Wall Street Series: 2022 Outlook with Citi Research 

NEW YORK FOREIGN PRESS CENTER, 799 UNITED NATIONS PLAZA, 10TH FLOOR (Virtual)  

MODERATOR:  Good afternoon and welcome to today’s New York Foreign Press Center briefing.  My name is Daphne Stavropoulos and I am today’s moderator.  It’s a pleasure to introduce our speakers from Citi Research. 

Nathan Sheets is the Global Chief Economist and Matt King is a Global Markets Strategist.  This briefing kicks off our annual Wall Street series providing our members with access to the latest from financial experts and other Wall Street analysts.  Over the next few weeks, briefers will explore various aspects of the U.S. and global economies.   

Today Mr. Sheets and Mr. King will provide their outlooks for economies and markets in 2022 covering everything from supply chains and surging inflation to tantrum risks as central banks start removing the liquidity.  This briefing is on the record and the views expressed by briefers not affiliated with the Department of State or the U.S. Government are their own and do not necessarily reflect the views of the U.S. Government or the State Department. 

If you’ve not had the opportunity to do so, please ensure your full name and media outlet appear on the screen.  You can do this by clicking on the blue button associated with your profile.  Following our speakers’ remarks, I will open the floor for questions, and if you have a question, go to the participant field and wait for me to call on you.  And when called on, please enable both your audio and your video and identify yourself by full name and your – and outlet. 

And with that, let me turn the floor over to Mr. Sheets.  Welcome again.  Thank you.  

MR SHEETS:  Well, thank you.  It’s wonderful to be with you, and very much look forward to your questions and back-and-forth. 

Let me just, from my perspective, put a few issues on the table that hopefully are of interest.  The first is last week, we published a revised global forecast.  And I think it’s fair to say that our overall global outlook is reasonably favorable.  We’re expecting global growth to proceed at roughly a 4 percent pace.  We bounced back, as you can see in these slides, pretty sharply from the depths of the downturn.  And we expect further above-trend growth through the year ahead. 

Now as I say that, the outlook is somewhat more favorable for the developed markets economies where we have the United States, the Euro area, and the UK all proceeding at kind of a 3.5 to 4.5 percent pace, which is substantially above their trend growth rates.  For Japan, the number we’ve written down is 3 percent, which is also substantially above trend.  We see the Japanese economy getting some traction toward recovery this year.  Now I should emphasize that a lot of this above-trend growth I would characterize as a recovery bounce.  It’s further recovery back to that pre-pandemic trend. 

The outlook for the emerging markets is more mixed; it’s more challenging.  They are more likely to grow at a trend kind of rate as opposed to above-trend rate, and we would – we’d see some particular challenges for Latin America in particular.  And I think in Latin America, and to a lesser extent some of the other emerging markets as well, they’re faced with the realities of tightening U.S. monetary policy and tightening global financial conditions as a result of that.  I think the global economy is going to be learning to live with the realities of slower Chinese growth and a slower pace of expansion of Chinese demand for commodities and other kinds of imports.  And then in addition in Latin America, to a lesser extent in Central and Eastern Europe, we’ve seen central banks respond to inflationary pressures by hiking rates, and those rate hikes are a source of headwinds for the economy as well.   

So the picture for the emerging markets in the year ahead is more mixed than what we see for the developed markets.   

Now the big theme we focus on in this outlook is inflation.  I think that is the framing thought and the framing challenge for the global economy and central banks through the year ahead.  We are, I would say, cautiously optimistic that we’re going to see some progress on inflation, but in order for that progress to be recorded, some things are going to have to happen.  One is we need to see further progress on the pandemic, and maybe some of that is a result of global vaccinations.  More of it may be a result of learning to manage the pandemic more effectively than we did previously, and so that the impact – cases and so forth – on spending and production is less intense.  A progress – further progress on the pandemic will also be helpful critically in bringing down inflation, in that the key driver of inflation that we’ve seen globally has been very strong goods demand.  And as we made progress with managing the pandemic, that should open the door to rebalancing back to services and help take some of the pressure off goods prices.   

Another factor that I think we need to see in order to make progress on inflation is we need some further moderation in pressures from global supply chains.  And we see kind of these stresses the global supply chains have experienced as being an ongoing challenging development for them. But we do see gradual improvement through this year.  Over the next three or four months, some improvements in shipping logistics – we can talk more about that if you have questions – and then as we move into the backside of the year, more fundamental rebalancing and improvements in semiconductors and autos and so forth.  But there’s still a lot of work to be done on inflation, which means that central banks are likely going to need to continue to be active.  We saw that start, as I mentioned, in 2021.  

