Second Half Outlook 2022

ISG

July 14, 2022

The first half of 2022 has been eventful, to say the least. It’s been full of various unprecedented events and numerous record-breaking statistics the markets have not seen in decades, if ever. As always, there are numerous competing positive and negatives forces in which the markets attempt to digest.

On one hand, the U.S economy has been hit by multiple shocks including further pandemic waves, China’s “zero-COVID” policy and a war in Europe. The U.S. stock and bond markets have had their worst first half of the year in over 50 years, and inflation has hit levels not seen since the ‘80s. Conversely, unemployment is near record lows, wages are increasing, consumer and corporate balance sheets are in relatively good shape, and corporate earnings are growing – all supportive of a healthy economy.

Before we get into the details, we’ll provide some context on how we arrived here. The Fed’s last tightening cycle ended in December of 2018. For the next several years, we generally saw accommodative monetary policy with very low interest rates. The pandemic, which began in early 2020, prompted trillions of dollars of fiscal stimulus as well as further quantitative easing by the Fed. All of this stimulus worked well in getting us through the pandemic driven lock-downs, but it also dramatically increased money supply (i.e. Monetary Inflation – see chart below) and put trillions of dollars in the hands of consumers who were tired of lock- downs and ready to spend. When the money supply grows faster than the growth of real output in the economy, consumer price inflation can result. Combine this spending with severe supply-chain disruptions across the globe and the result was increased demand, decreased supply, and rising prices, i.e. inflation. Add a war in Europe and inflation has gotten even worse.

For much of 2021, the Fed believed that higher inflation rates were “transitory” and that things would normalize once the pandemic faded and supply chains returned to normal. As we know, this did not occur as expected, and inflation has remained high. The Fed now has the difficult task of engineering a “soft landing”, i.e. bringing down inflation while avoiding sending the economy into a recession. With a strong labor market, the Fed is focusing on taming inflation and has gotten very aggressive in raising interest rates and reducing their balance sheet. We are beginning to see signs of slowing growth and declining inflation in various aspects of the economy including housing prices, energy costs, and corporate earnings growth, among others.

As the economy slows, the odds of a recession at some point increase. Opinions vary widely on if or when this may occur, but the still-strong cushion of household excess savings and the high level of cash on corporate balance sheets are primary reasons why there is still strength in the economy which may push out a recession or reduce its severity.

Although a recession certainly poses risks to the markets, focusing too intently on when a recession might strike also carries risk. During challenging conditions, people seem to forget that economic cycles are just that—cyclical, and that cycles have their ups and their downs. In the end, healthy economies grow, and markets generally move higher over longer periods. If greed were investors’ worst enemy at the top of a market, fear is their worst enemy when markets are challenged. The winner in either environment will be the clear-eyed investor who considers the long-term fundamentals and invests with conviction in markets that can deliver attractive risk-adjusted returns over time.

COVID

The U.S. Omicron wave saw confirmed cases peak at an astounding 800,000+ per day in January, temporarily slowing the economic recovery. Cases then fell to roughly 30,000 per day by mid-March but then rebounded to over 100,000 per day in May. However, the Omicron variant has proven to be less lethal than earlier COVID-19 strains, and vaccines continue to be very effective at preventing serious illness or death. This being the case, after more than two years of the pandemic, most Americans are returning to normal activities, providing a significant boost to aggregate demand in the short run.

Fiscal Stimulus

Conversely, demand is being reduced by a fast-falling federal deficit. According to the latest Congressional Budget Office estimates, the federal deficit could fall from $2.8 trillion or 12.4% of GDP in fiscal 2021 to just $1.0 trillion or 4.2% of GDP in fiscal 2022. This would mark the single largest decline in the budget deficit relative to GDP since 1947 and reflects an end to a host of government benefits, many of which were particularly significant for low- and middle-income consumers. Further significant fiscal stimulus is not expected from this Congress or the next one and, without this aid, consumer spending, particularly on basic goods and services, should grow more slowly throughout the rest of this year and into 2023.

