Key takeaways
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The Fed has shifted its focus to fighting inflation in 2022 and appears willing to accept higher unemployment and lower economic growth in order to do so.
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Consumer confidence is at historic lows as prices for all goods are well above 2020 levels, especially necessities such as gas, food and shelter. Should consumer spending decline precipitously, the Fed will find it difficult to deliver a soft landing for the U.S. economy.
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After a sharp rotation out of growth stocks and into stocks that benefit from inflation, leadership in the equity markets could rotate once again in the second half of the year, as the economy slows and investors seek their next port in the storm.
"There is only one kind of shock worse than the totally unexpected: the expected for which one has refused to prepare." - Mary Renault
As the second half of 2022 begins, it is clear that while inflation was expected to be the biggest concern for capital markets companies, and consumers this year, the war in Ukraine and China’s Covid-19 policies have combined to compound the supply chain pressures which built up following the lockdowns associated with the pandemic. Unable to meet end demand borne out of fiscal policy designed to cushion the impact of social restrictions, companies scrambled to hire workers and increase production, while passing on rising input costs to end consumers.
Peak inflation was expected to arrive during the first quarter of the year as global supply chains got back on track. Instead, inflation has morphed from transitory to persistent, and global central banks, including the Fed, have been accused of failing to anticipate the current situation and acting too slowly to remove liquidity and curb pressures on the demand side of the equation. As a result, aggressive tightening through the end of the year is anticipated. And yet the question remains – when will inflation ease, and will it ease quickly enough to avoid a deep recession?
The Fed squares off with inflation
As noted in our 2022 outlook, the Fed’s focus has shifted quickly from supporting the economy through an easy monetary policy to a less accommodative policy in order to deliver tighter financial conditions and slow demand. While initially it appeared that the Fed was going to raise rates only to hover at or slightly above the neutral rate of 2% by the end of the year, those expectations were based on peak inflation occurring in March or April, and then slowly declining throughout the year as the effects of the pandemic waned.
Unfortunately for companies and consumers, peak inflation did not arrive; instead, energy and food prices shot higher as Russia invaded Ukraine and rolling shutdowns stymied efforts to increase inventories and decrease backlogs in manufacturing. The Fed cited the continued strength of the job market and strong balance sheets as rationale that the U.S. economy could digest interest rate hikes, and as inflation improved modestly in April, there was optimism that a soft landing could be engineered despite the fiscal and monetary largesse of 2020 and 2021.
May’s CPI print, which came in well above consensus and exhibited increases across almost all categories, forced the Fed to modify its stance as well as its expectations – and vindicated the critics who had questioned the Fed’s assessment that inflation was only transitory. In addition to increasing interest rates by 75 basis points, the Fed released a revised dot plot which points to a fed funds rate of 3.4% by the end of the year – well above the neutral rate of around 2.5%.
Perhaps more telling was the decrease in growth expectations for this year to +1.7% and to +2.2% for 2023; to put this in perspective, prior to the pandemic, GDP grew at +2.3%, +2.9%, and +2.3% in 2017, 2018, and 2019, respectively. In addition to the change in expected GDP for this year and next, the Fed is forecasting that the unemployment rate will rise to 4.1% by 2024 from 3.6% today.
Source: Bureau of Labor Statistics, Federal Reserve
With these new expectations, the message is clear that the Fed will do what it takes to bring down inflation – and now, it is clear that the Fed anticipates that those actions will slow the economy. However, when taken at face value, it would appear that the numbers still point to a soft landing, although not as smooth as initially predicted. Skeptics would argue that without supply chain improvements and a decline in PPI (which measures input prices) the Fed is wielding a very blunt tool which could easily destroy demand well past the point of necessity. Our view is that it is incredibly important for the Fed to remain data dependent, and that the most important variable for it to monitor will be consumer spending, given its importance in terms of U.S. GDP.
All eyes are on consumer confidence
While the Fed is feeling significant pressure to bring prices down, U.S. consumers are bearing the burden of paying those prices – and the global economy at large stands to suffer as a result of their pain. The eye-popping increases in prices that the U.S. consumer has been forced to accept over the last year continue to depress consumer confidence.
In fact, one widely watched measure of confidence, the University of Michigan consumer sentiment survey, fell to 50 – a level not seen since the late 1970s. Historically the employment market has been a fundamental driver of confidence for consumers; however, purchasing power is now to blame for the subdued mood.
Historically, there has not been a consistent correlation between consumer confidence and consumer spending. Consumer confidence tends to be very time sensitive, meaning that real time events can have a meaningful impact even on the future expectations component of these surveys.
