By: Michelle Cluver, CFA; Jon Maier
It appears the hawks and bears may have scared away the doves and bulls, at least in the short term. In the first half of 2022, surging inflation, and expectations for accelerated Federal Reserve (Fed) interest rate hiking dominated market sentiment, and market returns showed it. In the second half, we expect inflation, higher interest rates, and market volatility to remain front and center, but with added emphasis on how these factors challenge the consumer and their spending. Excess pandemic savings put the U.S. consumer in a relatively strong position. However, the big question is whether it will be enough to stave off a recession. Overall, we believe labor market strength holds the keys to consumer spending and U.S. recession risk. Should economic growth turn negative, the U.S. economy currently faces fewer negative feedback loops, reducing the risk of a severe recession.
- Recessions are typically deeper when multiple cycles contract simultaneously. Currently, the profit cycle is weak while the areas that impact the real economy remain strong. Should a recession occur, its scale is likely to be limited by the reduced number of negative feedback loops.
- Soft or hard landing, inflation protection and quality remain essential. Reduced profit expectations increase the focus on defensive positioning and quality. We expect elevated inflation to continue into 2023 due to the lagged impact of food supply disruption and elevated energy costs.
- We’re entering a new era of security. Three key security focuses include energy security, food security, and cybersecurity.
- The balance between interest rate sensitivity and growth sensitivity currently favors value. Should economic growth deteriorate, defensive sectors may become more important than cyclicals, growthier areas may look more appealing if economic growth slows and the interest rate environment improves.
Inflation Has the Fed and Global Central Banks Playing Catch-Up
In our view, markets expect weaker economic growth and higher inflation than central banks have been openly admitting. We expect the inflation trajectory will likely remain a focal point for the second half of the year as markets assess how long inflation will remain above normal levels.
Higher energy and food prices are major culprits in the current scenario. While they are removed from core inflation, energy and food prices are the most visible everyday prices, and therefore have the largest impact on inflation expectations.
We expect inflationary pressures on food and energy to persist, particularly with Europe committed to moving away from Russian energy. Along with higher energy costs, we expect droughts and higher fertilizer costs to weigh on future crop yields, further exacerbating food prices. Additionally, shelter prices and services inflation are expected to increase core inflation.1
After the news that U.S. CPI reached a new peak in May, the Fed raised policy interest rates 75 basis points (bps) to 1.75% in June. This was the Fed’s largest rate hike in 28 years and opens the potential for a more aggressive rate hiking cycle during the second half. Currently, market expectations put year-end policy rates at roughly 3.5%, a staggering increase from 0.25% at the beginning of the year.2 Currently, U.S. policy interest rates are at their pre-pandemic levels. Should this hiking trajectory persist, which we expect, policy rates are likely to reach 2008 levels by year-end.
Inflation isn’t just a U.S. story. Over the last year, inflation has increased at a faster clip in Europe than the U.S. A year ago, inflation in the Euro Area and UK was below 2%. Currently, it’s more than 8%.3 The Bank of England raised interest rates 25 bps to 1.25% in June, the fifth consecutive increase since December 2021. The hike brought UK policy yields to their highest levels since 2009. Similarly, the European Central Bank (ECB) shifted to a more hawkish stance to combat rising inflation pressures. The ECB is set to end their asset purchases in Q3 and increase interest rates by around 175 bps by year-end.4
Lesson: Don’t Fight Central Banks
Historically, the correlation between global equity markets and the size of central bank balance sheets is high, which aligns with the famous adage, “Don’t fight the Fed.” Over the last decade, low yields and high liquidity were a boon for markets. But we’re at the end of the cheap money era that dominated the last decade. Quantitative tightening (QT) began in June, with $30bn Treasuries and $17.5bn mortgaged-backed securities expected to roll off the Fed’s balance sheet monthly.5
With rates moving meaningfully higher and QT under way, liquidity in the Treasury market is weaker and interest rate volatility has increased. Volatility is likely to remain elevated as the market adjusts to its new reality.6
Resetting yields back to pre-quantitative easing (QE) levels will likely be a painful process for markets. Higher Treasury yields and reduced liquidity has implications across asset classes, and this combination has and likely will continue to result in a higher correlation between equities and fixed income. On average, since 2000, equities and bonds offer a negative return correlation. However, from the late 1970s until 2000, equities and bonds typically had a higher correlation. Year-to-date correlations are back to pre-2000 levels, creating headwinds for multi-asset portfolios, at least for the near-term.