Now, let me just conclude with just a couple of minutes specifically on the Fed and what Jay Powell presented in his press conference in the FOMC meeting this week.  In some sense, I think this was Jay Powell standing up and saying the Federal Reserve is prepared to do whatever it takes to fight inflation, that fighting inflation for the Federal Reserve is now job one.  And that means that policy is going to have to be tighter than what we thought was imaginable even three or four months ago.   

Now, the Fed – another way to frame this is the Fed is dramatically behind the curve.  Just think about this.  You got 7 percent inflation, 3.9 percent unemployment – so below what they think of as the normal rate over the medium term.  They’ve got solid economic growth and the rate is still – the policy rate is still at zero and they’re still buying assets.  So this is significantly behind the curve.  Why are they so far behind the curve?  It’s the same reason why markets have been so surprised by the pivot from the Fed.  We’re moving from a world that we were familiar with for the 10 years before the pandemic of low inflation.  We moved into another world where inflation is higher, and the Fed is shifting gears and preparing to fight it.   

It’s almost as if Jay Powell at his press conference was saying:  You know that chap that was up here talking to you last year, forget about him.  I’m a new Jay Powell.  I have – I’ve had a personality transformation, and now I’m Jay Powell, the hawkish twin of that chap that was talking to you last year.   

Bottom line here, Fed’s going to be hiking rates.  How much the Fed hikes rates will depend on how rapidly inflation comes down.  If inflation is on a path to get back to 3 precent and some of these positive developments I described are actually kicking in, then I think that the Fed can do 4-ish this year and 4-ish next year.  But if inflation proves to be somewhat more stubborn, which is a very significant risk, then the Fed’s going to have to move more frequently.  And what “more frequently” looks like I think is an open issue, but I think at a minimum it’s fair to say every meeting is going to be live, meaning they will be considering the option of hiking rates at every meeting for the foreseeable future.  And they will also be, as the year progresses, reducing the size of their balance sheet.  So I think that this – these challenges with inflation and the Fed’s response and central banks’ response more broadly kind of frames the challenges that the markets are facing.   

And with that, let me pass the baton to my good friend and colleague Matt King. 

MR KING:  Oh, as – that works very neatly because in a funny way, maybe one of the things that will actually determine the nature of the Fed’s response, and indeed ultimately the outlook for inflation, is the response in markets.  And I think as I think about the outlook for markets here, one of the most interesting features is the way in which it interacts so deeply with the question of the outlook for the economy.  And really, we end up asking quite deep and fundamental questions about which is driving which.  Is it the market – the economy driving markets, as you conventionally think, or markets driving the economy?  And I think coming into this year, most people’s main question was we began already then to see that the Fed was going to have to tighten more aggressively, accelerate the pace of tapering.  And coming into the year, everyone was saying, well, where are the tantrums?  I had a presentation last year that said if they really do focus on inflation, there will be tantrums in credits and equities.  But if they fail to do so, the risk is they get tantrums in the bond market.  And until very recently, we didn’t have too much of either.  

And now, even as you start to see a correction in the equity market, my impression is that people are still really quite divided on this.  And there are two very different views you can take, and one view basically says, don’t worry, it’s largely priced in.  If inflation slows as some of the supply chain problems sort themselves out and the Fed doesn’t have to be too aggressive beyond what’s priced in, maybe everything will be okay because we’ve discounted it ahead of time.  

And that’s kind of the conventional – what I might call the conventional economic view.  And indeed, I’d say that view also tends to say that there’s almost too much liquidity sloshing around already, there’s too much stimulus because the level of rates is very low, the level of real yields is very low.  And in a conventional view that should be really important, primarily as a driver of the economy, but maybe also as a driver of markets.  

There is, though, an alternative view, which I’m much closer to, that actually says markets, over the last decade in particular and maybe longer still, have been overwhelmingly driven not by fundamentals – they’re not just reflecting the economy – but by flows of liquidity, by flows of money creation.  And if that view is correct, then actually the main driver of markets risks not being this conceivable overheating in the economy as real yields remain low and there’s too much stimulus floating around.  I think if I was just thinking about the economy, I would probably share that view and would tend to think that inflation would remain a little bit sticky and elevated.   

But all the work that I’ve done over the last decade or so really points to markets not following fundamentals, markets being driven by liquidity flows, and those liquidity flows coming directly from central banks.  And for me, this has shown up in the extraordinary valuations that we’ve had in things like the tech sector – and yes, some of that is due to corporate profits, and again, we had Apple earnings just recently, and yes, they’re amazingly good.  But so much of the market valuation has been a re-rating driven by this wave of liquidity which has come ultimately from central banks.  

