Despite a strong finish to 2021, which resulted in a 5.5% year-over-year increase to GDP, the domestic economy contracted by 1.5% during the first quarter of 2022, sparking fresh concerns that the U.S. could slip into recession, which is simply defined as two consecutive quarters of GDP declines.i Variables such as rampant inflation, substantial geopolitical uncertainty, and broken supply chains have significantly eroded consumer confidence, further exacerbating fears that a reckoning is on the horizon. However, while the economic landscape through the first half of 2022 has certainly turned more hostile toward growth, a number of factors contradict the notion that a “traditional” recession is imminent, or at least that the consequences from one would necessarily be all that challenging to weather relative to prior periods of economic contraction. Monthly data since April 1st seems to indicate that the U.S. benefited from solid growth in the second quarter, thanks to significant upticks in consumer spending related to industries most impacted by the pandemic (travel, restaurants, leisure, and entertainment). Furthermore, a strong June jobs report (372,000 new hires) and an unemployment rate of merely 3.6% are not generally signals of an economy gasping for air.
That being said, it’s apparent that a number of forces are conspiring to slow economic momentum. One notable one is fiscal drag, with the federal budget deficit likely to fall from 12.4% of GDP last year to less than 4% of GDP in 2022, the single biggest decline as a percentage of GDP since the demobilization following World War II. Specifically, this reflects an end to stimulus checks, enhanced unemployment benefits, enhanced child tax credits, and a host of other programs that were supporting income and encouraging spending of lower to middle-income households.ii Of course, as mentioned above, rapid price increases (particularly in food and energy) and declining consumer confidence remain the most immediate obstacles to avoiding an economic downturn. Additionally, it seems very likely that the war in Ukraine, coupled with zero-tolerance COVID policies in China, will continue to obstruct global supply chains and further impede momentum. ii While the risk of a near-term recession is relatively elevated, the potential fallout from one may not be as severe as we’ve
come to expect in recent decades (2008 Global Financial Crisis). That said, expectations that the historic economic prosperity of 2021 will continue in 2022 have considerably tempered. As of its June 15th meeting, the Fed has substantially decreased its prior quarter estimates for FY22 GDP growth from 2.8% (as of March 2022) down to 1.7%. iii
Following a spectacular 2021, in which S&P 500 operating earnings per share increased by 70%, it’s not surprising that corporate profits are growing much more modestly this year, with analyst predictions for year-end 2022 earnings growth of roughly 8%. Through 1Q22, corporate earnings for S&P 500 companies was up 4.2%. ii
While energy companies (with high margins) will likely continue to benefit from supply disruptions caused by the conflict in Ukraine, rising labor costs, higher interest rates, and slower nominal sales growth are expected to negatively impact profitability across many other economic sectors. Furthermore, a much higher dollar, relative to other currencies, will erode the value of overseas sales. Already we’ve seen that U.S. exports have been impeded by an 8%+ increase in the trade-weighted dollar since the beginning of 2022.ii While a recession would likely drive corporate earnings down further, it could potentially set up a better long-term economic environment going forward. Despite the severe labor shortage, a slowdown in economic activity could temper upward wage pressure, which is a key driver of long-term inflation.
Though 2021 proved to be a blowout year for consumer spending, the first half of 2022 has been much more challenging for many Americans due to a number of factors. Historically high inflation, which has been muted for many years, rising rates, and falling stock prices, have served to offset much of the individual prosperity achieved during the recovery. Combined with an extremely hostile political environment, geopolitical uncertainty in Ukraine, and the continued emergence of new COVID variants, consumer sentiment finished 2Q22 at its lowest levels since 1971.ii
While still increasing, personal spending continues to weaken and grew by a modest 0.2% in May (month over month), down from 0.6% in April and 1.2% in March. Additionally, in May, the domestic personal savings rate was up 5.4%, up from 5.2% in April, but well below pre-pandemic highs. Among the largest increases in consumer spending, housing and energy outpaced every other category growing by $21.8 billion and $20.3 billion, respectively. The largest consumption declines not surprisingly came from the motor vehicles sector, which has experienced some of the largest price increases due to semiconductor shortages, and subsequently saw related consumer spending shrink by -$53.4 billion over the same period. iv
Retail sales rose 1.0% in June, narrowly beating expectations, and are up 8.4% vs. a year ago. However, sales are not keeping pace with inflation. Once adjusted for inflation (CPI up 9.1% YoY), real retail sales actually declined year over year by -0.3%. The loose monetary policy and massive fiscal stimulus following the pandemic caused retail sales to run much hotter than they would have if COVID had never happened. Now the effects from all the stimulus are waning. v While consumer spending is still expected to grow the rest of the year, “real” spending growth will likely remain soft. The recent moderation is expected to continue as the last remnants of fiscal stimulus flush through the system and personal savings continue to erode in the face of high inflation.