Inflation

Inflation has soared over the past year due in part to strong demand and in part to supply chain difficulties due to the disruptive effects of the pandemic. These problems are being extended in 2022 given the COVID situation in China and Russia’s invasion of Ukraine. On the former issue, the Chinese government is likely to maintain a “zero-COVID” policy for most of the year. While this may prevent an immediate huge wave of fatalities, it will also result in rolling lockdowns, disrupting both domestic economic activity and exports. On the latter issue, the brutal Russian invasion of Ukraine has evolved into a protracted conflict in the east of the country. Disruption from the war itself along with sanctions on Russia have resulted in further increases in food and energy prices. However, provided there is no further escalation, global producers and consumers will gradually adapt to the situation. High commodity prices should play their normal role of promoting more supply and less demand, allowing global commodity prices to generally move sideways or down in the months ahead.

GDP

Real GDP fell 1.5% in the first quarter following a 6.9% gain in the fourth quarter of last year. Both the fourth-quarter gain and the first-quarter loss were likely exaggerated, although the Omicron wave added genuine weakness to first-quarter economic activity. Real GDP growth appears to have reaccelerated in the second quarter, however, expectations are for growth to drift down in the second half of the year as demand is hit by fiscal drag, a high dollar, higher mortgage rates and lower consumer confidence. That being said, demand is not expected to collapse, as there appears to be huge pent-up demand for vehicles, houses and consumer products that have been in short supply over the pandemic. Spending should also be buoyed by pent up demand for travel, leisure and entertainment after the pandemic.

Employment

Another source of resilience has been pent-up demand for labor. At the end of April, there were 11.4 million job openings, which amounted to almost twice the number of people counted as unemployed in the May jobs survey conducted two weeks later.

Very low unemployment should also contribute to continued strong wage gains and this, in turn, should feed through to higher inflation. Some transitory forces, such as high energy prices partly due to the Ukraine invasion, a chip shortage boosting auto prices and government aid boosting food spending, are expected to wane in the months ahead. However, the effects of higher wage inflation, higher shelter inflation due to the lagged impact of higher home prices, and higher inflation expectations should linger.

One crucial assumption is that the Federal Reserve will be patient in trying to guide inflation back to its 2.0% target. Clearly, current inflation numbers are higher than the Fed would like and it would prefer inflation to come down quickly. However, it is worth noting the significant braking power being applied to the economy by falling budget deficits, a higher dollar and higher mortgage rates. Since this could prompt a recession and because long-term forces should continue to reduce inflation in the years ahead, the Fed’s rhetoric may turn more dovish in the months ahead. That being said, markets are still expecting the Fed to follow its current path of another 0.75% hike at its July meeting followed by more gradual increases at the remaining meetings.

In Summary

The debate continues on whether the Fed can engineer the elusive “soft-landing” or are we headed into a recession. As it is often said, “better or worse matters more than good or bad” when it comes to both the timing of economic inflection points and the relationship between economic data and stock market behavior. Levels remain healthy among most labor market data (one of the more important statistics); but it’s the deterioration in the trends that bears watching to declare the winner of the recession vs. soft- landing debate.

As inflation remains high, the odds of a recession may be increasing, and, in fact, hindsight may eventually tell us that a recession has already begun. However, given the bear market in stocks is already well underway, the semantics of a recession matters less than it would have back at the market’s high at the start of this year. Equity markets usually bottom before recessions and are already rising by the time a recession is underway. Statistics such as employment and GDP are backward looking and markets tend to bottom long before these indicators start improving.

Market volatility is normal, and history has shown us, time and time-again, not to panic. We continue to rebalance portfolios where appropriate, and reposition investments as needed. We have shortened duration in fixed income and have added to investments that we believe will exhibit lower volatility and more consistency in the current economic environment, including certain private market investments.

We continue to focus on the core tenets of our investment process – long-term risk adjusted returns and constructing durable diversified portfolios.

If you have any questions or would like to discuss anything in more detail, please do not hesitate to call.

Sincerely,

Your team at ISG

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