And for me, this is why there are so many odd correlations in markets between Bitcoin on the one hand and Tesla on the other.  And indeed, what I’d say as a market strategist is over the last decade, all my favorite fundamental relationships have broken down, and what has taken over is basically QE.  And as I look at the – and it’s global QE, not just U.S. QE, that matters – and what we’ve seen consistently there is that markets have struggled to price in the effects ahead of time.  It’s only as you – as the liquidity is hitting the market or is not hitting the market that actually the market seems capable of responding.  

And if that’s the right framework, and I think it is, then actually, markets remain vulnerable as the Fed is forced towards its QT, and risk assets in particular end up vulnerable.  And some of this was visible already in a narrowing of the equity market rally that we had been seeing beforehand.  And this is a real complication when it comes to the Fed thinking about the outlook.  And as I said, it’s a bit like politics at the moment.  There are these two sides, and neither side understands the other.   

One view is there’s too much stimulus.  We will again see the “you should buy the dip,” and although there had been a slowdown in inflows to credit and equity funds even before there was much of a move up in real yields – one view would say maybe that rebound is going to continue – the view I’m closer to is one that looks at the long term and says, actually, it’s taken an ever-lower level of real yields, an ever-larger amount of stimulus, to persuade investors to keep buying at ever more elevated valuations.  And whenever the central banks have tried to slow down their inflows of liquidity, actually markets have ended up vulnerable.  

And so as I look at things, I’m much more reluctant to chase the markets higher and to buy the dip than most of the other strategists at Citi.  I’m much more conscious of flows of global liquidity, global money creation.  Also, China becomes important in this respect.  And many of those have been going in the wrong direction.  And effectively, for me the flattening of the yield curve that many people are puzzled about is not only right but it sends a warning signal for risk assets like equities here.  

And so just, again, summarizing – and I’m conscious I’ve gone quite quickly over probably a decade’s work – as I say, if you believe that it’s all about the level of stimulus and it’s about markets following fundamentals, and you think there’s too much liquidity in markets – and that’s where most of the Citi house view is – then actually you’re still probably bullish.  You want to buy the dip.  You think yield curves should be steeper.  And you don’t really understand why yields are as low as they are despite all of the inflation pressure in the system.  

But if, like me, actually you think it’s flows of liquidity that have been driving markets, and it will be very difficult to slow down those flows of liquidity without a correction in markets, then you’re much more worried about a sort of 2018-style correction.  You think that markets are well ahead of the economy in terms of the cycle, and in that context, actually you’re probably to biased to think that the yield curve flattening may continue and that nominal yield levels don’t get as high as people might have expected from the fundamental economic picture.   

And as I say, these things take you to a very different point, but this is the debate that we are having with many investors in the global outlook.  And to my mind, again, both the economic outlook and the markets outlook are much more deeply intertwined than I think is widely recognized because there is the risk, as in 2018, that if the market correction becomes more severe, at some point it does create a threat to the outlook.  And yet, given the inflation pressures that are ongoing, it will be much harder for the Fed to respond to it. 

So with that, let me stop the slideshow, and we are both at your disposal for questions.  And I actually have lots more slides and other material from multiple different presentations which I may try and pull up, depending on which issues you’d like us to focus on. 

MODERATOR:  Thank you so much for those opening remarks.  You’ve given us a lot to think about.  And if – I’ll open the floor for questions.  If a journalist has a question, please raise your virtual hand and wait for me to call on you.  Otherwise you can also submit your question in the chat function. 

Okay, our first question will go to Alex.  Alex, please introduce yourself and your outlet. 

QUESTION:  Thank you, Daphne.  This is Alex Raufoglu from Turan News Agency of Azerbaijan, and thanks to both of the speakers for a very timely presentation. 

As you know, IMF this week warned of “multiple challenges,” quote-unquote, to global economic recovery as China and the U.S. outlooks downgraded amid concerns over higher inflation.  Do you expect inflation to rise further than, let’s say, 5 percent globally for the next couple of months?  And what level do you expect at the end of the year? 

And one last question to the elephant in the room, the geopolitical crisis in Ukraine these days due to possible Russian military offensive:  Do you see any side effects to the global economy should the situation in Eastern Europe deteriorate further?  Thanks so much again. 

MR SHEETS:  On the global inflation outlook, as you can see, our sense is that inflation remains a challenge this year but is more on a downward rather than an upward trajectory.  And specifically, at the end of 2022 we’re at 3.9 percent by our global – our global index.  The rudiments of our view are, one, we expect some approval in supply chains, and I touched on some of that in my opening remarks, and I can go into more detail if there’s interest; two, our sense is that commodity prices are likely to come off the boil this year.  Specifically, we see improving both supply and demand conditions for energy, and that’s likely to be very helpful, again, in supporting a decline in inflation. 

