Highlights:
- Real GDP has officially exceeded pre-pandemic output levels thanks to a sharp rebound in 4Q21, up 6.9% from the previous quarter.
- Corporate earnings achieved all-time highs in 2021, but will likely see gradual deceleration in 2022 due to higher interest rates and input costs.
- Consumer spending remained strong in 1Q22, but will likely come under pressure from inflation and lower personal savings rates.
- Unemployment dropped below 4% (considered “full employment”) in 1Q22 and is expected to continue its descent as job openings outpace eligible workers.
- Inflation remains a concern with headline CPI finishing the quarter at 8.5% due primarily to a combination of supply shortages and surging energy prices related to Russia’s invasion of Ukraine.
- After raising rates by 0.25% in March, the Fed has taken a hard, hawkish stance in order to combat inflation, and now projects rate hikes in each of its remaining six sessions this year. [As of 5/4, there was an additional 0.50% increase]
- Fiscal stimulus continues to fade with very little opportunity for new spending on the horizon.
- Equity markets struggled in 1Q22 due primarily to geopolitical uncertainty in eastern Europe, as well as an acceptance that central banks will pursue hawkish monetary policies throughout 2022.
- Fixed income investing will likely be challenging this year as multiple rate hikes will likely continue to impede bond prices and high inflation keeps real yields negative for the rest of 2022.
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 March FOMC meeting, the Fed increased interest rates for the first time since the pandemic began, albeit by a mere 25 basis points. However, Chairman Powell indicated (and continues to stress) that the Fed will likely need to more aggressively raises rates throughout the remainder of the year, potentially by more significant margins across each of its remaining six meetings in 2022. i As of March, dot plot projections indicate the Fed intends to raise the Fed Funds rate to roughly 2% by year-end, and up to the 2.75-3.0% range by the end of 2023. ii While it’s apparent these moves are designed to curtail runaway inflation, they have also already begun impacting interest rate-related markets which will likely contribute to a softening in home-building and capital spending over the next two years. i
As for the remainder of 2022, as unemployment continues to drift lower and inflation remains well above the Fed’s targets, it is expected that the Fed will follow through on its recent hawkish rhetoric, leading to further increases in long-term interest rates throughout the year.i However, given that impacts from monetary policy on economic activity tends to lag implementation, coupled with a slowdown in expected economic output, a more hawkish Fed also adds to potential recession risks for 2023. i 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. However, given the relative strength of our domestic labor market, from our view there is reason to believe that a soft landing is plausible.
Fiscal Policy
Unprecedented fiscal stimulus, from both the previous and current administrations, has proven to be a powerful accelerant for the economic recovery as the most recent $1.9 trillion package passed back in March is still working itself through the system and will likely continue supporting the economy through the end of 2022. However, the loose spending practices of 2020 may finally be coming to an end now that economies have reopened, and labor shortages have induced 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 has proven to be a powerful accelerant for the economic recovery, concerns over inflation appear to have tightened the clamps on the stimulus faucet (for now). Furthermore, 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 seems to be dead in the water due primarily to opposition within its own party. While it is anticipated that the overall economy will continue expanding throughout the remainder of 2022, it will most likely achieve this end without meaningful fiscal support.
Inflation
After being relatively stable at 2% for the past 25 years, inflation soared in 2021 to levels not seen since 1982 due to a perfect storm of surging consumer demand (fueled by fiscal stimulus) and severe global supply shortages across all major economic sectors. i This trend continued in 1Q22, amplified by a general recovery in rental, travel and hospitality rates from their pandemic lows. Of course geopolitical events have further exacerbated this trend as the Russian invasion of Ukraine has caused additional spikes in energy prices over the past two months, and China’s “zero-tolerance” policy towards COVID continues to stall supply-chains thanks to mass economic shutdowns within many of its major manufacturing centers. vi At the end of March, headline CPI was up 1.2% from the previous quarter and 8.5% from the previous year (Core PCE Deflator: 6.5% increase from previous year). vi The large increase was primarily driven by an 11% rise in energy prices, no doubt a direct result of economic sanctions imposed on Russia in response to its invasion of Ukraine. vi
While inflation will likely remain a key obstacle to economic growth for the remainder of 2022, there is hope it will gradually subside throughout the year as supply-chain issues and headline inflation ease. The longer the current inflationary environment persists, the greater the likelihood that core inflation remains over 3% for the next couple of years.[i] In this scenario, although longer-term forces would likely cut inflation further by the middle of the decade, the potential for inflation well above the Fed’s 2% target level through 2023 would likely have major implications for short-/mid-term monetary policy.
GDP Analysis
The economic recovery coming out of pandemic shutdowns has been very bumpy as surges in economic output collided with severe supply-chain disruptions further exacerbated by new waves of COVID variants. However, when the dust finally settled by the end of 2021, the U.S. economy had actually exceeded its pre-pandemic output levels by 3.2%. i In particular, a meaningful part of this recovery has largely been due to productivity gains as output per worker grew at an annual rate of 2.7% over the past two years, more than twice the 1.2% growth seen over the 20 years prior. i This data is somewhat interesting given the uncharacteristically high number of companies that pivoted to remote working conditions during the pandemic.
