- U.S. economic growth has slowed in 2022 than was the case in 2021.
- The Federal Reserve continues to push interest rates higher, raising fears that a recession may be unavoidable.
- Yet many key economic indicators continue to demonstrate resilience in the face of significant headwinds.
In the closing months of 2022, there seem to be more questions than answers about the direction of the U.S. economy. A mix of developments – from spiraling inflation to a dramatic shift in Federal Reserve (Fed) monetary policy to the fallout from Russia’s invasion of Ukraine, and persistent issues related to COVID-19 – fanned concerns that a recession may be on the horizon.
While recessions are difficult to forecast, the economic environment in 2022 is markedly changed from 2021. As measured by Gross Domestic Product (GDP) growth, the economy in 2021 grew at an annualized rate of 5.7%, the fastest rate of growth in a calendar year since 1984. In the first quarter of 2022, GDP declined by an annualized rate of 1.6%, followed by a 0.6% annualized decline in the second quarter. The economy showed some resiliency in the third quarter, rising at an annualized rate of 2.6%1. Throughout the year, consumer spending remained solid and corporate profit growth was generally strong.
Nevertheless, there are questions about the direction of the economy going forward. “The key reason economic growth moved backwards in the first two quarters is a contraction in inventories held by companies,” says Rob Haworth, senior investment strategy director, U.S. Bank. “We’re still waiting for inventories to bounce back,” says Haworth. “Major factors pushing growth in a positive direction in the third quarter were trends related to imports and exports,” according to Haworth. He believes that there are some concerns bubbling to the surface. “We have a manufacturing economy at stall speed. There is not a recession yet in the manufacturing sector, but no major acceleration either.”
While many have speculated this year as to whether the economy was already in a recession, there are indicators that seem to refute that. For example, the job market continues to feature a very low unemployment rate (3.5% in September). In addition, there are significantly more job openings than there are available workers.2
How should investors assess the state of the economy today and what should they expect from here?
The primary economic issue dating back to early 2021 is the re-emergence of inflation as a threat to the nation’s economy. The inflation rate, as measured by the Consumer Price Index, rose 7% in 2021 and peaked at 9% over previous 12-month periods by June, 2022.3 This was the highest level in more than four decades and exceeds by a wide margin the inflation target established by the Fed as it sets its monetary policy. The inflation rate has moderated only slightly since June. The Fed targets an inflation rate that averages close to 2% over time.
“The Fed has to thwart inflation. Their bias will be to keep tightening monetary policy. There is certainly the potential that they keep raising rates into 2023.”
- Eric Freedman, chief investment officer, U.S. Bank
Given the persistence of higher living costs, the Fed made a dramatic pivot in its strategy. In March, it raised the primary interest rate it controls, the fed funds rate, for the first time since 2018. In November, the Fed set the target fed funds rate to 3.75% 4.00%, up from near zero percent before the March rate hike. The Fed also ended its bond buying program and began reducing its bond holdings. The Fed’s altered strategy is designed to push interest rates higher in the broader bond market as a way of tempering the pace of economic growth. “The Fed has made clear its first target is to soften inflation,” says Haworth. The Fed’s new policy direction is aimed at bringing the inflation rate back to its 2% target range.4 Haworth says that while the Fed’s 2% target goal may not be reachable before 2024.
Investors have justification to be concerned about the risk of persistently high inflation, says Eric Freedman, chief investment officer, U.S. Bank. He’s closely monitoring whether “we’ll continue to see higher commodity costs as well as higher borrowing costs structurally trickle into the economy and stay there for some time.” He thinks investors need to remain cautious about the impact of that potential development.
Other clouds on the horizon
While investors and consumers are more attentive to inflation’s spike, other factors could complicate efforts by the Fed to manage the economy. For example, COVID-19 continues to create problems in pockets of the world. The Chinese government’s attempts to manage the ongoing spread of the virus caused it to shut down major cities this year. Chinese factory production slowed as a result, affecting global supply chains.
Another factor is the economic fallout from Russia’s invasion of Ukraine. Russia is a significant energy supplier, particularly for much of Europe. Both Russia and Ukraine are notable agricultural exporters. Supply disruptions raise concerns about the potential impact on commodity prices. Oil and natural gas prices have been more volatile since the start of the war in February 2022.
Freedman notes that outside pressures like the continued imbalance between supply and demand put the Fed in a challenging position. Recent events, like a cut in oil production by members of the Oil Petroleum Exporting Countries (OPEC) and flareups in the Russia-Ukraine war that may impact grain shipments are factors out of the Fed’s control. Both are examples of events that add to inflationary pressures. Nevertheless, says Freedman, “The Fed has to thwart inflation. Their bias will be to keep tightening monetary policy. There is certainly the potential that they keep raising rates into 2023.”
Despite the Fed’s monetary tightening actions since March 2022, it’s notable that throughout 2022, job growth exceeded projections, averaging more than 400,000 per month through September. “We don’t see signs of the labor market being disrupted,” says Haworth. This fact seems to contradict rising concerns that a recession is already underway.
Can the economy hold its ground?
A key question is whether the Fed’s aggressive posture allows it to successfully tackle the inflation threat while steering the economy toward a “soft landing,” and avoiding a recession.
“The Fed would love to achieve a soft landing, but it’s first priority is to stem the inflation threat,” says Haworth. “At current levels, it would consider the fed funds rate to be ‘normalized.’ Now it must calculate its next steps.”
Haworth says despite increased chatter about the possibility of a recession and record low consumer sentiment (based on recent surveys),5 much of the economic data remains positive. “Consumers have not stopped spending. They’re spending less on goods and more on services. We see it reflected, for example, in faster growth in the travel and hospitality industries.”
The housing market is another key indicator of economic health. Housing prices soared in the immediate aftermath of COVID-19’s onset in early 2020. The Fed’s interest rate hikes are reflected in the market for mortgage loans. Mortgage rates rose significantly in 2022. That slowed activity in the housing market. Yet it does not appear to be a crippling blow for the economy as a whole. “Housing demand is softening,” notes Haworth, “yet underlying fundamentals of consumer finances and the housing market both remain favorable, even as higher mortgage rates affect home affordability.”
Implications for investors
Both stock and bond markets have experienced negative returns in 2022. As the Fed laid out its planned policy shift in the early part of the year (raising interest rates and ending its sizable bond market investments), investors became more wary. “When the Fed says they’re going to raise rates, generally other asset classes will reprice lower in response,” says Freedman. In July, when the Fed gave indications that it might slow the pace of rate hikes, stocks surged. But when the Fed signaled that more rate hikes were ahead in August, stocks declined again. In October, investors speculated that the Fed might be ready to temper the pace of rate hikes, which again boosted the stock market.
Interest rates moved up rapidly on bonds across the board. Rising rates may continue to put pressure on equity markets. “If investors can earn higher interest rates now than they did in 2021, it makes stocks less attractive,” says Haworth. “Investors are less willing to bid up stock prices in that kind of environment.” The result, says Haworth, is a more volatility for stocks that may persist through for some time.
Haworth cautions that corporate earnings could be under more pressure if the economy slows and consumers pull back. Yet in the current cycle, that scenario has yet to develop. “Keep an eye on the jobs market,” says Haworth. “If that starts to weaken, it may mean the economy is about to face more headwinds.” To this point, the strong jobs market appears to be bolstering the broader economy.
Consider reviewing your current portfolio with your wealth management professional to determine if it is consistent with your long-term goals and positioned to meet the challenges of what continues to be an uncertain market and economic environment.
Have questions about the economy, the markets and your finances? Your U.S. Bank Wealth Management team is here to help.
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