by
Badgley Phelps
| Oct 17, 2022
Outlook: 4th quarter 2022
Growth across our economy has been uneven this year. In fact, the economy contracted modestly in the first half of 2022 driven by reductions in government spending and inventory investment. Fortunately, we have benefitted from robust labor markets, sustained
increases in consumer spending, and solid corporate earnings growth.
Despite the lackluster growth, inflation remains high, and the Federal Reserve continues to tighten their policy. Last month the central bank raised its target rate by 0.75 percentage points to 3.25 percent. While that rate is low in historical terms,
the pace of tightening has been dramatic given that the policy rate was close to zero in early March. In addition, the central bank continues to reduce the size of its balance sheet, by $95 billion per month, which is another means of tightening financial
conditions.
Looking forward, we expect the Federal Reserve to continue shifting to a more restrictive stance. As of the end of the third quarter, pricing in the futures markets suggests the central bank will raise interest rates to a range between 4.25 and 4.50 percent
by the end of the year. Given the sustained tightening of financial conditions, we expect the economy to soften. In tandem, inflation should decline, but remain elevated in the coming months, as a reduction in the growth of price levels is typically
a process that takes time.
Strength in employment markets, growth in corporate earnings, and sustained consumer spending may allow for a resilient economy that can muddle through a challenging environment. However, today’s high inflation rate and the corresponding aggressive
policy by the Federal Reserve are likely to generate a deceleration in the fundamental drivers of the economy. Accordingly, the risk of a recession has increased, and caution is warranted.
Inflation
The Consumer Price Index increased at an annual rate of 8.3 percent in August and the core rate, which excludes the volatile food and energy components, increased 6.3 percent. Both figures were higher than the consensus estimates and showed that inflation
is spreading from hard goods, such as autos, to services.
We expect the rate of inflation to decline as we progress into the fall and through the winter. However, the key question relates to where inflation will settle on a longer-term basis. In the years leading up to the pandemic, the Consumer Price Index
increased at an annual rate close to 2.0 percent, but at this stage it remains unclear if the rate will return to that level without a more significant downturn in the economy.
U.S. dollar
The U.S. dollar has been strong this year and has appreciated significantly against most major currencies. The dramatic increase in interest rates in the United States, coupled with heightened uncertainty about the global outlook and the war in Ukraine,
continue to generate persistent demand for our currency. Looking forward, we expect the U.S. dollar to remain elevated as the recent drivers remain intact.
Asset class
Cash/Money Market Instruments
To tame stubbornly high inflation, the Federal Reserve announced a rate hike of 0.75 percentage points during its September meeting and signaled a more aggressive series of future increases than the market expected. Following that change in policy, the new target rate is between 3.00 and 3.25 percent.
This year the Federal Reserve has tightened their policy aggressively and yields on short-term bonds have increased. After starting the year at a yield of 0.04 percent, the three-month U.S. Treasury bill currently yields 3.5 percent. Rates are expected
to continue to rise given today’s high inflation and recent guidance from the Federal Reserve suggesting there will be an additional 1.25 percentage points of tightening by the end of the year.
Intermediate Government/Credit Bonds
As the Federal Reserve continues to tighten financial conditions, the probability of a soft landing for the economy diminishes. With inflation pegged as public enemy number one, the Federal Reserve’s hawkish tone is unlikely to shift in the near
term as the tight labor market, elevated core inflation, and signs of a potential wage-price spiral remain major concerns for Chairman Powell.
Inflation is at a 40-year high and the Federal Reserve has prioritized a return to price stability over maximum employment. In conjunction, our central bank has signaled that it is willing to risk a contraction in economic growth to ensure that higher
inflation expectations do not become entrenched.
Reflective of heightened concern of a recession, credit spreads for both investment grade and high yield bonds have widened and are at the higher end of the 2022 range. However, they remain well below levels indicating credit dislocation. As a measure
of investment grade credit risk, the spread between the Bloomberg U.S. Aggregate Corporate Index and the U.S. Treasury bond, is only slightly higher than the 132-basis point average since its inception in 1988, and it is a long way from the 373-basis
point high reached in 2020.
Tax-Exempt Municipal Bonds
State and local government bonds have experienced sustained price declines as the Federal Reserve continues to aggressively hike interest rates. The pressure is unlikely to ease soon given that policy makers have signaled additional rate increases by the end of the year. Though it is of little consolation, the poor performance is one of interest rate concerns rather than credit quality as many governments are flush with cash from federal stimulus and strong tax receipts. Demand is currently weak but with yields at the highest levels in 14 years, we expect an eventual increase in sentiment.
U.S. Equity
Last quarter the market was unusually volatile with strong gains in July offset by losses in August and September. In last quarter’s earnings season, companies generated strong revenue and earnings growth with results that were better than expected.
Despite high inflation, margins remained at a historically high level which suggests companies have been able to pass along rising input costs to consumers. The rise in profits, coupled with solid consumer spending, and strong employment markets,
served as catalysts for a rebound in stock prices in July. However, inflation remains high, and the Federal Reserve has become more aggressive in tightening its policy, signaling additional rate increases will be needed. Accordingly, stocks declined
from their mid-summer highs with the S&P 500 Index ending the period near its low point for the year.
