Outlook: Second quarter 2022

Economy

Last year, the U.S. economy expanded at a rapid pace with GDP growth of 5.7 percent. That is a healthy increase from the pre-pandemic average of just over 2.0 percent. Starting in early 2020, aggressive stimulus programs from our central bank and federal government have fostered a dramatic rebound. Unfortunately, the strong acceleration in the economy has also been accompanied by a persistent increase in inflation, and in March the Consumer Price Index reached a generational high of 8.5 percent.

In response to the high inflation, the Federal Reserve is just now starting to reverse its crisis-era policies. This includes a shift in focus from stimulating growth to fighting inflation. After nearly two years of engaging in a zero-interest rate policy, our central bank raised interest rates by 25 basis points in March. Market participants are now forecasting a series of rate hikes with the Federal Funds rate expected to reach 2.75 percent by the end of the year.

The rapid reversal of the Federal Reserve’s policy is expected to slow the rate of economic growth, with 2022 expectations around 2.5 percent, followed by a 2.0 percent growth rate next year. In other words, the economy is expected to decelerate and move back to its pre-pandemic trend. We are hopeful for that outcome, but cognizant of the fact that the Federal Reserve has a challenging road ahead. Given the need to tame the inflationary pressure, the range of outcomes has become more varied, and the risk of a policy error has increased.

Inflation

Inflation has increased dramatically. In the ten years prior to the pandemic, the Consumer Price Index (CPI) averaged 1.8 percent. Last month, the CPI came in at 8.5 percent, which is the highest level since 1981. Notably, the rise in prices was broadly based, but the gains were particularly strong for energy, automobiles, and food.  

The high rate of economic growth and a significant increase in wages has resulted in strong demand. At the same time, supply chain issues and the war in Ukraine have constrained supply. This has resulted in a perfect storm for consumer prices, and they show no signs of falling in the near term.

Later this year inflation may decline if the supply chain issues and the war in Ukraine are resolved, but it is likely to settle at a level higher than we’ve enjoyed over the last ten years given solid demand for goods and services and the fact that it will take time to replenish supplies of raw materials and intermediate goods.

U.S. dollar

The U.S. dollar continued to appreciate last quarter as the global flight to quality continued. Strength in the U.S. economy and a significant increase in U.S. interest rates, coupled with heightened uncertainty about the global outlook and the war in Ukraine, generated 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

With the latest CPI report coming in at 8.5 percent, the Federal Reserve is now prioritizing the need to bring down inflation over the pursuit of full employment. The market and the Federal Reserve have adjusted to this new reality with interest rates increasing sharply and our central bank adopting a more restrictive tone regarding monetary policy. Since the beginning of the year, the 3-month Treasury Bill has increased by 45 basis points to 0.84 percent.

The 25 basis point increase in the Federal Funds rate on March 15 marked the first increase of this rate hiking cycle. Current expectations are for a 50 basis point hike in rates to a target rate of 0.75-1.00 percent during their May 4th meeting and the commencement of quantitative tightening. As detailed in the minutes of the March FOMC meeting, with quantitative tightening the Federal Reserve intends to reduce the size of its $9 trillion balance sheet by trimming its bond holdings at a pace of $95 billion per month. In addition to the 50 basis point increase in rates expected in May, the market currently anticipates a series of rate hikes later this year with the Federal Funds rate ending 2022 at 2.75 percent.

Intermediate Government/Credit Bonds

With inflation taking center stage, the pivot in the Federal Reserve’s stance on monetary policy has impacted both short-term and intermediate-term bonds. The yield on the 10-year U.S. Treasury has increased 125 basis points year to date to 2.75 percent, with the bulk of the move starting in March.

Credit spreads have widened from the quiescent period we experienced in 2021 and are now approximately at the long-term average. A temporary inversion of the yield curve, where the interest rate on short-term Treasury Bills exceeded the yield on long-term Treasury Bonds, has raised fears of an economic contraction, yet credit fundamentals for credit bonds remain solid. While an inversion of the yield curve has historically served as an indicator of a forthcoming recession, several caveats apply due to the extremely short-lived nature of the inversion experienced in early April. Furthermore, the normalization of credit spreads is notably different than the dramatic widening of spreads which typically occurs prior to a looming economic contraction. Overall, the macroeconomic factors highlighted by inflation signal the need for caution, yet credit fundamentals are not indicative signs of stress.