The labor market remains strong with the most recent jobs report showing 372,000 new jobs added in June. This also marked the third consecutive month that the unemployment rate remained at 3.6%, just 0.1% off its 50-year low set in 2019 (pre-pandemic). Despite this typically favorable trend, there still remains a massive excess demand for labor, with the latest data reflecting approximately 5.45 million more job openings than unemployed workers. Due primarily to an aging baby-boomer generation, overall labor force participation will likely continue struggling to regain pre-pandemic levels for the next few years. ii
While demand is expected to somewhat fade over the next few months with slowing overall economic momentum, in general, job growth is expected to remain positive for the foreseeable future. Although the pace of job gains will likely slow down over the near-term, the Fed anticipates we will remain at “full employment” and is projecting year-end unemployment rates of 3.7%, 3.9% and 4.1%, respectively over the next three years. vi
Many factors appear to have converged to create one of the tightest labor markets in recent memory, and the labor shortage will likely continue to drive wage growth, which is already up 6.5% from last year. Should this trend persist, chronic excess labor demand could continue driving wage gains further sustaining strong underlying inflation, which remains the primary concern of consumers, investors, and policy makers. ii
After being relatively stable at 2% for the past 25 years, inflation soared in 2021 to levels not seen since 1982 thanks to a perfect storm of surging consumer demand (fueled by fiscal stimulus), a sizeable increase to the money supply (due to accommodative monetary policy), and severe global supply shortages across all major economic sectors. This trend has continued throughout the first half of 2022, amplified by a general recovery in rental, travel, and hospitality rates from their pandemic lows.
Of course, geopolitical events have further exacerbated inflation, as the Russian invasion of Ukraine has caused spikes in energy prices over the past two months, and China’s “zero-tolerance” policy towards COVID continues to stall supply-chains due to mass economic shutdowns within many of its major manufacturing centers. In June, the headline Consumer Price Index soared 1.3%, the largest monthly increase in more than a decade, and is now up 9.1% vs. a year ago, with nearly every category rising. v
While inflation is expected to remain a key obstacle to economic growth for the remainder of 2022, there is hope it will gradually moderate throughout the year as supply-chain issues ease. That being said, the longer inflation persists, the stickier it gets, increasing the possibility that core consumption inflation (ex food and energy) remains above 3% for the next few years. In this scenario, the potential for inflation well above the Fed’s 2% target level through 2023 is likely to have major implications for short/mid-term monetary policy.
A rapidly improving labor market and persistent inflationary pressure has pushed the Federal Reserve to finally adopt a more hawkish stance as we enter 2022. At its June FOMC meeting, the Fed increased interest rates by 0.75%, following increases of 0.25% and 0.50% in March and May, respectively. Furthermore, there is an expectation of a cumulative 1.75% of rate hikes throughout the remainder this year and another 0.50% in 2023. Assuming these projections are realized, it would mean the fed funds rate would finish 2022 in the 3.25%-3.50% range (3.75%-4.00% in 2023). The Fed also plans on continuing to reduce their sizeable bond holdings with the pace ramping up to $95 billion per month by September. ii
While many have argued that the Fed waited too long to implement these more hawkish policies during the recovery, those same critics now believe the Fed is in danger of overreaching in its attempt to combat historically high inflation. While the futures markets now roughly agree with the Fed’s forecasts for rate increases in 2022, they are actually pricing in rate cuts by 2Q23, reflecting the risk that the Fed’s aggressive pivot could actually result in a self-induced recession if not reigned in. ii It will certainly be a difficult balancing act for the Fed to aggressively clamp down on inflation, without jeopardizing favorable growth trends coming out of the pandemic. That being said, given the relative strength of our domestic labor market, there is reason to believe that a softer landing is still attainable.
