Outlook: 3rd quarter 2022

Economy

After strong growth in 2021, the economy is decelerating, and the risk of a recession has increased. A dramatic reversal in the Federal Reserve’s policy, which now includes rate hikes and a reduction in the size of their balance sheet, coupled with an end to the government’s COVID-19 related stimulus programs, has tightened economic conditions. At the same time, inflation remains at the highest level since the early 1980s driven by the prior year’s government stimulus programs, ongoing supply chain issues, and the war in Ukraine.

Evidence of the deceleration can be seen in the economic data. Last year the economy expanded at a robust pace of 5.7 percent and in January consensus expectations called for 3.0 percent growth this year. However, the outlook has deteriorated. It now appears we are on track for an increase in the 1.0 percent to 1.5 percent range and the risk of an economic contraction is rising.

In response to today’s high inflation, the Federal Reserve is expected to raise the overnight borrowing rate from its current level of 1.75 percent to approximately 3.50 percent by the end of the year. They are also tightening financial conditions by allowing almost $50 billion worth of bonds to roll off their balance sheet each month with an increase to $95 billion in September.  This dramatic reversal in policy is intended to lower inflation by reducing the demand for goods and services. However, it also raises the risk of a recession as it will be difficult for our central bank to reduce demand without generating significantly weaker economic conditions.

Inflation

The Consumer Price Index increased at an annual rate of 9.1 percent in June and came in ahead of the consensus estimate. The price increases were broadly based, with significant upward moves across the energy, food, auto, and service-related industries.

There are a few indicators that suggest inflation rates are reaching a plateau, but we expect price levels to remain elevated in the coming months as the reversal in monetary policy takes time to work through the system. Furthermore, central bank policies will not impact the supply related drivers of inflation such as the rise in commodity prices from the war in Ukraine or the COVID-19 induced supply chain issues.

U.S. dollar

The U.S. dollar has been unusually strong this year and has appreciated significantly against most major currencies. The dramatic increase in interest rates in the United States, coupled with heightened uncertainty about the global outlook and the war in Ukraine, continue to generate persistent demand for our currency. Looking forward, we expect the U.S. dollar to remain elevated as the recent drivers remain intact.

Asset class

Cash/Money Market Instruments

The 9.1 percent increase in the Consumer Price Index not only exceeded expectations but raised doubts about the narrative that inflation has peaked. That figure marks a 40-year high in inflation and was a key driver in the Federal Reserve’s decision to raise interest rates by 75 basis points on June 15th, despite their initial guidance for an increase of half of one percent. Following that change in policy, the new target rate is between 1.50 and 1.75 percent.

The Federal Reserve has a dual mandate to promote price stability and to generate stable economic growth. However, in recent months, the Federal Reserve has made it clear that fighting inflation is their number one priority and expectations for additional rate hikes have increased dramatically. At the end of June, market expectations for the year-end Federal Funds Rate stood at 3.4 percent, up from 2.7percent in May.

Intermediate Government/Credit Bonds

The bond market has recently adopted a negative tone with fears of both an economic contraction and persistently high inflation. For most of this year, concerns about inflation have been the focus for the market. As inflation fears increased, the yield on the ten-year U.S. Treasury rose in tandem, peaking at 3.47 percent during the middle of June. However, within the span of a week worries of an economic contraction superseded inflationary concerns and the yield on the ten-year bond fell to 3.09 percent.  We expect this type of volatility to persist until there is more clarity on the long-term trajectory of inflation rates.

Reflective of the higher level of concern about a recession, credit spreads for both investment grade and high yield bonds have widened and approximate the highest levels we have seen in 2022. However, spreads remain substantially below the levels seen during the height of the pandemic or during other episodes of sharp economic contractions. This suggests that the current level of stress in corporate finances remains relatively low, although there is risk to a further widening of credit spreads through the year.

Tax-Exempt Municipal Bonds

The municipal market saw historic outflows in the first six months of 2022. This selling pressure resulted in improved valuations as municipal bond yields have increased between 100 to 200 basis points across the maturity spectrum since the beginning of the year. Volatility often creates opportunities, and this year is no exception. For investors in the top tax brackets these yields and valuations, relative to other fixed income alternatives, have not existed for several years. Demand may strengthen over the summer months as principal and interest payments often exceed new issuance throughout the June-August period.

U.S. Equity

Last quarter we officially entered a bear market with the S&P 500 Index falling more than 20 percent from its high. While there are many factors affecting equities, the losses were primarily driven by the persistence of high inflation and the expectation that the Federal Reserve will be required to raise interest rates significantly to get it under control. While some elements of the economy are healthy today, many leading indicators are suggesting that growth is slowing, and the Federal Reserve’s tightening policy is expected to lead to a meaningful deceleration.

On a positive note, valuations have declined significantly from their recent peak. A little more than a year ago, equity valuations were close to historical highs with the forward price-to-earnings ratio at almost 23x. However, earnings growth has been robust and equity prices have declined. That combination has brought valuations close to the historical norm, at 16x.

