022 off to a volatile start, Dominic Nolan, CEO of Pacific Asset Management (sub-advisor to Pacific Funds fixed-income funds) sat down with Brian Robertson and Max Gokhman to get their economic insights how the year (and beyond) will play out, especially regarding inflation and expected Fed rate hikes. Robertson is a founding member and managing director of Pacific Asset Management, and Gokhman is chief investment officer at AlphaTrAI, an AI-driven asset manager.

Dominic Nolan:

When the two of you think about what the market should be paying attention to right now, what are your top two or three items?

Max Gokhman:

These aren’t going to shock anyone who’s been awake for the past few months. Number one is going to be the fact that the Fed is not just going to be aggressively hiking rates, but it’s also going to be actively reducing the size of its balance sheet. And I think that sets us up a secular rising-rate environment that we haven’t seen since the early ’80s. This is a really important factor because a lot of traders who are trading right now at an institutional level haven’t lived through that cycle before.

We also have the changing of the supply-chain dynamics of 2021, where some of the log jams are going to start clearing up. Some of the chip shortages, mainly for automakers, are going to start easing, which could have the potential to drive inflation down. And I do think inflation takes a dip toward the back half of the year.

Brian Robertson:

I think the market has things pretty right at this point, as far as what it’s worrying about. It does start with inflation. At the end of the day, inflation seems like it’s going to drive just about everything. The speed with which inflation comes down, I think, will be the primary driver for all asset-class returns in 2022. And it’s going to really determine how aggressive the Fed needs to be.


But there’s one thing I’d push back on a little bit, Brian, and I don’t disagree with you on the broad concept, but I think markets may get a little too excited if we see inflation come down, which both you and I think will. What I would be concerned about is if folks forget that the Fed’s FAIT (flexible average inflation targeting) does work both ways. Just like they let it run hot in 2021, I think that they’re going to let it run cool, especially on a year-over-year basis, in 2022. Especially in the equity space I would be looking for it as an opportunity to actually go short if I see markets really rally between Fed meetings after we get a low inflation print.


I think that's fair. I think that the Fed wants the increase in rates to be a bit on autopilot. And it's going to take a lot for them to move off the rate-hike cycle they see in their mind right now. But the market narrative has started to shift. You've seen folks predicting 5, 6, 7 hikes on the sell side. I think there's a pretty low likelihood of us getting that many hikes because if the equity market looks favorably at an inflation print that is below expectations, I think that gives the Fed a little bit more flexibility to actually insert the balance sheet more and not necessarily just increase the speed with which they hike rates.

And I think as much as the balance sheet has grown in the last handful of years, the Fed doesn't quite know how to use that mechanism. And Fed Chair Jerome Powell said as much in the last press conference after the Federal Open Market Committee meeting, that they don't know where to take the balance sheet down to, and they don't know the speed with which to bring it down.


And for the record, I think we're going to have four hikes in 2022 versus even the five that Fed futures project right now. There are definitely folks out there who are also saying, "We're going to see a 50-basis-point hike in March. I don't see how the Fed would kick off the party in such a loud fashion.


Well, technically unwind the party, right?


Maybe end the party.


So Max, you're predicting four rate hikes of 25 basis points.




Brian, what's your base case right now on number of Fed hikes?


I think four is the most likely, but if I had to choose between three and five, I'd pick five. Some of that is on the premise that the U.S. economy is still really quite strong. February might be challenging with the COVID interruptions so we're going to get a pocket of weakness. But overall, I don't think that's the state of the economy right now. I think we're going to be driven by the U.S. consumer. I think the consumer both has the ability to spend and a huge amount of desire to spend and go out like they haven't in a couple of years. I think that drives the market and which is why I think the Fed, ultimately, if they're going to go one direction or the other, they're going to see a strong economy and end up hiking more than that four.


I've heard investors talk about how consumers' pent-up savings went away in 2021, but I actually don't think that's true. I think when we look at the excess saving flows, they're certainly gone, but the stock of excess savings is still there. When I look at credit card data, it's extremely aggressive relative to both 2020 and pre-pandemic 2019. And interestingly, the wealthiest pockets of consumers, who traditionally would take their savings and put them in less liquid investments instead kept them very liquid, perhaps because there was such uncertainty around the pandemic.

The other thing I think interesting is we have a fundamentally different situation with COVID than we did in 2020 or last year. I think the Omicron variant really brought that to light in the sense that we had massive spikes in cases, but we didn’t see deaths go up. And to me, that really shows that we are past the hump of this fear of lockdowns and fear of more restrictive policies.


I’m in agreement. If you have a situation where you had significant cases without the hospitalizations and deaths, that’s kind of a win for humanity, right? Because you’re getting a level of herd immunity in there. By July of this year, I’m unsure whether COVID will be officially declared endemic, but the world will act as though it is. Is that in line with what you think?


I’m in a similar camp, but we’ve been there before. Every subsequent wave of different variants has created a little bit of concern, and the economic impact has been smaller with each. But every new variant does not need to be more benign than the last. And so, I think it’s at least worthy of contemplating the fact that there is a scenario where we get a variant that does increase hospitalizations. The impact could still be with us, new variant or not, and would impact supply chains. While I would like to stop talking about COVID, there are plenty of scenarios where it’s still playing a pretty meaningful role in supply chains, and it’s going to stay in the narrative.