After quarterly GDP growth for the first two quarters of 2021 of 6.3% and 6.7%, respectively, 3Q21 saw the recovery slow down a bit due to acute supply-chain issues and the impact of the Delta variant as quarterly GDP growth declined to just 2.3% (4.9% year-over-year) by the end of September. However, the U.S. economy rebounded sharply in 4Q21 as quarterly GDP growth jumped back up to 6.9% and finished the year up 5.5% from 2021. ii
Omicron appears to have slowed GDP growth early in 1Q22, although expectations are for stronger data in 2Q22 thanks to robust consumer and business spending. While it is still way too early for reliable predictions, output gains are expected to gradually fade throughout 2022 as the economy reaches full capacity. Early projections for year-end GDP are around 3% YoY, with growth slowing to roughly 2% by 2023. i
Corporate Earnings
Earnings have recovered substantially since the big declines in early 2020 achieving all-time highs in 2021. i This trend primarily reflects record profits within some of the most important sectors of the U.S. equity market, including technology and health care, that thrived during the pandemic. More generally, earnings have been bolstered by powerful consumer demand and higher productivity thanks to cost reductions related to more virtual work environments.
Corporate earnings grew 25% in 2021, although growth slowed considerably in the second half of the year with 3Q21 and 4Q21 quarterly growth of 3.4% and 0.7%, respectively. iii This trend towards slower economic growth is expected throughout 2022, as higher wages and interest rates squeeze margins to the single digit range. i Additionally, high inflation will likely continue to drive input costs higher resulting in elevated breakeven price points that could begin to temper consumer demand.
Consumer Spending
After consumer spending had a blowout year in 2021, posting double-digit growth in the first half of the year, it’s possible that we finally see consumption slow down a bit in 2022. That being said, consumer spending continued its upward trajectory in the first quarter, albeit at a more modest rate than prior periods. In 1Q22, real consumer spending on goods and services is estimated to have grown 3.5-4.0% from the previous year. iv
While inflation accelerated considerably in 1Q22, consumer confidence continues to fare relatively well on the back of more favorable labor prospects as hourly wages in February were up 0.5% ($101.5 billion) v from the previous month. While still increasing, personal spending grew by a more modest amount over the same period, up only 0.2% ($34.9 billion) from the prior month. v In addition, the domestic personal savings rate was 6.3% in February, up from 6.1% in January, but well below pre-pandemic highs. v
The largest increases in consumer spending was seen in food and energy, which more than doubled compared to every other category, growing by $33 billion and $27.1 billion, respectively. v The largest consumption declines came unsurprisingly from the motor vehicles sector, which has experienced some of the largest price increases due to semiconductor shortages. Subsequently, this sector saw consumer spending shrink by $30.7 billion over the same period. v
It remains to be seen how much longer the consumer can continue to fuel this expansion. While still expected to be relatively strong the rest of the year, a moderation of sorts is likely, as the last remnants of fiscal stimulus flush through the system and personal savings continue to erode in the face of inflation.
Labor Markets
The labor market has continued to improve rapidly with unemployment falling below its 4% “full employment” benchmark to 3.8% as of February 2022 (compared to 6.2% in February 2021). i Despite this strong data, there appears to still be a massive demand for labor with the latest data showing approximately 5 million more job openings than unemployed workers. This excess demand, coupled with rising wages, and the elimination of most pandemic-related stimulus should see unemployment continue to tick downward throughout the year, with the possibility of unemployment dropping below 3.4% by year-end (lowest rate since 1953). i
Given largely to an aging baby-boomer generation and tighter immigration policies, overall labor force participation will likely continue to struggle to regain pre-pandemic levels over the next few years. i If this were to be the case, chronic excess labor demand would likely continue driving wage gains, further sustaining relatively strong underlying inflation. i
In general, job growth is expected to remain positive in the foreseeable future. However, many factors appear to have converged to create one of the tightest labor markets in recent memory. Although the pace of job gains is expected to pick up a bit now that enhanced unemployment benefits have expired, the pandemic appears to have created some structural and cultural changes to our domestic labor market that may need to be addressed before a return to full employment is attained.