For other commodities, it’s more like they move sideways.  But the implication of that for inflation is if commodities move sideways, that means that on a year-over-year or a month-over-month basis, they’re zeroes rather than big positive numbers, so their contributions to inflation will be much reduced.  So commodities are a second factor that’s important. 

And then, as we’ve discussed, I think a third factor that’s likely to be in play here is the central bank tightening that we’ve discussed.  And I think that in a number of key countries, including the United States, a number in Latin America, some in Europe, we’re going to see central banks hike rates, and that should also help contain the inflationary pressures. 

Now, how confident am I about all of this?  I’m pretty nervous, and I think the risks are skewed to the upside.  And what the reality is – we were surprised by inflation last year.  And to say that all the inflation surprises are behind us – that may be true, but I’m going to pay careful attention to it.  And specifically in response to your question, could things get worse before they get better, I think that is a risk.  So we’re watching this closely, but we’re guardedly optimistic about it. 

MR KING:  And maybe the only thing I would add on that front is conventionally, when we think of Russia/Ukraine or geopolitical risks, markets often don’t handle these sorts of geopolitical risks very well.  They find it difficult to price in an appropriate risk premium ahead of time.  And even if the risks materialize, often conventionally we might think of it through things like oil prices.  I mean, if there’s a further spike in oil prices, again, what is the knock-on effect and which are the exposed sectors and so on?   

The only complication at the moment is the conundrum that central banks are facing with inflation generally.  And normally, if it were deemed just to be oil prices and just to be a temporary factor, they would do their best to look through it.  But of course, all of that is more complicated than usual, and likewise, again, given the potential for markets suddenly to be a little bit more vulnerable in the first place, anything that adds to the impression that central banks are behind the curve and going to have to tighten more again risks having a larger effect than you might have anticipated on fundamental grounds alone.  

MR SHEETS:  Just following up on what Matt said, which is critical, I think, that the Federal Reserve has broadly followed a policy where it looks through headline inflation into the core.  But I think that consistent with what he was suggesting, that headline – particularly headline CPI inflation in the United States – got so high first late last year with six handles (ph), and now at a 7 percent reading, that the Fed couldn’t look through it anymore.  And I think that the way Matt framed that, that as you have any further adverse shocks, central banks now are in a place where they have to move more aggressively to defend their credibility, and it’s more difficult to look through even while it might be a temporary shock to the system.  I think that’s a very trenchant point that he was making.   

MODERATOR:  Thank you so much.  The next question will go to Niki.  Niki, please, introduce yourself and your outlet. 

QUESTION:  Sure.  Can you hear me? 

MR SHEETS:  Yep.  

QUESTION:  Okay.  Hi, I’m Nikhila Natarajan from Indo-Asian News Service, which is headquartered in India, but I am here in the U.S.  Several things that I was smiling as Matt was presenting his slides, and he said this is like 10 years of work.  There was a lot to unpack there.  There’s a particular slide, if you could go back to it – the bitcoin and Tesla going together.  There was a red and blue line, if you can find that.  What’s going on there is a question.  If you could, like, detail that a little more, that’ll be great.   

One more thought.  It’s not a question really.  I mean, whether it’s the Fed or it’s regulators in any other field, whether it’s the FTC, regulators are playing catchup with industry and with markets and with trends.  Like, we saw inflation coming at the gas – at the gas station far before the Fed reacted to it, right?  So given that and given how you’re talking about Powell taking on a completely different aura now or persona, given all of these forces, what does that tell you about the shape of – the shape this is going to take?  What – how are you – what kind of personas are you taking on as analysts, which is slightly different from what you used to do earlier, based on the fact that regulators aren’t keeping up with the market no matter which industry?  Yeah.   

MR KING:  Interesting.  So let me – I’ve got lots to say on this, but I’ll try and do it concisely.  So – and I’m going to be using some older slides, not all of which are completely up-to-date.   

So for me as an analyst or strategist, something interesting has happened in the QE era over the last decade, where all my favorite fundamental relationships broke down – companies levered up but spreads tightened in; people got more bearish on earnings and the market – equities didn’t sell off, they rallied; there was lots of uncertainty but not very much volatility.  And rather than there being just one price that included all the available information, it’s almost as though if you just looked at fundamentals, you would have sold everything because the market was too expensive and you would have underperformed horribly.  And instead, as analysts or as investors, we’ve ended up focusing more and more on what we think has been driving markets, and that has come down to different measures of – you can call it the wall of money, you can call it global liquidity, you can call it reach for yield.   