The most recent $1.9 trillion package, passed back in March 2021, is still working itself through the system and will likely continue to do so through the end of the year. However, the loose spending practices of 2020 may finally be coming to an end now that economies have reopened, and labor shortages have induced considerable wage inflation.
As the pandemic fades so too has the extraordinary fiscal support provided by the federal government. While the $5.3 trillion of stimulus legislation passed throughout the pandemic proved to support and aid the recovery, concerns over inflation have now tightened the clamps on the stimulus faucet. Despite successful passage of a $1.2 trillion “traditional” infrastructure bill in 4Q21, the current Administration’s ambitious “soft” infrastructure proposal of an additional ~$2 trillion appears to be dead in the water, primarily to opposition within its own party.
Going forward, election year politics are expected to stall any potential new fiscal policy at this point, as this year’s mid-term elections are set against the backdrop of a historically divided electorate. While there remain many questions regarding economic outlook over the next 6-12 months, perhaps the most reliable bet is that legislative stagnation will continue throughout the remainder of 2022.
U.S. equities slumped into a bear market during the first half of 2022 as investors worried about inflation, aggressive monetary policy, and the threat of recession. While all of these issues are very real and concerning, it’s worth noting the S&P 500 forward P/E ratio is now sitting at 15.9x, below its 25-year average of 16.9x. ix As a result, investors are looking at better long-run return potential going forward, especially if the economy’s worst-case scenario is not realized. As of the end of Q2, the S&P 500 Index was down -20.0% YTD. While declines were experienced across most sectors, the biggest losers this year have been the Consumer Discretionary (-32.8%), Communication Services (-30.2%), and Technology (-26.9%) sectors, with only the Energy sector (31.8%) posting positive YTD returns. ix Mid and small cap sectors posted even steeper losses, down -21.6% and -23.4% respectively. Similar to domestic equities, international stocks have also struggled in 2022. The MSCI All Country World Index ex USA finished the quarter down -18.8% YTD. Developed international markets have seen losses of -19.6% YTD while emerging markets are down -17.6%.vii While international equities still remain more vulnerable to future COVID outbreaks and geopolitical risk, they may also currently provide a more favorable value proposition than domestic stocks.
Following back-to-back years of robust returns and record highs for equity markets, hawkish monetary policy, record high inflation, and heightened geopolitical risk have caused volatility to spike and are expected to provide significant headwinds for the remainder of 2022. In particular, high inflation and rising interest rates tend to be more problematic for growth stocks, whose valuations are largely based on projections tied to the cost of borrowing. Through the first half of the year, Growth stocks were down -27.6%, more than double the loss of Value stocks, down -11.4%. Although equities will likely remain volatile throughout the year, and no one can predict the bottom, it does appear that the recent correction may have been necessary to more closely align market expectations with the Fed’s new hawkish tone. As such, it’s possible that much of the bad news is already baked into current valuations. However, higher interest rates will likely continue to cause compression in valuations across all financial markets, with U.S. value and international equities generally positioned best to outperform. ii
Despite extreme volatility in the public markets, Private Equity (PE) valuations have remained elevated with little evidence of a downturn. Though there is much more caution given the current economic environment, deal flow remains active and robust. The private markets are a long-term assets class focused on long-term themes and growth drivers. The best PE managers anticipated and were prepared for the cycle to turn and have been highly selective over the last few years. They have focused on investing in high quality businesses that are resilient, with the ability to pass through higher supply chain prices to customers, and that are appropriately leveraged and can absorb margin pressure and interest rate increases. While absolute levels of returns are likely to come down in the near/midterm, PE tends to exhibit significantly lower volatility than public markets and the relative outperformance of private markets has historically been better when public returns are lower.
