- High inflation and rising interest rates create headwinds for the economy, markets and investors.
- The Federal Reserve is focused on facilitating what is referred to as a “soft landing” for the economy – slower, but still positive, growth.
- The initial stage of asset repricing that occurred in the first half of the year may be over, but a second wave of repricing may be underway, putting additional downward price pressure on assets.
Investors face a range of challenges and considerations in today’s market.
Broad segments of the capital markets, including stocks and bonds, suffered setbacks in the year’s first half. The Federal Reserve’s (Fed’s) substantive policy shift – rapidly raising short-term interest rates and reducing its bond market holdings – contributed to a change in market tenor. The Fed took significant steps designed to stem inflation’s rising tide while maintaining slower but positive economic growth. Geopolitical events such as Russia’s invasion of Ukraine and continuing challenges resulting from COVID-19 add to market uncertainty.
“Consumer and corporate health will likely become more challenged in the latter months of 2022,” says Eric Freedman, chief investment officer for U.S. Bank. “Investors need to keep this in mind as they position their portfolios for the near term.”
The first six months of 2022 represented a rare period when major asset classes weathered simultaneous declines. After a solid recovery in July, markets hit another rough patch as stocks declined and interest rates moved higher. Year-to-date through August 31, the Standard & Poor’s 500, a benchmark of broad domestic stock market performance, was down more than 16% on a total return basis. The yield on the 10-year U.S. Treasury note rose from 1.52% to a high of 3.49% by mid-June before falling back to 2.60% in mid-August (bond prices fall when yields rise). By the end of August, yields on the 10-year Treasury bond were back above 3%. “As yields rose on relatively safe government bonds, all other assets that carry more risk, such as stocks, repriced at lower levels,” notes Freedman.
The U.S. Bank investment team remains focused on two primary factors that will help determine the direction of capital markets through the remainder of 2022 and into 2023 – the degree to which the U.S. economy slows and inflationary trends.
Headwinds for the economy
The U.S. economy took a sharply slower turn in 2022. This followed a year of solid economic expansion in 2021, when Gross Domestic Product (GDP), the headline measure of economic activity, grew by 5.7%. In the first quarter of 2022, GDP declined by 1.6% on an annualized basis, and fell again in the second quarter, at an annualized rate of 0.9%.1 “We’ve seen a mini-boom in travel activity and a still strong labor market in 2022, but other parts of the economy, such as retail spending, have slowed,” says Freedman.
Inflation has an impact on consumer behavior. The most dramatic price increases occurred in the volatile food and energy sectors. As a result, consumers were forced to spend more on non-discretionary items. “Concerns about consumer demand sustainability and questions about whether corporate spending will hold up are common themes,” says Freedman.
He adds this creates more uncertainty about the direction of the economy. “A year ago, we were on a positive path, and we may be again in the middle of 2023. But the confluence of issues we see today bears watching. While the range of outcomes remains wide, risks are likely skewed to the more negative side of the ledger.”
The Fed’s balancing act
The current environment offers multiple challenges for the Fed as it tries to tame inflation without causing the economy to fall into a recession. The Fed is hoping to achieve what is referred to as a “soft landing” for the economy – slower, but still positive, growth.
“The Fed is in a position to somewhat manage demand,” says Freedman. “It hopes to find an equilibrium that results in a little less consumer demand without a massive departure from its more normal state. It wants to accomplish the same outcome with business spending.”
By contrast, the Fed has little to no control over the supply side of the relationship between supply and demand; current events have exacerbated supply issues.
- Russia’s war with Ukraine has added complications for policymakers. Most notable is the interruption in the flow of Russian energy resources to Europe. Select European countries are highly reliant on Russia as a source of oil and natural gas. Both Russia and Ukraine are also major agricultural producers. The economic impact of supply disruptions has been significant, with Europe’s economy facing the most serious repercussions.
- China’s repeated “lockdowns” of selected cities to combat COVID-19 outbreaks has also contributed to supply chain perils. Lockdowns force Chinese-domiciled companies to slow production, limiting goods availability.
- Freedman also notes that labor shortages in the U.S. affect the ability of manufacturers, service businesses, and even government entities to keep pace with current demand.
These aggregate factors contribute to pricing pressures that result in an elevated inflation rate. “The ability to achieve a ‘soft landing’ may rely in large part on how well we can match supply to meet demand,” says Freedman. “To phrase it in gymnastics terms, some people think the Fed can ‘stick the landing’ and keep the economy moving in a positive direction even if growth slows. Others see a possible foot fault, while those who are more pessimistic fear an outright fall.”
“A year ago, we were on a positive path, and we may be again in the middle of 2023. But the confluence of issues today bears watching.”
- Eric Freedman, chief investment officer for U.S. Bank
Freedman believes the Fed may have difficulty executing a perfect soft landing but that any potential economic downturn will be modest.
Economic growth will be key to the markets
Equity investors should monitor whether businesses can continue to grow earnings and revenues, a key to positive stock performance going forward. Business results trend to be highly correlated to the rate of economic growth or contraction. “Business leaders have to decide whether it’s a good time to invest in future growth by spending on upgraded technology, more advertising and a larger workforce,” says Freedman. “Their decisions depend in large part on expectations for consumer spending.”
A recent trend shows consumers cutting back on expenditures for goods, but spending more on experiences, such as travel and leisure activities, for example. “It becomes an inter-dependent relationship between consumers and businesses,” says Freedman. Stubbornly high inflation and additional anticipated Fed rate hikes add to the uncertainty in today’s business environment. “Businesses are confronting higher costs for energy, wages and borrowing. That can have a cascading effect on business expenditures. If business spending slows, that can ultimately impact consumer spending, and the interdependence persists.”
Freedman is confident that the economy will ultimately adjust to current circumstances through both demand and supply side considerations. These adjustments, likely to involve a combination of changes in consumer saving and spending dynamics and businesses recalibrating to current conditions, will eventually result in reduced levels of inflation through energy and food cost moderation and the conclusion of tightening monetary policies from the Fed.
Positioning your portfolio
The initial stage of asset repricing that occurred in the first half of the year may be over, but Freedman says investors need to be prepared for additional repricing. “As interest rates rise on fixed income investments, all other assets need to re-price at lower levels,” says Freedman. If consumers and businesses cut back on spending, it would likely result in reduced corporate profit growth, and consequently, lower stock prices. Freedman says this scenario is not a certainty but should be an investment consideration.
Now is a good time to review your financial plan with your U.S. Bank wealth professional. If you don’t have a plan, take the time to establish one. Determine whether there are opportunities to rebalance your portfolio to more appropriately reflect your investment objectives, your risk tolerance level, and the current market 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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