But it’s been a very momentum-driven sort of investing, and I think for many investors that’s created a difficult environment.  And simple mean-reversing patterns where you would buy when it was cheap and sell when it was expensive, that hasn’t worked at all.  Instead, in many cases, people have had to carry on buying as markets have gone upwards.  And so this has led to big differences in how certainly I do research.  In 2000, I was focused on corporate balance sheets.  In 2007 and 2008, I was focused on broker dealers.  But over the last decade, I’ve just been focused overwhelmingly on central bank liquidity and QE because that’s explained markets more than anything else.   

And so for me, the sort of underlying – and this relates in terms of the inflation question and the way that central banks deal with the inflation question.  And so this sort of the whole interesting thing for me in the outlook is the way that you can’t just do what we would normally do, which is say here’s where we are in the cycle and here’s how to invest.  You get all these deep secular questions around inflation and how it works and whether we’ve turned the corner.  And roughly – these ones are not fully up to date, but for a decade or more the central banks have almost been trying to create inflation and until recently were disappointed that they couldn’t.  And they’ve looked back generally and said our policy was too tight, we should have had easier policy, because CPI fell short. 

But there’s another story which I’m much closer to, which is that if you take a slightly broader definition of inflation, you may not have been getting CPI inflation but you were getting asset price inflation, you were getting house price inflation, you were getting equity price inflation, as the flow of liquidity created or X or money growth or credit growth and more recently QE for an extended period was propping up asset prices and causing them to deviate from fundamentals.  And for me it’s that which is behind things like the Tesla-Bitcoin relationship.  Yes, we might try and invoke individual transformational prospects for the auto sector or money finding its way into Bitcoin, but in essence this is a central bank technical that has been driving markets across the board.   

And as I say, the temptation – now the central banks are seeing also CPI inflation and realizing they need to reduce it somewhat.  But for an extended period they would look at this bubble risk in markets, let’s say, or what I might have considered bubble risk in markets, and they would say we don’t see bubbles, and if there were bubbles we would use macro prudential or other tools to deal with them.  And I for a long time have been tempted to say the real purpose of a central bank is to protect the purchasing power of the dollar in my pocket, and you’ve created this odd world where everyone can afford to buy a loaf of bread but actually we can’t afford to buy real estate and we definitely can’t afford a pension, and therefore again, and then in addition, pushing asset prices up and up and up has contributed to inequality and then potentially to political polarization and other things.   

And so you see what I mean.  There’s the whole deep debate there as to the way central banks have responded and whether that’s been – and roughly where that leaves us now is I think we would all agree that they were right to step in with extraordinary amounts of QE and fiscal support in 2020, but conceivably they should have been faster to withdraw that in 2021 when it became clear that the economy was overheating, and at least with hindsight I think you can make a case that maybe they contributed more to asset price bubbles in the previous decades than they themselves would like to recognize.  Sorry, long answer. 

QUESTION:  Yeah, no.  Thank you so much.   

MR KING:  Nathan, you need to unmute.  Nathan was going to comment as well. 

QUESTION:  Yes.  There’s just one thing that I wanted to add before Nathan jumps in.  So essentially what I’m hearing you say is as analysts and researchers, you’re moving towards a place where you think about, okay, given that central banks will not move in in time, or given that regulation usually takes time to catch up, this is what has happened?  You showed us the house price graphs, the four of them.  And based on that, this is how our research will shift, let’s say, from corporate balance sheets to QE, right?  But broadly that’s what you’re saying? 

MR KING:  Our research has shifted according to whatever we think is driving the markets.   

QUESTION:  Correct. 

MR KING:  But increasingly that has focused almost in an unhealthy fashion on central banks and their response function.  I think for them the debate is – the broader debate is really should they be what the BIS would call leaning against the wind, which historically they’ve not liked to do, or should they – and maybe continue to provide downside protection but facilitate some form of long, slow deleveraging; can they act as a backstop but be more cautious about inflating bubbles.  And that is the way that some central banks seem to be going.   

Or what the U.S. has been doing generally until very recently is, to my mind, very supportive in the near term with larger and larger amounts of stimulus, but with a risk of the boom turning to a bust as there’s more and more debt in the system and some of the political pressures and the inequality and so on are exacerbated.  So you’re starting to have these deep, existential questions almost about the purpose of central banks. 

Sorry, Nathan. 

MR SHEETS:  No, that’s very interesting.  I was just thinking about your question from a completely different perspective, and that is I spent over 20 years in the public sector at the Federal Reserve and the U.S. Treasury and thinking about, well, why is it that regulators often seem as if they’re behind the curve.  And I think the challenge is – and we saw this with the Federal Reserve over the last year or so – is that you enter these episodes with an intellectual framework.  This is how we’re thinking about the world.  And then what happens?  Well, you can think about gradual change and you kind of see these events kind of percolating around you.  And that’s a little bit like what we had last year, where we started to see some inflation, but we had this other intellectual perspective that said inflation is not a problem, it’s going to go away.  And we made an argument that it was going to be transitory, and it seemed quite compelling at the time.   

