Is economic recovery on schedule or at risk?

February 1, 2022 | Market news

Forecasting the direction of the U.S. economy is never easy. It can be even more challenging in uncertain times.

In the past two years, we’ve transitioned from the most dramatic short-term recession in history to an economy growing at its fastest annual rate in years. This see-saw of economic activity can be directly attributed to the sudden emergence of the COVID-19 pandemic early in 2020 and a resurgence of economic activity as the world adjusted to the new environment. The situation continues to evolve as additional variants of COVID-19 create more question marks about the potential economic impact of the virus.

The economy grew 5.7% in 2021, the fastest rate of annual growth since 1984. At the same time, inflation measures also generated a dramatic increase. Demand for goods such as single-family homes, lumber (for new home construction and renovation work), food and energy played a big part in the cost-of-living surge. It was the first time in decades that inflation became a top concern. At the same time, employers have millions of job openings, as a large number of Americans have made the decision to leave the workforce or switch jobs.

How should investors assess the state of the economy today and where might we go from here? Investment strategists from U.S. Bank review the headwinds the market faces and the potential impact on investment strategies and your portfolio.

An economy still searching for ‘normal’

This has not been in any way a “run-of-the-mill” economic environment. The U.S. economy suffered a steep and rapid decline in the first half of 2020, including a 33% annualized drop in Gross Domestic Product (GDP) as COVID-19 first emerged on the scene. Since that time, the broader economy has demonstrated significant strength. Most companies managed to grow their profits throughout 2021, which helped fuel a strong stock market. Despite the improved environment, many businesses are not yet operating as they were in the pre-pandemic era, (i.e., employees still working remotely, restaurants limiting service, etc.). It reflects the reality that COVID-19 continues to influence the shape of the economy.

“We’ve anticipated a two-horizon investment environment,” says Eric Freedman, chief investment officer at U.S. Bank. “We are still in horizon one, where the economy continues to recover and adjust to the COVID environment. The second will be when the environment transitions from one driven by the pandemic, to a circumstance where COVID-19 becomes more endemic, with the situation at least somewhat closer to the normal state we knew before 2020.” There is not yet a specific timeline on when the second horizon may commence.

Cross currents in today’s economy

While economic growth in 2021 was impressive, a number of headlines were devoted to the inflation story. The cost-of-living, as measured by the Consumer Price Index, rose 7% in 2021.1 This was the highest level in four decades and is far in excess of the inflation target established by the Federal Reserve (the Fed) as it sets its monetary policy. The Fed seeks to maintain an inflation rate “that averages 2% over time.”2

Since the early days of the pandemic, the Fed’s focus was to boost economic growth. This included reducing the target federal funds rate it controls to near 0%, and regularly purchasing $120 billion worth of Treasury and mortgage-backed securities each month to help add liquidity to the market.

“By absorbing some of the inventory in the market, the Fed was able to help keep longer-term interest rates lower,” says Rob Haworth, senior investment strategy director at U.S. Bank. In recent months, the Fed has altered its stance, making clear that its bond-buying strategy would be quickly wound down and end by early 2022. That could push long-term interest rates higher. In addition, the Fed indicates that it intends to raise the short-term fed funds rate at least three times in 2022.

“What’s clear is that inflation definitely got the attention of the Fed,” says Haworth. “It appears that higher inflation may linger for a time, as consumer demand remains strong.” The Fed’s new policy direction is aimed at trying to contain inflation and bring it back to its 2% target range.

The Fed’s new position was made public just as word of the emergence of the highly-transmissible Omicron variant of COVID-19 became a concern. The new variant was a reminder that the economy may continue to face challenges going forward due to ongoing issues related to the pandemic. This will put the Fed under pressure to walk a tightrope in trying to tamp down inflation by cooling off the rate of economic growth while still keeping the economy moving in a positive direction. Yet the Fed has made clear it is shifting from a monetary easing stance (lower interest rates, Fed assets invested in the bond market) to a monetary tightening stance (rising interest rates, less Fed liquidity in the market).

“The question is, does the Fed get more aggressive and potentially damage economic growth, and with it the labor market, prospects for consumer spending, and the strength of the bond market,” says Haworth. High inflation presents a new scenario unlike any with which central bankers have had to contend for decades.

“We think the Fed will intelligently manage the situation,” says Freedman, “but the markets at the start of 2022 seem to be anticipating that economic growth is likely to slow from the pace of the prior year.”

Investment ramifications in an uncertain economic environment

After repeatedly reaching record highs in 2021 and in the opening days of 2022, major stock market indices, including the benchmark S&P 500, retreated in the early weeks of 2022. “Given the change in Fed policy, anticipation of the midterm elections in November and questions about the current legislative agenda, there seems to be room for more stock market volatility this year,” says Haworth. “Another risk is that corporate earnings fail to live up to expectations.” Freedman concurs, noting that comparative earnings growth from 2021 to 2022 will likely be lower than it was for the prior year. “But we still think growth is there and that stocks remain reasonably well positioned for 2022.”

The bond market is clearly affected by Fed interest rate policy and the risk of higher inflation. “It’s a much more complicated market for bond investors today,” says Freedman. “Simply owning Treasury bonds and high-quality corporate bonds may not deliver sufficient results for many investors.” He says there is a need to broaden bond allocations to consider other types of fixed income for differentiated return streams, such as non-agency mortgage-backed securities, municipal bonds (in taxable accounts) and reinsurance.

Consider reviewing your current portfolio with your wealth management professional to determine if it’s well positioned given the possibilities of where the economy may go from here.

Have questions about the economy, the markets and your finances?
Your U.S. Bank Wealth Management team is here to help

Diversification and asset allocation do not guarantee returns or protect against losses. Investments in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Investment in fixed income securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term securities. The municipal bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issues of municipal securities. Interest rate increases can cause the price of a bond to decrease. Income on municipal bonds is free from federal taxes, but may be subject to the federal alternative minimum tax (AMT), state and local taxes. Reinsurance allocations made to insurance-linked securities are financial instruments whose performance is determined by insurance loss events primarily driven by weather-related and other natural catastrophes (such as hurricanes and earthquakes). These events are typically low-frequency but high-severity occurrences. In exchange for higher potential yields, investors assume the risk of a disaster during the life of their bonds, with their principal used to cover damage caused if the catastrophe is severe enough.

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