I would highlight it’s not just the U.S., but also emerging markets and all of our importers that we need to be concerned about. Investors need to understand that if the rest of the world is still dealing with it as a pandemic, even it’s an endemic in the U.S., that does flow through to our economy as well.


Let’s take a world where we know we’re not going to have a significant COVID strain. On one hand, you may have demand going full bore and pushing up inflation. On the other hand, supply chains may free up, pushing down inflation. How does that play?


Let’s start off the consumer. Demand is going to continue to increase. There’s certainly ample opportunity within labor to see incomes go up on a real, not just a nominal, basis. We have the excess saving stock that we mentioned. And then you also have an excess inventory for a lot of retailers, especially a lot of consumer-focused goods. So, there’ll be demand, but there’ll also be an excess supply. To me, that’s deflationary. But then we’re going to have other pockets where inflation is slower to readjust, and I think services is one of those.


The goods inflation has been absolutely enormous, and there are plenty of scenarios when we go to that endemic world that goods inflation can get back to flattish, let’s call it. Some of that will be caused by not ordering as much. Some of that will be the consumer shifting to services over goods. Even if the consumer is spending quite heavily on some goods, the unclogging of supply chains will offset the increase in demand, and inflation may come down pretty materially as we get to summer.

As much as a reduction in goods inflation and a clearing up of the supply chain would drive down the inflation rate, if wages continue to run hot because of a labor shortage, overall inflation is going to be reasonably high, and the Fed will need to respond to wage inflation.


Brian’s right that participation in the labor force is going to be a key factor to watch, especially as a leading indicator.


When people say inflation’s here to stay, I feel like I have to differentiate. Is it the rate of inflation or the prices that we’re paying now? I think we’re all in agreement the rate of inflation is expected to be lower, but do you believe prices will return back to 2019 levels or are those elevated prices here to stay?


In aggregate, it certainly feels like that level of prices are here to stay, though there will be pockets of the economy that will see prices return to 2019 levels. Many economists expect inflation will drop, not necessarily to 2%, but somewhere in that 2.5 to 3.5% range. That’s still higher inflation than the Fed wants, and that’s still inflation on top of this spike in prices that we have seen in the last couple of years.

We spent decade-plus with inflation below 2%. And if the rate of inflation is coming down pretty consistently from, call it 7 to 3%, I think the Fed is going to want to be a little bit cautious because we’ll start to have memories of what it was like to have 1.5% and not know how to get it higher. I think that’s going to be enough to give them pause and see where inflation ultimately settles because the last thing they want to do is hike rates and reduce the inflation rate back under 2% and be back in the situation that we were in pre-pandemic.


Usually at the end of these Fed cycles, there is typically some sort of calamity following the last rate hike. What causes the Fed to stop and will we be able to get a soft landing?


The general market rule of thumb is that the first rate hike doesn’t cause the issues, it’s the last one. It tends to coincide with some market event. I think the reality is that it’s generally the cumulative effect of the tightening that eventually tightens conditions to the extent that the consumer retrenches, and you start an avalanche of issues that ultimately turns into a recession.

Risk markets usually have upside when you start a Fed hike cycle with extra volatility. That works in most of the rate hiking cycles. The times that it certainly doesn’t is if the Fed needs to hike aggressively because they need to break the back of inflation. If inflation can come down naturally on its own, that is going to be the determinant on what 2022 looks like.

I think ‘22 will be volatile, but until you get to four-plus rate hikes and some reduction of the balance sheet, you’re really not going to run anywhere near tight. And I think tight becomes a ‘23 into ‘24 event, when your concerns move from too much inflation to not enough growth, and your recession probability increases.


Generally, what I’m concerned about is the quantitative-tightening portion, the balance-sheet shrinkage, because that’s not something we’ve seen really happening at the same time as we’re seeing rate hikes. So that is what makes this a more aggressive cycle than what we’ve seen before.

If liquidity was to dry up, or even if there’s the perception of liquidity drying up at a quicker pace than markets are comfortable with, that’s where I would be concerned. I would expect the impact starts in the high-yield market before the equity markets, but very quickly just spreads to equities and other asset classes.

I’m also concerned about a yield curve inversion. If the curve inverts, there’s going to be some folks who get really nervous. Now, I think it’s being artificially held down at the long end by both institutional investor flows, as well as the fact that we haven’t really started issuing as much longer dated debt as we’ll need to, in part to pay for a lot of the stimulus that has already been issued and some that will be getting issued most likely. And I hope we see a steeper yield curve for many reasons, but if it does invert on the long end, that’s another risk we need to consider.


Flexible average inflation targeting (FAIT) is a Federal Reserve strategy that seeks a rate of inflation that averages 2% over a timeframe that is not formally defined.

A yield curve inversion represents a situation in which long-term debt instruments have lower yields than short-term debt instruments of the same credit quality.

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Pacific Asset Management LLC is the sub-adviser for the Pacific Funds Fixed Income Funds. The views in this commentary are as of Feb. 8, 2022 and are presented for informational purposes only. These views should not be construed as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment. The opinions expressed herein are subject to change without notice as market and other conditions warrant. Any performance data quoted represents past performance which does not guarantee future results. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. Sector names in this commentary are provided by the Funds’ portfolio managers and could be different if provided by a third party.

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