Equity Markets
U.S. equity valuations pulled back significantly in 1Q22 before somewhat settling into a volatile news cycle. Specifically, geopolitical uncertainty regarding the Russia/Ukraine conflict, coupled with the Fed’s hawkish repositioning, led to a sharp 13% correction in the S&P 500 by mid-March. i As of 3/31/22, the YTD return for the S&P 500 Index was -4.6%. ii While declines were experienced across almost all sectors. The biggest losers in 1Q22 were Communication Services (-11.9%), Consumer Discretionary (-9.0%), and Technology (-8.4%), with only Utilities (4.8%) reflecting positive YTD returns. viiii Going forward, rising interest rates will likely make it difficult to justify increases to P/E multiples as rising wages and slower growth are expected to impede earnings gains. i
After multiple years of strong returns among growth stocks, the long-awaited rotation back to value appears to finally be in play, thanks largely to a combination of higher commodity prices and rising interest rates. i In 1Q22, this trend played out rather strikingly across the Russell 1000 Indices, as the Russell 1000 Growth Index fell roughly -9% while the Russell 1000 Value Index finished the quarter down less than -1%. vii Furthermore, value stocks remain substantially cheaper than growth stocks, as evidenced by their 14.1x average forward P/E multiple compared to 20.7x for growth. i Additionally, value stocks are currently reflecting dividend yields of more than 2% versus dividend yields for growth stocks slightly above 0.80%. ii
Similar to domestic equities, international stocks also struggled in 1Q22. The MSCI All Country World Index finished the quarter down -5.3% while EM markets followed suit at -6.9%. ii Germany and China stand out as two nations whose equities were hard hit in 1Q22, ending the quarter down -12.8% and -14.2%, respectively. ii In the case of Germany, fears related to that nation’s heavy dependence on Russian oil likely played a critical role in hampering equity performance. In China, a “zero-tolerance” COVID policy resulted in broad lockdowns across many of its most critical financial and manufacturing centers. However, while international equities still remain more vulnerable to future COVID outbreaks and geopolitical risk, they 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 and elevated levels of inflation are expected to provide significant headwinds in 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. While still susceptible to the same obstacles, value appears to be relatively cheaper than growth through the 1st quarter of 2022. Although equities will likely remain volatile throughout the year, it does appear that the recent correction may have been necessary to more closely align market expectations with the Fed’s new tone. Specifically, for the moment, it appears that domestic equity markets are now pricing in a more aggressive rate-hiking schedule for the next two years. viii As such, it’s possible that most of the bad news is now baked into current valuations. If this is true, barring any unforeseen negative catalysts, the likelihood of a steep correction over the next nine months would seemingly be reduced.
Fixed Income Markets
High inflation, falling unemployment, and a hawkish Fed caused a sharp reversal in existing bond yields during 1Q22 resulting in negative returns across fixed income markets. i Particularly, the Barclays Aggregate Bond Index finished the quarter down -5.93 % YTD reflecting its largest quarterly loss in more than 40 years. vii Similarly, the 10-year Treasury also struggled in 1Q22, declining -6.86 % as yields jumped from 1.52% to 2.32% by the end of March. ii
Furthermore, the likely persistence of inflation, combined with continued unemployment declines, suggests additional monetary policy tightening and broad increase rate increases throughout the remainder of 2022. i When also factoring that real long-term Treasury yields remain negative and U.S. credit spreads are historically tight, the outlook for fixed income investors will likely remain challenging over the next nine months. ii
Of course, these trends tend to level off over time as prospects for fixed income markets will likely become increasingly favorable as higher interest rates ultimately result in higher yields over the long-term. Additionally, default rates have plunged in recent months, as even high-yield debt defaults are well below 1% over the past year. viiii While supply-chain disruptions could still cause some idiosyncratic stress, it does not seem that these issues will have a broader impact on default rates. viiii
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 resume their ascension in 2022 against the backdrop of rising inflation and a hawkish Fed.
Outlook
The global economy is expected to continue improving in 2022 with much of the world better off than it was a year ago. That being said, 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 over the same period. As always, we strongly encourage you to review your personal situation with a fiduciary advisor to ensure your investments are properly allocated in a manner most suitable to your overall financial needs.
| Andrew Mescon, MBA
VP of Strategy |
Sarah Archer
Chief Investment Officer |
Sources:
i. J.P. Morgan – Economic Market Update 2Q 2022 (as of 3/31/22)
ii. J.P. Morgan – Guide to the Markets 2Q 2022 (as of 3/31/22)
iii. https://www.bea.gov/data/income-saving/corporate-profits
iv. First Trust – Data Watch: March Retail Sales (as of 4/12/22)
v. https://www.bea.gov/news/blog/2022-03-31/personal-income-and-outlays-february-2022
vi. First Trust – Data Watch: March CPI (as of 4/12/22)
vii. Columbia Threadneedle Investments – Market Mosaic Fixed Income Summary Q1 2022
viii. BlackRock – Global Outlook: 2Q 2022 Update (as of 3/31/22)
ix. FS Investments – Q2 2022 Corporate Credit Outlook – A Balancing Act: Risk vs. Fundamentals
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.
The MSCI ACWI is a free float-adjusted market capitalization-weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI Index consists of 49 country indices comprising 23 developed markets, including Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom and the United States; and 25 emerging markets, including Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, the Philippines, Poland, Russia, Qatar, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.
The S&P 500 Index is the Standard & Poor’s Composite Index and is widely regarded as a single gauge of large cap U.S. equities. It is market cap weighted and includes 500 leading companies, capturing approximately 80% coverage of available market capitalization.
The Bloomberg US Aggregate Bond Index is a broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the United States.