High inflation, falling unemployment, and a hawkish Fed caused a sharp reversal in bond yields during the first half of 2022, resulting in negative returns across fixed income markets. As of 6/30, the Bloomberg Aggregate Bond Index was down -10.4% YTD. Similarly, the 10-year Treasury struggled, down -11.7% YTD as yields jumped from 1.52% to 2.98% by the end of June. ii Long-duration government and credit bonds (-21.9%) and securities with lower credit quality, such as high yield (-14.0%) and EM debt (-18.8%), suffered the biggest losses among fixed income assets. x
The likely persistence of inflation combined with continued unemployment declines suggests additional monetary policy tightening and rate increases throughout the remainder of 2022. However, heightened recessionary concerns could potentially limit further increases to long-term Treasury yields. A silver lining to rising rates is that after several years of extremely low bond yields, fixed income assets now offer relatively better income with more attractive valuations. Credit spreads have also widened in anticipation of a slowing economy, which may present opportunities in both high-yield and convertible bonds. Of course, these securities would likely also struggle if the economy experiences a deep recession. ii
Moving forward, the Federal Reserve will be a key driver for fixed income markets as we await its decisions related to rate increases. While it is likely the bond market’s initial response to these actions could be somewhat disruptive in the short-term, a “normalization” of monetary policy can be perceived as a bullish indicator to investors and would ultimately provide more income potential in the long-run. Regardless, it seems apparent that interest rates will continue their ascension in 2022 and into 2023 against the backdrop of a tight labor market and rising inflation.
Going forward, geopolitical uncertainty, high inflation, and hawkish central bank policies will likely limit upside potential throughout the remainder of the year, while simultaneously laying the groundwork for heightened market volatility and increased recession risk. It is more likely than not that we are headed for a moderate downturn, but we don’t believe the caliber of carnage will be like that of the Global Financial Crisis in 2008. Performance from here is likely to be driven by more specific and tactical investment considerations. The industry, geography, and strategy profile of portfolios will more meaningfully dictate returns as the tide goes out. We are strong proponents of a well-balanced and diversified portfolio, incorporating defensive and alternative investments where possible. We believe private assets and real estate, while not appropriate for all investors, should play a significant role in strategic portfolios, though selectivity of managers and funds is extremely important. Finally, we believe the tried-and-true method of staying invested and not timing the market will be the better long-term path for investors. In other words, breathe deeply and stay the course.
As always, we strongly encourage you to review your financial plan and investment strategies with a fiduciary advisor to ensure you are properly allocated in a manner most suitable for your overall financial needs and goals.
Andrew Mescon, MBA, MPA
VP of Strategy
Kristofer Gray, CFP®, CRPS, C(k)P®, MPA, DBA
Chief Investment Officer
Disclosure: Past performance is not indicative of future results. The opinions expressed are those of the Integrity Financial Corporation (“Integrity”) and should not be taken as financial advice or a recommendation to buy or sell any security. Integrity is a registered investment adviser. Registration does not imply a certain level of skill or training. Any forecasts, figures, opinions or investment techniques and strategies described are intended for informational purposes only. Past performance is not indicative of future results. Investing involves the risk of loss of principal. Investors should ensure that they obtain all current available information before making any investment. Indices cited in the information above are intended to support the opinions expressed and are shown as general examples of market trends. It is not possible to invest directly in an index and the volatility of the index may vary from that of an investor’s actual account. Note that index performance shown does not take into account management fees and is not intended to be indicative of future results. Additional information about our investment strategies, risks, fees, and objectives can be found in Integrity’s Form ADV Part 2. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions. There is no guarantee of the future performance of any Integrity Financial portfolio. Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed. Nothing herein should be construed as a solicitation, recommendation, or an offer to buy, sell, or hold any securities, other investments or to adopt any investment strategy or strategies.