A New Era for Fixed Income Begins
In investment circles, the TINA effect, or “there is no alternative,” has been in place since the Global Financial Crisis. With fixed income yields so low and cash earning next to nothing, equities were the “only” asset class investors could go to generate returns. However, the TINA era is nearing its cycle end.
The yield difference between fixed income and the earnings yield on the S&P 500 is starting to narrow. While fixed income is likely to remain a challenging space as policy yields rise to their terminal rate, Treasuries potentially can offer value.7 The short end of the curve has risen to reflect higher policy rates, while the longer end has flattened. The Fed’s commitment to bring inflation under control creates headwinds for equities and fixed income. However, as recession risks rise, fixed income, especially Treasuries, is likely to outperform equities.8
1. Morgan Stanley, Midyear Investment Outlook, June 2022
2. Bloomberg data as of June 16, 2022
3. Trading economic data as of June 16, 2022
4. Bloomberg data as of June 14, 2022
5. Federal Reserve, Plans for Reducing the Size of the Federal Reserve’s Balance Sheet, May 4, 2022
6. Analysis from Bloomberg data as of May 31, 2022
7. RBA, RBA Fixed Income Insights, June 16, 2022
8. Alpine Macro, Fed Panic = Recession, June 20, 2022
9. The Conference Board, C-Suite Outlook 2022: C-Suite View of Volatility, War, Risks, and Growth for Global Business, June 17, 2022
10. WSJ, Recession Fears Surge Among CEOs, Survey Suggests, June 17, 2022
11. OECD, OECD Economic Outlook, Volume 2022 Issue 1: Preliminary Version, June 2022
12. Morgan Stanley, Midyear Investment Outlook, June 2022
13. WSJ, Stores Have Too Much Stuff. Here’s Where They’re Slashing Prices, June 14, 2022
14. BofA Securities, Global Fund Manager Survey: Summer of Volker, June 14, 2022
15. Merrill, Capital Market Outlook, June 13,2022
16. Alpine Macro, Fed Panic = Recession, June 20, 2022
17. Morgan Stanley, Midyear Investment Outlook, June 2022
18. Alpine Macro, Fed Panic = Recession, June 20, 2022
19. Morgan Stanley, Midyear Investment Outlook, June 2022
20. WSJ, Amazon CEO Andy Jassy’s First Year on the Job: Undoing Bezos-Led Overexpansion, June 16, 2022
21. Vanguard, Vanguard Downgrades Global Economic Growth, June 15, 2022
22. Trading economics data as of June 19, 2022
23. Trading economics data as of June 19, 2022
24. Reuters, EU Unveils 210 bln Euro Plan to Ditch Russian Fossil Fuels, May 18, 2022
25. WSJ, Russia Steps Up Pressure on European Gas Supplies, June 17, 2022
26. WSJ, Russia Steps Up Pressure on European Gas Supplies, June 17, 2022
27. WSJ, Germany Steps Up Measures to Conserve Gas as Russia Slows Supply to Europe, June 19, 2022
28. WSJ, European Natural-Gas Prices Jump as Russia Cuts Supplies Again, June 15, 2022
29. WSJ, Russia Steps Up Pressure on European Gas Supplies, June 17, 2022
30. WSJ, European Natural-Gas Prices Jump as Russia Cuts Supplies Again, June 15, 2022
31. Fortune, Another ‘Stable’ Currency Peg is Falling, but this Time it Looks Like it Might Vindicate Crypto Bulls, June 18, 2022
32. Trading economics data as of June 19, 2022
33. Reuters, Explainer: What Would Japan’s Currency Intervention to Combat a Weak Yen Look Like, June 10, 2022
34. BofA Securities, Global Fund Manager Survey: Summer of Volker, June 14, 2022
35. UBS, UBS House View, June 2022
36. Merrill, Capital Market Outlook, June 13,2022
37. Alpine Macro, Fed Panic = Recession, June 20, 2022
38. Morgan Stanley, Midyear Investment Outlook, June 2022
39. UBS, UBS House View, June 2022
40. Morgan Stanley, Midyear Investment Outlook, June 2022
Consumer price inflation (CPI): CPI measures the average change in prices that consumers pay for a defined basket of goods and services.
S&P 500 Total Return Index: The index includes 500 leading U.S. companies and captures approximately 80% coverage of available market capitalization.
Originally Posted June 28, 2022 – Second Half Outlook: Recession or Not, That’s the Question
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