Looking forward, we expect the equity market to remain volatile, characterized by additional selloffs and relief rallies. The process of reducing inflation will take time and the Federal Reserve is providing guidance that suggests they will engage in a series of rate hikes in the coming months. At the same time, ongoing concerns about the war in Ukraine, government policies surrounding COVID-19 related lockdowns, the potential for slowing earnings growth, and widespread concern about an eventual recession, has resulted in a lot of bad news being priced into the market. Given these dynamics, we expect a continuation of today’s choppy market conditions.

International Equity

Many of the domestic market dynamics are also present across international economies. Inflation, supply constraints, a strong U.S. dollar, and rising interest rates are headwinds for international equities. Across many economies, Russia’s invasion of Ukraine has increased the impact of these challenges. Europe has a high level of dependence on Russian energy products while the Middle East and northern Africa rely heavily on agricultural exports from Ukraine and Russia. COVID-19 also remains a challenge in some Asian countries as lock-down policies continue to be implemented and that is reducing economic output, exacerbating supply chain problems, and adding to global inflationary pressures.

While the headwinds noted above are widely discussed, international equities are attractively valued. Many of the markets are trading at discounted valuations relative to their long-term averages, suggesting that when fundamental improvement in the macro-economic environment occurs, these assets are poised for solid performance.

Commodity

Commodities were mixed last quarter. Prices in the energy segment increased while many agricultural products and metals declined. Despite the recent disparity in returns, the price level of most commodities remains well above pre-pandemic averages. In terms of the outlook, a slowing economy should result in lower demand and a general softening in prices, but the extent of the declines may be tempered by ongoing supply constraints such as the war in Ukraine, global supply chain bottlenecks, and a low level of investment in production capacity for some commodities over the last decade.

Potential opportunities & risks

Opportunities

New opportunities/new markets—The outbreak of COVID-19 has presented a unique set of challenges. It also provides businesses with a unique opportunity to differentiate and develop new markets. By some estimates, technology has been pulled forward two to three years and new products and services are in high demand. Prevalent themes include the increased use of technology, home improvement, home ownership, plus products and services that facilitate working from home. 

The emergence of new technologies—The convergence of cloud computing, significant increases in computing power and the advent of the smartphone have created a connected world in which new technologies change the way we live. This convergence has created investment opportunities centered around long-term themes in which disruptive companies can capture high levels of market share in a relatively short period of time.

The evolution of finance—Technological advancements are disrupting traditional methods of banking, finance, and transfers of cash. We are experiencing a global shift from paper currency to electronic payments fueled by the popularity of credit and debit cards, as well as the emergence of cryptocurrencies. Online payment systems facilitating money transfers, e-commerce, buy-now-pay-later arrangements, and electronic bill paying services are also experiencing strong demand. This shift is still in its early stages and is expected to have a long runway as it is occurring across both the developed and the developing economies. In the coming years, blockchain technology may become a significant disruptor in the finance industry with opportunities for new entrants while creating risks for the firms that currently dominate this space.

Risks

Inflation—Given the unprecedented amount of fiscal and monetary stimulus in previous years, the war in Ukraine, supply chain bottlenecks, underinvestment in production capacity for some commodities, the trend towards de-globalization, and a shortage of labor, there is a risk that inflation may remain well above the average of the last thirty years even if it declines somewhat from current levels.

Deglobalization—Rising geopolitical tensions across many parts of the world have resulted in a reversal of the globalization trend we have enjoyed since the fall of the Berlin Wall. A renewed priority to secure access to commodities and other vital product inputs, along with a race to establish global dominance in certain technologies, have led to a reversal of the free trade movement. We expect this development to be coupled with a sustained increase in geopolitical tensions, upward pressure on inflation, and a rising cost structure for some industries.

Setbacks in the re-opening of the economy—The rate at which vaccines have been developed is unprecedented. However, variants of the virus and the uneven distribution of vaccines globally could be problematic and may slow the rate at which some countries can return to more normal lifestyles. In addition, some countries are employing lockdown policies when outbreaks occur, meaning cities, ports, and manufacturing facilities are shut down from time to time. Accordingly, future outbreaks threaten to extend the supply chain issues and corresponding inflation we are experiencing today.

Debt related issues—Sovereign debt levels were rising prior to the outbreak of COVID-19. However, in the wake of the virus, debt has increased significantly. In the U.S., government debt has increased approximately 38 percent since the end of 2019 and that trend shows no sign of reversing course.

Increasing government regulation of technology companies—Several of the leading technology companies have established dominant market positions and have few competitors. As the power of these companies continues to increase, government regulators are placing them under greater scrutiny by assessing their privacy policies, acquisition plans, and competitive practices.

Geopolitical risks—Conflicts in many parts of the world have escalated or have near-term catalysts that may result in a change in dynamics. We are closely monitoring developments in the war between Russia and Ukraine as well as relations between the West and China.

Cybersecurity—Cybersecurity remains a significant issue as evidenced by persistent attacks on governments, businesses, and individuals worldwide.

Originally posted on July 22, 2022