So when the world changes, it doesn’t come with a big sign that says “new regime.”  And so the central banks and the regulators – and you can make similar kinds of arguments about regulating the financial system – are stuck responding once there’s a critical mass of evidence.  But once there’s a critical mass of evidence, it may be too late, and you’re trying to catch up.  I think the implication of all of this for policy means that over the next couple of years the Federal Reserve is going to have to be more aggressive.  And I think that they’re way off the curve – way behind the curve.  They’re going to have to move aggressively to try to catch up.  And so I think that that’s sort of where we are.  It’s making up for lost ground going forward is the implication of your observation that it also often feels like they’re lagging.   

QUESTION:  Thank you, Nathan.  Thank you, Matt.  Whenever you have a moment – I don’t want to interrupt – I just wanted to know how recent that graph is, theory versus practice, the boom or bust graph that you showed just now.   

MR KING:  That was a — 

QUESTION:  Fundamentals, theory, practice.  

MR KING:  That presentation was from 2015 or 2016, but I still stand by it.   

QUESTION:  Yeah, sure.  Thank you. 

MODERATOR:  Thank you so much.  Let’s move on.  We have a few other journalists with questions.  The next question will go to Ines.  Ines, can you enable your audio and video? 

QUESTION:  Yeah, hi.  It’s Ines Zoettl Germany magazine Capital.  I have two questions on U.S. inflation.  One is going to the past and one into the future.  The first one is:  To what extent would you say fiscal policy has contributed to the inflationary pressures?  I think there’s a debate about that going on.  And the next question is:  Do you see any emerging price-wage spirals?  Or is there no danger of that right now?  Thank you.   

MR SHEETS:  On your first question, I think it’s pretty clear in retrospect that the combination of the 900 billion of stimulus in late 2020, coupled with 1.8-1.9 trillion that was approved in March of last year, was larger than was necessary to ensure recovery.  Now, as I say that, I say that with the benefit of 20/20 hindsight, and we don’t have that luxury as policy is being set.  And I think the part of what was being done through that period people thought of as an insurance policy.   

And I think that this inflation that we’re seeing is in part paying the premium of the insurance we took out, that we didn’t want a further downturn, we didn’t want a disruption in demand, and we put in an enormous amount of fiscal stimulus.  And in retrospect, demand is overshot in the economy, particularly goods demand, and inflation I think is a notch more challenging than it would be otherwise.  But by the same token, the economy’s growing smoothly, and if the Fed is able to extinguish this inflation, in the fullness of time we may say, well, that was still – insurance is worthwhile.  But it’s tricky at the moment.  

On your second question about wage-price spirals, I think that this is a significant risk.  And let me frame it out the following way:  Part of the solution we need to bring down inflation is the pandemic to improve and for there to be a rebalancing from goods expenditure into services.  As there’s a reduced pace of growth in goods, that should allow goods inflation to moderate.  But what about services?  As we have rising demand for services, where are the hotels, the restaurants, the theaters, and so forth?  Where are they going to get the labor that they need in this relatively tight labor market?  And could we actually see a second round of services-driven inflation that might have this feature of wage-price spiral?  And I think the answer is yes.  And adjustment in services and potential overheating and wage-price spirals is a concrete upside risk that I’m watching for closely, and I’m confident that the Federal Reserve is watching for.  

The final point I would make here is a little more encouraging, and that is to date we have seen some wage increases, including the data in the ECI that was released this morning.  But my reading about those compensation and wage data is it’s essentially workers trying to catch up to inflation.  It’s workers seeking to keep their real wage constant and minimize the damage to their real wages.  It doesn’t feel like the workers are saying, well, inflation was up 7 in 2021 and I think it’s going to be up another 6 in 2022, ergo I demand 13, 15 percent wage gains.  And that would be more the wage-price spiral where it’s being extrapolated forward, and it doesn’t seem like we have that dynamic.  But I believe it’s a risk in the year ahead particularly that could arise from services sector adjustment. 

QUESTION:  All right, thanks. 

MODERATOR:  Thank you.  So let’s go to Takenori next. 

QUESTION:  Hi, can you hear me? 

MODERATOR:  Yes. 

QUESTION:  Okay.  Thank you for taking the time – taking a question.  So I have questions each for Matt and Nathan. 

So the first question is for Matt.  So there are other tech companies announcing their earnings right now.  So Netflix was sold after the result – earning result.  But also – but on the other hand, Microsoft and Apple were bought.  So why there is a difference in the reaction of the stock after earnings? 

