We offer the following economic and market commentary for the first quarter of 2022.
Russia's invasion of Ukraine continues to loom large on the global economy as the war has intensified. Western countries have introduced a series of sanctions on Russia, including a U.S. ban on Russian oil and energy imports. The full degree to which the war will affect the broader U.S. economy remains to be seen, and it is difficult to foresee how the crisis on the ground will evolve in the coming weeks.
Separately, the U.S. economy is pushing through the Omicron surge well. Against a backdrop of soaring case counts, employment growth, retail sales, and industrial production each expanded at a robust pace during the first few months of the year. The expansion of economic activity at the beginning of the year is an encouraging sign that not only are households and businesses taking new waves of the pandemic in stride, but they are also standing tall in the face of supply chain disruptions, labor shortages, and the hottest inflation in over 40 years. Keeping this fairly strong start to the year in mind, real GDP is expected to expand by 3.5% in 2022 as a whole, which is a significant moderation compared to the blazing 5.7% pace registered in 2021, yet still above the average rate of growth seen in recent history before the pandemic. Moreover, not only will growth moderate, we think the drivers will shift, with consumer spending on goods abating and a larger share of growth coming from business’s fixed investment and inventory rebuilding.
While COVID-19 cases have plummeted in much of the United States, the lengthy list of supply-side problems that have accompanied the public health crisis stubbornly persists. Tangled supply chains and multiple rounds of fiscal support from years past have resulted in a broadening of inflation pressures, which has spurred a hawkish pivot from the Federal Reserve. The most notable change in the economic outlook is that the Fed is now expected to raise the federal funds rate five more times in 2022, bringing the current target range of 0.25%-0.50% up to 1.5%-2.0% at the end of the year. The Fed is also expected to complete its taper of asset purchases and begin to gradually shrink its balance sheet later this summer. The result of such actions will be modestly higher interest rates across the board.
The global economic landscape has changed since the Russian invasion of Ukraine. Soaring commodity prices, sweeping financial sanctions, and the potential for a ban on energy imports from Russia are threatening to hobble a global economy still weakened by the COVID-19 pandemic. Although few Western governments have outright banned the importation of Russian petroleum, with the notable exception of the United States, many Western oil companies have implemented self-imposed boycotts of Russian oil. This conflict is likely to drag on for some time. Even if the war ends in the near term, the West will continue to reduce purchases of Russian oil in the future. Consequently, oil prices should remain elevated in the coming quarters.
Higher petroleum prices will lift U.S. inflation rates even higher than expected just a month ago. Rising inflation will erode growth in real income, which will lead to slower growth in real consumer spending. Consumer spending is not expected to collapse unless oil prices rise significantly higher than currently expected. Household balance sheets are in solid shape at present, and the household savings rate could fall further to support continued growth in consumer spending.
On both sides of the Atlantic, inflation is at levels that have not been seen for decades and are still rising. International stock markets are wilting, and the dollar is surging against other currencies as investors rush for the safety of U.S. assets. This may lead to a bout of stagflation, particularly in Europe. Europe, with its geographical proximity to the conflict and heavy dependence on Russian energy, is potentially facing its third recession in two years.
In Russia, we expect an economic contraction of as much as 10%, which the nation has not experienced since the messy post-Soviet economic overhauls of the 1990s. The initial shock is likely to be followed by a prolonged period of low growth or stagnation as Russia is pushed into economic isolation.
In China, growth is slowing, and high energy costs are a mounting concern. The country is still implementing a zero- COVID-19 policy, and household consumption has been weak, while policymakers are cracking down on excesses in the housing market. Further easing of monetary policy and fiscal support is expected to offset reduced purchasing power. For now, China's economy is expected to grow a little over 5% this year.
With the COVID-19 pandemic receding from the headlines, news of war, surging and sticky inflation, rising interest rates, and ongoing supply chain issues have filled the headline gap. Adding to that is the uncertainty of an as-yet unformed changed world economic order brought on by sanctions on Russia. Investors are groping for what it may all mean to business relationships, cash flows, and profits. There seems to be widespread agreement that no one knows the answers because the war’s course is unknowable. This uncertainty has created the conditions for recent greater market volatility.
However, an important backdrop to global stock performance will be corporate earnings comparisons in 2022 vs. 2021. It is expected that corporate earnings growth will continue to be strong in 2022 but just not at 2021 levels. With that said, it will be no surprise if 2022 U.S. equity performance comes in lower than in 2021 for no other reason than corporate profit growth will slow. Rising interest rates especially in the U.S. will eventually take a bite out of the economy and slow demand for goods and services (which in itself should help supply chain disruptions). This action should take some steam out of the rising long-term interest rate trend. In addition, this increase in interest rates in the U.S. and better relative economic performance here than overseas should keep the dollar strong relative to foreign currencies. This strength should attract foreign capital seeking safe and higher yields. This demand for U.S. dollar-based assets will put some downward pressure on rates and also be a positive for U.S. stock prices. Assuming that is true, the question is, what will the shape of the yield curve look like in the months ahead?
The recent ambivalence about the persistence of inflation displayed by the bond market, with low rates in the face of inflation, appears to have disappeared. Market rates have now climbed, with the 10-year U.S. Treasury bond trading north of 2%, hitting almost 2.5% in the first quarter. The yield curve is moving back and forth between flat and inverted. Notably, prolonged inversion is often a sign for recession in the quarters ahead. We will continue to monitor the key indicators.
There remains a litany of other factors that will impact earnings, stock, and bond prices that cannot be forecasted but must be considered. First, the course of the war in Europe is unknowable. Does it continue to grind away week after week with more death and destruction? What will the global impact be of the sanctions? The pundits do not know themselves, so some investment caution would seem appropriate.
Second, interest rates seem sure to rise and that will affect the performance of companies in different economic sectors and companies of different fundamental quality. After years of lagging growth stocks, this rise in rates should help value stocks (e.g., financial companies) lead the market. Rising rates should benefit companies that do not need to tap the capital markets to fund business operations and hurt those whose borrowing costs are going up. So, the quality factor should also profile stock market leaders.
Third, as rates rise, economic growth will begin to slow, with the Fed hopefully able to engineer a "soft landing" in the quarters ahead rather than tipping the economy into recession. As the economy slows, stocks that pay reliable and growing dividends should attract investor attention. A growing percentage of stock market return should be coming from dividends rather than capital appreciation driven by rapid earnings growth and or price multiple expansion.
But strategic asset allocation and portfolio diversification remain key. Spreading risk out across asset classes in a period of rising uncertainty is prudent given the unknowns. Tilting portfolio capital allocations to market segments that should have the wind at their back, but within the context of a broad strategic asset allocation plan, could make the difference in higher relative portfolio returns.
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Based on the S&P 500 trailing twelve-month Price-to-Earnings ratio, our gauge of U.S. equity valuation registers a current reading at the 15th percentile from January 1871 to March 2022.
Based on the Federal Reserve Bank of Philadelphia’s U.S. Coincident Index, our gauge of U.S. economic activity registers a January reading at the 91st percentile from April 1979 to January 2022.
The equity valuation and economic activity gauges have been reviewed by GW & Wade and are consistent with the firm’s near-term outlook.
This economic and market commentary was prepared by Capital Market Consultants, Inc. (CMC), an independent investment management consulting firm, and has been approved for distribution by GW & Wade, LLC. Data used to prepare this report by CMC are derived from a variety of sources believed to be reliable including well-established information and data software providers and governmental sources. CMC is not affiliated with any of these sources.
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