Economic and Market Review and Outlook, July 2022
“It’s absolutely essential to restore price stability. Economies don’t work without price stability.” — Jerome Powell
Second Quarter Review
Financial markets fell again in the spring. Posting its worst first half since 1970, the S&P was down 16% while the NASDAQ slumped 22%. Foreign markets fared only slightly better with developed markets dropping 14% and emerging markets declining over 11%. Bond prices also slumped, with the yield on ten-year Treasuries rising from 2.34% to 3.01% (recall it was 1.51% at the start of the year).
Commodities were mixed, as metals rallied early in the quarter only to sell off sharply in June. Oil rose, though its gains were more subdued relative to the spike of the first quarter. Gold came off its winter highs, while the US dollar was the standout, displaying strength throughout the spring. On the other hand, crypto assets crashed with bitcoin declining 59%, almost three-quarters from its highs of last year.
An Economic Cycle and Financial Markets in Fast Motion
From an overheating economy in January, to the beginning of Fed rate hikes in March, followed by concerns of recession in June — the first half of 2022 was a whirlwind of gloomy news unlike any other economic cycle since World War II. Financial markets also reflected this dynamic. At the start of the year, there was a rotation out of highly valued stocks into inflationary beneficiaries, then in the spring, a move into defensive stocks that would perform better in a slowing economy.
The effects of the pandemic have made economic forecasting even more challenging. Although there are job openings, many people haven’t returned to the labor force. Government stimulus checks swelled consumer savings but spending patterns have changed. When Covid first struck, people stayed home for safety reasons and ordered goods online like electronics, furniture and home improvement items. Services such as restaurants, hotels and airlines suffered.
As the population became vaccinated, many began venturing out and traveling, helping services recover, while the demand for goods fell. Retailers and other businesses had a difficult time determining how much to order, especially with the persistent supply chain issues. To make matters worse, the war in Ukraine has added to uncertainty about global energy and food prices.
The Federal Reserve and the Fight Against Inflation
To fight inflation, the Fed has steadily restricted monetary policy, sharply raising the Federal Funds rate from 0.25% in March to 1.75% currently. The logic is that by increasing rates, the overall demand in the economy will decrease, causing inflation to cool off. Yet rising prices have persisted, with the latest Consumer Price reports revealing they may still have not yet peaked as many economists earlier predicted.
Chair Powell and other members are increasingly concerned that inflationary expectations may become imbedded, leading to price instability and further compounding problems. However, Fed rate hikes along with “jawboning” or tough policy talk have already had some effect in slowing demand, especially in the housing sector where 30-year fixed mortgage rates have spiked from 3.11% to almost 5.30%.
Soft Landing or Recession?
In a soft-landing scenario, growth moderates but does not contract, while a recession features an economic contraction with a significant rise in unemployment. There is a great debate going on about which outcome will occur.
The yield curve has inverted (displaying a negative slope) among many maturities although the most important one — the 90-day Treasury yield to the 10-year Treasury yield — remains positively sloped. While growth has slowed in manufacturing and retail areas and consumer confidence surveys indicate a more pessimistic outlook, other indicators show a moderate expansion.
As mentioned earlier, consumer spending has come off its highs, although this is largely a shift to service spending. There is still about $2 trillion in consumer savings from Covid stimulus checks sent by the government, which provides a cushion against a weakening economy. In addition, the labor market is holding firm, producing over one million jobs in the last quarter alone.
Reflecting the more difficult environment so far this year:
- We have further trimmed our U.S. core equity tilt over bonds and other asset classes.
- Since January, we have steadily reduced exposure to stocks where possible, with the stocks currently in portfolios having positive earnings, cash flow and good balance sheets. They will be even stronger once inflation subsides and the economy turns up again.
- Funds have been primarily reallocated into short-term fixed income investments, although if rates continue to rise, we will be increasing our allocation to longer maturities.