And also I’d like to ask your opinion on the software company such as Adobe or Salesforce.  So their stock price has been dropped considerably since December, so can you tell me why software companies are selling so much? 

MR KING:  So I’m not going to be very good on the individual stocks, and we have tech analysts who are much better on this than me, but I can maybe make some general observations which may conceivably help a little bit with these questions. 

So one of – there are several factors.  So one of the things that has meant that for an extended period not only has the market been getting excited about software companies, but also until recently why inflation was not showing up, is just this big shift in corporate investment away from traditional structures and equipment and old-economy sectors towards improving your website, towards improving your brand.  And the scalability that comes with software again has been tremendously attractive.  I like to say Microsoft can sell a billion copies of Windows over the cloud for the same cost as selling a thousand copies of Windows over the cloud.  And that’s very different from traditional, old-economy sectors. 

And as real interest rates have gone lower and lower, so that has encouraged this whole emphasis on the tremendous opportunity from the tech sector.  And similarly under lockdown initially with the impact of the virus, you saw this enthusiasm not only for Netflix and other stay-at-home companies but also for stocks like Tesla and so on as well, and you get these remarkable comparisons in overall market values. 

At the same time, I think that both in the response then and the response now, you need to look a bit – and certainly at an aggregate level, you need to look more deeply.  What I find shocking, say, is not the idea that a transformation of the auto sector means that Tesla can gain market share from everybody else or Netflix can gain market share from – relative to traditional television companies.   

But instead, what you see here when we look at the market capitalization of the sector as a whole, it’s that it doubled.  And so effectively it’s just – well, it’s not just saying there is an amazing transformation and therefore there can be a shift in market share.  It’s the market saying, oh, the whole global auto sector is worth twice what we thought previously.  And similarly, the whole tech sector is worth, again, multiples of what we thought previously.   

And for me it’s that across names, that re-rating that we’ve seen.  Again, we’re not saying that Apple is not a tremendously profitable company.  It clearly is.  But the debate – and then that’s been fueled further by things like share buybacks.  But the debate then comes not only mostly on how much you are then supposed to re-rate that potential.  And I think for all of that tech sector that is increasingly in question and risks being questioned more if real yields in the bond market rise.   

So as I say, I’m really not very good on the individual stocks.  We can get you better answers from the individual stock analysts.  But from a big picture perspective, that’s how I think of it.   

QUESTION:  Thank you so much.  And next I have a question for Nathan.  So we see the bear flattening of U.S. Treasury yield curve now, so do you think the market concern about the risk of – the risk the Fed will fail in the future?  So could – I want to know your opinion. 

MR KING:  And I can comment on this as well if you want, Nathan, but you go first. 

MR SHEETS:  Yeah.  And you said risk that the Fed will fail? 

QUESTION:  Yes.  

MR SHEETS:  Fail to bring inflation down?  Is that —  

QUESTION:  Mm-hmm.  So yes, I want to know your opinions of the bear flattening of the U.S. Treasury yield.  So this means that the market concern about this caused a Fed failure? 

MR SHEETS:  Yeah, yeah.  So for me, maybe the most interesting issue in the bond market and in the financial markets more broadly – and this is something that I think it’s fair to say that both Matt and I will have views on – is what’s going on with the 10-year Treasury yield or, if you prefer, in the back end of the curve.  My feeling is that there are a large group of investors who have the view that the post-pandemic economy is likely to be broadly similar to the pre-pandemic economy, meaning low growth, limited inflation, inadequate aggregate demand, and hence low rates.   

And these folks also believe that as a result of that, kind of the equilibrium – Fed funds rate, the r-star – is very low, and as the Fed starts hiking, it’s likely to hit a place where it creates headwinds for the economy more rapidly than what the Fed is expecting.  And I think that the back end of the yield curve is saying the Fed’s not going to be able to go very far, and if the Fed does go that far there is a good chance that we’re going to have a recession.  Another way to put it is that there is a good chance the Fed makes a policy mistake. 

And how all of this shakes out, is that view in the bond market correct?  What does the medium-term Fed funds rate look like?  Is the bond market right or is the Fed right?  Or alternatively, in several years when we’re beyond this cycle, is the 10-year Treasury yield back to having a one handle or is it substantially higher?  And I think that that is – that is real – a real tension. 

As to where I personally fall in this debate, I think that the – we ought to seek to learn lessons from history.  And my view as a macro economist is the last 10 years we had inadequate aggregate demand in the global economy, inadequate nominal demand.  I don’t see where it’s going to be coming from and it’s debatable, but I don’t see where it’s going to be coming from over the medium term.  