For example, consumer confidence began to decline after April of 2021, and yet retail sales and consumer spending data remained fairly robust through the end of last year – likely attributable to both continued fiscal stimulus and a strong labor market. However, over the last three months, consumer spending has been growing at a slower rate, consistent with consumer sentiment data.
Source: Bureau of Labor Statistics, Bureau of Economic Analysis
Will this trend continue? There is room for optimism. First, the labor market is still very strong. With over 11 million job openings, and only 3.6% unemployment, consumers remain comfortable in their opportunities for employment. In addition, wages are still growing, albeit it a slower clip than experienced in 2021. Perhaps even more importantly, commodity prices are falling, which is likely to translate over the summer into both lower food and energy costs for consumers. Wheat is already down almost -30% from its recent high, copper is down over -20% and oil has fallen almost -15%. Consumers are extrapolating that the inflation they have experienced over the last year will continue at the same pace during the coming year, and that is highly unlikely against the backdrop of a slower global economy.
While it is perhaps too early to pinpoint when demand might recover, our belief is that end consumer demand is likely to be delayed, rather than permanently destructed, at this point in the cycle. Areas like housing that are closely tied to rates could face stronger headwinds in the coming year and discretionary spending for lower income households, many of which have now moved from a credit to a debit position on their balance sheet, may not recover as quickly.
However, with household financial obligations still running well below levels experienced leading up to and following the great financial crisis, the U.S. consumer is likely to withstand this patch of economic softness and come out spending on the other side.
A changing of the guard for equities
A significant concern for U.S. equity investors coming into 2022 was that growth stocks, which had represented both opportunity and safety for much of 2018-2020, would fall out of favor as the Fed raised interest rates – and that concern was borne out through the end of June. Technology stocks specifically, and long duration growth stocks more broadly, underperformed the S&P 500 in some cases by a significant margin and despite continued robust top and bottom line results for many of the larger companies in the index.
Conversely, while many expected cyclical sectors such as energy, materials, industrials and financials to outperform, the only sector from that group that exhibited strong performance in the first half was energy. The rest of the outperforming sectors through mid-year are typically those associated with risk-off periods, including utilities, health care and consumer staples.
One could argue that energy is outperforming not just as a beneficiary of inflationary pressures, but due to the undersupply of fossil fuels in the market following a decade of underinvestment. While we agree with the thesis behind the argument, and acknowledge that supply will likely need to grow to meet demand, our view is that energy and materials could face some near term headwinds based on slowing growth expectations.
Another pain point for companies coming out of the pandemic have been supply chain challenges, and as a result, we expect that companies will considering shortening the distance between production and distribution, which would imply a move back onshore for U.S. manufacturers, particularly those in sensitive industries. Health care remains ripe for disruption, and there are meaningful opportunities for top line growth in the sector even without secular tailwinds. Finally, we believe that with job openings to job seekers at an almost 2 to 1 ratio, companies will be forced to invest in productivity enhancing technology across a broad swatch of sectors and industries.
Combining the challenges of slower growth with the opportunities laid out above, our view is that investors will remain selective through the back half of the year, targeting companies in the industries outlined here, but gravitating towards companies that are generating meaningful free cash flow which can be used for acquisition or capital expenditure, with strong management teams and the ability to grow their business even in a low to no growth economic environment.
While it is difficult to project where the major indices will end up at the end of the year, our view is that investing into the equity markets at the current valuations with an appropriate time horizon and the ability to withstand near term volatility is still an attractive option in this new higher interest rate, higher inflation environment.
Summary
Our view coming into 2022 was that prices would begin to moderate through the first half, and clearly, that has not occurred. Interest rates have moved higher but are expected to crest levels well above our initial expectations in response to higher-than-expected inflation. The U.S. economy is likely to grow at a slower pace this year, but we remain skeptical that it will face a sustained and/or deep recession in either 2022 or 2023, based in large part on the strength of the economy coming into this rate hiking cycle.
Equities over time are positively correlated to inflation, but lofty valuations and overly rosy earnings estimates have demanded a reset in pricing, and there is possibly more pain to come as companies adjust to a new paradigm of higher input prices and lower end demand. At current valuations and absent another exogenous shock to the U.S. economy, however, valuations are attractive in terms of initiating positions in global equities for the next several years.
The patience of bondholders has been tested, and despite the near term pain, a higher rate environment will benefit them longer term. As such, we acknowledge that policy will create volatility for the second half – and we have not even broached the topic of elections – but believe that remaining invested and avoiding the urge to attempt to time the recovery in stocks and/or bonds is the most appropriate course of action.
We encourage you to reach out to your Private Wealth Advisor for a deeper discussion regarding the points above, or a review of your current plan to ensure it remains aligned with your long term needs and goals.