Tax-Exempt Municipal Bonds

Municipal bonds were not immune to the risks of high inflation and rising interest rates in the first quarter. However, we believe credit risk in the state and local bond market is low due to the multiple rounds of fiscal aid Washington gave state and local governments during the pandemic. Additionally, tax revenues have also soared, led by a surge in income and business taxes as well as strong real estate markets. Following this volatile quarter, valuations in the municipal market are now closer to fair value when compared to other high-quality fixed income alternatives such as U.S. Treasuries and corporate bonds.

U.S. Equity

The equity markets have been volatile given the rapid acceleration in inflation, the war in Ukraine, and expectations for the Federal Reserve to aggressively withdraw from the emergency stimulus measures enacted at the outset of the pandemic. The major indexes experienced moderate declines last quarter with the S&P 500 finishing the period with a loss of 4.6 percent, but returns were bifurcated, and many stocks experienced dramatic sell-offs. In fact, when the stock market reached its low on March 8, almost a third of stocks in the Russell 1000 Index had declined more than twenty percent year-to-date.   

Looking forward, we expect the market to remain volatile driven by a confluence of positive and negative factors. Positive factors include sustained earnings and economic growth. On a long-term basis, these two factors are primary drivers of equity markets. This year, profits are anticipated to rise approximately nine percent, which is a rate significantly above the long-term average. In terms of the economy, it is expected to grow at a healthy pace of 2.5 percent this year. 

While there are powerful factors that support higher stock prices, there are also increasing risks that may negatively impact earnings and economic growth in the future. These include high inflation, an aggressive reversal in policy by the Federal Reserve, and the war in Ukraine. Inflation acts as a tax and is a headwind to growth. It also threatens to reduce earnings growth if companies are unable to pass along price increases to their customers. Currently, inflation is running at levels last seen in the early 1980s and the Federal Reserve is poised to raise interest rates at a rapid pace as they attempt to moderate the acceleration in prices. This rapid reversal in policy increases the risk of a policy error.

The war in Ukraine also presents its own risks for the global financial markets. We are hopeful that there will be a peaceful resolution soon. However, from a financial perspective, a sustained military battle threatens to keep inflation elevated as both countries had been large suppliers of commodities across the energy, agriculture, and metals segments. If there is no resolution in the near-term, commodity supplies will remain constrained and that will keep prices elevated.

In short, we expect the confluence of positive and negative forces to keep volatility levels high and to lead to choppy market conditions in the coming months.

International Equity

The pressures and opportunities seen in the domestic market are also present across international equity markets. Inflation, supply constraints, and rising interest rates are near-term headwinds for international equities. The increase in the U.S. dollar is also creating headwinds for U.S. investors in foreign stocks. 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, positive opportunities are also in place after more than two years of diminished manufacturing and consumer goods production. Global demand for materials and finished products remains high. As production and transportation services recover, the pent-up global consumer demand should provide a positive opportunity for companies. In addition, many international equities are attractively valued, trading at discounts to their long-term averages, which suggests that fundamental improvement in the macro-economic environment can lead to solid performance for this asset class.

Commodity

Commodity prices soared in the first quarter with oil, natural gas, corn, wheat, and palladium experiencing dramatic increases. Looking forward, we expect prices to remain well above their pre-pandemic ranges as the ongoing economic expansion should sustain high levels of demand. At the same time, the war in Ukraine and bottlenecks in the supply chain are leading to shortages of many raw materials and intermediate goods.

While eventual improvements in the supply chain may reduce some of the inflationary pressure later this year, the war in Ukraine has the potential to be a much more significant factor for some commodities. Russia accounts for approximately ten percent of the world’s petroleum production, six percent of the global aluminum, and ten percent of the world’s nickel. In conjunction with Ukraine, they provide thirty percent of global wheat production. A sustained conflict will support high commodity prices for the foreseeable future.

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, products and services that facilitate working from home, and a significant increase in the use of online retail relative to shopping in stores. 

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

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 33 percent since the end of 2019 and that trend shows no sign of reversing course.

Inflation—Given the unprecedented amount of fiscal and monetary stimulus, the war in Ukraine, supply chain bottlenecks, and a shortage of labor, there is a risk that the recent increase in price levels may persist and be harder to contain than policy makers anticipate.

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 U.S. and China.

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

Originally posted on May 2, 2022