So I see a case for a world where rates are historically low.  And whether that means upper one handles, low two handles, you can debate.  But I think it behooves the Fed to think hard about what message it’s hearing from the bond market.   

MR KING:  And the only thing I’d add to that, but I do think it’s important, is this link back to markets.  If I was just thinking about neutral for the economy, if I could be sure that the Fed could withdraw stimulus and there wouldn’t be a big selloff in equities and eventually real estate, then maybe I would believe that neutral rates had moved up.  But what’s ended the last few expansions is actually not overheating of the economy.  It’s markets giving way and then dragging the economy down.  And each times it’s happened at a lower level of real interest rates, each time it’s happened with more debt in the system.  Now there is more debt still and my guess is that what we’re seeing in markets already this year is the beginnings of the vulnerability – again, longer for what you might have expected it in the economy in isolation, but with the risk that as in 2018 to ’19 it feeds through into the economy.  And that’s where, again, I think there are sort of two ways of thinking about markets and about the low level of yields in the long end.  Many probably U.S. investors I speak to would tend to think, oh, we really don’t understand the low level of non-dated yields and the long end, maybe it’s just a technical associated with pension funds rebalancing out of equities or something like that.  But at this level of inflation and with this level of momentum in the economy, there should be a big backup.  And that’s behind many people’s views, including to some extent Citi’s own rate strategists’ views.   

But actually, if you buy into partly some of the secular stagnation themes that Nathan was referring to, but in particular this way in which flows of liquidity have pushed up markets and markets have become dependent on liquidity, for me those – and the way that the overhang of debt is in itself disinflationary because of the way it’s gone into asset prices and it always feels mildly inflationary when asset prices are going up, but then that pressure disappears when markets are selling off, then there’s a much more fundamental constraint that once the cyclical inflation pressure is dealt with it’s liable to bring us back down to even lower yields.  And certainly when I speak to Asian or Japanese investors, that’s the view that I have and that I think many of them share, and it’s just very different from that whole – from that whole more U.S. and maybe more traditionally economic view in a sense.   

QUESTION:  Thank you so much.  I appreciate it. 

MODERATOR:  Thank you so much.  We’re at the top of the hour again.  I want to be respectful of your time.  We have several questions that were submitted in advance.  Could we go to one of those questions before we let you gentlemen leave? 

MR KING:  Yes, of course.  And/or we can email people afterwards. 

MODERATOR:  Perfect.  Why don’t we do one and then I will follow up with my contact in your communications department if that’s okay with you. 

The question was submitted by Mariana Sanches from BBC News Brazil, and she is asking:  “What are the prospects for the Brazilian economy and the expectations over the electoral process in the country in 2022?”   

MR SHEETS:  I’ve touched on this a little bit in my – in my overview.  A word that I think is appropriate for the challenges that Brazil is facing is stagflation.  Inflation is currently running around 10 percent, and the economy’s performance has been – has been very soft.  And I think that the outlook for the year ahead remains quite, quite, quite rough and challenging.  Fed rate hikes – and as we’ve discussed, they could be fairly vigorous rate hikes – are likely to put pressure on global liquidity, with implications for the Brazilian economy.  I think that Brazil is likely to feel some headwinds from the new realities of Chinese growth.  We’re certainly not expecting disruptions from the Chinese economy this year, but it’s going to grow more slowly than it did before the pandemic.  And in addition to these global factors, the central bank is very much in play and has been hiking rates, and we expect substantial further rate hikes during – at least during the first half of the year.   

So putting that all together, it will be challenging.  I think over the medium to long run, I think the Brazilian economy has enormous capacity and potential.  And I’ve seen cycles where Brazil has grown very rapidly, and I would be hopeful that over time we’d see the economy return to those rapid growth rates. 

The election, I think, is characterized by significant uncertainties.  It’s likely to be a contributor to volatility going forward.  And I think the frame is – you think about some of the various scenarios that could eventuate – there’s a lot of difference if you have Bolsonaro reelected versus Lula being elected.  And if it’s Lula, there’s even a frame of uncertainties about what kind of policies he’s going to pursue.  His rhetoric might make one think that they’d be more radically left; his track record when he was in before was more of a moderate.  And if it’s Lula, which one of the Lulas will take office I think is an open issue.  And these are uncertainties and questions that I think markets are going to be struggling with as they think about the implications of this upcoming election. 

MODERATOR:  Well, I appreciate both of your time this afternoon, and Mr. King, this evening from London.  Thank you for participating.  It was great to see both of you.  This concludes today’s briefing.  It was on the record.  I will share the transcript as soon as it is available.  Thank you for participating, and with that, have a good afternoon and evening.   

MR KING:  My pleasure.  Thank you. 

MR SHEETS:  Bye-bye.   

MODERATOR:  Bye.