Investment Review & Outlook – April 2022

 

• The transition from a low inflation environment to a higher inflation
• The transition from a historically low interest rate environment along with the accompanying unwinding of quantitative easing (QE).
• A transition towards deglobalization as the role of China as a provider of relatively inexpensive labor, manufacturing resources, and products has slowed due to higher wages and price increases. At the same time, Russian aggression has caused the US and Europe to reconsider security budgets and energy and food dependency, while navigating complex geopolitical and diplomatic dynamics.

Quelling Inflation, A Fed Imperative

Pricing pressures emerged as a result of COVID-19 stimulus and supply chain dislocations, leaving inflation at a 40-year high. At its last meeting, the Fed raised the Fed Funds rate from near zero to range between 0.25% and 0.50% as a starting point to quell inflationary pressures. The Fed also penciled in at least six additional rate hikes this year, potentially raising the Fed Funds rate to slightly below 2% at the end of 2022 and to approximately 2.75% next year. These rate hikes will be implemented in conjunction with the end of QE, the Fed’s bond-buying program.

More recently, Chairman Jerome Powell said the Fed needed to move “expeditiously” to combat high inflation while also raising the possibility of 50-basis-point hikes instead of the six additional 25-basis-point hikes previously outlined. “If we think it’s appropriate to raise by a half point at a meeting or meetings, we will do so,” Mr. Powell has stated, signaling a bias toward lifting rates more quickly until the central bank sees clear evidence that inflation is falling to its 2% target.

The Impact On Commodities & Supply Chain Issues

As a result of the Russian invasion, the long-term impact from a reduced supply of commodities, such as oil and grains, and the accompanying higher commodity prices, is an issue that bears consideration and may reverse a period of relatively low commodity prices that Americans have enjoyed for the past decade.

An upswing in commodity prices also may have a negative impact on stocks and bonds and may spur inflation higher. In addition, heightened COVID-19 concerns in China as new variants emerge, have resulted in factory and port closures, which may further disrupt supply chains. Following the global pandemic, supply chain resiliency remains a focus for many firms that import from China and other areas of the globe.

Housing Affordability Considerations

The housing market remains under-supplied, with affordability stretched for many buyers. As interest rates rise, mortgage rates will increase, and buyers competing for limited housing stock may face larger mortgage balances and higher monthly payments as a result. Banks will be eager to lend, yet the combination of higher house prices and higher rates ultimately may dampen future demand for housing in general.

2022 Recession Risk Is Low For Several Reasons

Despite the many dynamics discussed so far, we believe recession risk in 2022 is low for several reasons. US household wealth is up $40 trillion since the start of the pandemic to a record $150 trillion at the end of 2021. Net worth exceeds disposable income by eight times compared with four and a half times in the 1970s, although much of that wealth is at the higher end of the income spectrum. Fiscal stimulus did help Americans during the pandemic and was clearly meaningful at the lower end of income levels, providing a much-needed cash infusion for consumers and the economy as a whole.

There still is ample consumer savings and liquidity for many consumers to manage through this inflationary period. According to the US Bureau of Labor Statistics, as of January 2022 there were a record 11 million job offerings in the US economy, with more than two jobs available for every unemployed worker. In light of these factors, a 2022 recession does not appear to be likely.

In response to the Fed’s more aggressive interest rate stance, Treasury yields have climbed rather quickly, particularly in the shorter end of the yield curve. This reflects expectations for a rapid series of interest rate hikes this year.

While the gap between 2- and 10-year Treasury yields has narrowed, seen by some as a leading indicator of recession, in August 2019, longer-term yields briefly dropped below short-term yields, but the economy remained strong with subdued inflation and low unemployment. This time around, should the curve invert for more meaningful periods, investors likely will become concerned.

In this rate environment, we expect the 2-year Treasury ultimately to end up in the 2.50% to 2.75% range while the 10-year Treasury should reach 2.75% to 3%, by year end, which we believe will slow growth but not bring about a recession..

An Update On Municipal Bonds

Municipal bonds saw persistent outflows in the first quarter of 2022, sparked by fears of rising inflation, higher interest rates, and the turmoil surrounding geopolitical events. However, the municipal bond market still offers attractive opportunities for higher-income investors.

• The resulting decline in prices over the last several months has translated to higher tax-free yields.
• From a credit perspective, the strength of municipal bond market fundamentals buoyed by fiscal stimulus, a better-than-expected economic recovery, and increasing tax revenues, is notable.

While the volume of new municipal bond issuance on a national basis is down 16% relative to this time last year, we expect issuance to increase as municipalities seek to issue bonds before meaningful interest rate hikes.