In the coming months, we expect equity markets to remain volatile with periods of weakness followed by relief rallies. The Federal Reserve is expected to continue raising interest rates this quarter and in early 2023. In addition, inflation remains high,
the war in Ukraine is ongoing, and housing markets are slowing. Earnings will be particularly important this quarter as some of the recent volatility is predicated on the assumption that earnings growth will fall significantly from current levels.
On a positive note, equity valuations have declined from historically high multiples to a level that is slightly below the long-term average. If stock prices decline meaningfully, valuations will start to become attractive from a long-term perspective.
In short, the cross currents of positive and negative drivers are expected to keep volatility elevated in the coming months as the market searches for a durable bottom.
International Equity
Many of the domestic market dynamics are also present across international economies. However, they are amplified by a confluence of factors. For example, up until recently, European economies were dependent upon Russia for their energy needs. This has
resulted in dramatic spikes in energy costs. In Asia, some governments continue to pursue lockdown policies to limit the spread of COVID-19 which is slowing growth and exacerbating supply chain issues. Given the turbulence in the global economy this
year, the U.S. dollar has appreciated significantly against most currencies. This is making inflation worse in many foreign countries and is a threat to nations that have high levels of debt denominated in our currency.
Given the confluence of events, we expect international equities to remain volatile, following the path of stocks in the U.S. However, valuations are lower in international equity markets and a sizeable portion of this year’s decline is attributable
solely to the appreciation of the U.S. dollar. We remain cautious in our outlook for foreign stocks, but low valuations, coupled with the U.S. dollar at historic highs, could set the stage for some powerful rallies, even if we remain in a bear market.
Commodity
Commodities declined last quarter. In a marked change to prior periods, the declines were widespread and occurred across the energy, metals, and agriculture segments. Energy prices experienced some of the largest losses with oil prices dropping approximately
20 percent last quarter. Despite the recent declines, price levels remain elevated with most commodities above their pre-pandemic averages.
In terms of the outlook, a slowing economy should result in lower demand and a general softening of prices. However, the extent of the declines may be tempered by ongoing supply constraints related to the war in Ukraine, global supply chain bottlenecks,
and a low level of investment in production capacity for some commodities over the last decade.
Potential opportunities & risks
Opportunities
New opportunities/new markets—The outbreak of COVID-19 has presented a unique set of challenges. It also provides businesses with a unique opportunity to differentiate and develop new markets. By some estimates, technology has been
pulled forward two to three years and new products and services are in high demand.
Despite a push for a return to the workplace, many people are resisting that pressure and continue to advocate for flexible work policies. The ongoing demand for remote work opportunities increases the demand for technologies that can facilitate a world
of distanced co-workers. In addition, a shortage of labor is leading companies to invest in technology to boost productivity, automate processes, and adapt to the lack of labor supply.
The emergence of new technologies—The convergence of cloud computing, significant increases in computing power and the advent of the smartphone have created a connected world in which new technologies change the way we live. This
convergence has created investment opportunities centered around long-term themes such as cloud computing, artificial intelligence, and Big Data.
The evolution of finance—Technological advancements are disrupting traditional methods of banking, finance, and transfers of cash. We are experiencing a global shift from paper currency to electronic payments fueled by the popularity
of credit and debit cards, as well as the emergence of cryptocurrencies. Online payment systems facilitating money transfers, e-commerce, buy-now-pay-later arrangements, and electronic bill paying services are also experiencing strong demand. This
shift is still in its early stages and is expected to have a long runway as it is occurring across both the developed and the developing economies. In the coming years, blockchain technology may become a significant disruptor in the finance industry
with opportunities for new entrants while creating risks for the firms that currently dominate this space.
Risks
Inflation—Given the unprecedented amount of fiscal and monetary stimulus in previous years, the war in Ukraine, supply chain bottlenecks, underinvestment in production capacity for some commodities, the trend towards de-globalization,
and a shortage of labor, there is a risk that inflation may remain well above the average of the last thirty years.
Deglobalization—Rising geopolitical tensions across many parts of the world have resulted in a reversal of the globalization trend we have enjoyed since the fall of the Berlin Wall. A renewed priority to secure access to commodities
and other vital product inputs, along with a race to establish global dominance in certain technologies, have led to a reversal of the free trade movement. We expect this development to be coupled with a sustained increase in geopolitical tensions,
upward pressure on inflation, and a rising cost structure for some industries.
The dramatic increase in the U.S. dollar—The U.S. dollar has appreciated significantly this year against many currencies. The pace and magnitude of the increase puts pressure on foreign entities who have debt denominated in our
currency, have their currencies pegged to ours, or those who have other liabilities payable in U.S. dollars. Accordingly, a spike in our currency has been associated with some financial crises including the Mexican Peso Crisis of 1994 and the Asian
Crisis of 1997.
Debt related issues—Sovereign debt levels were rising prior to the outbreak of COVID-19. However, in the wake of the virus, debt has increased significantly. In the U.S., government debt has increased approximately 38 percent since the end of 2019
and that trend shows no sign of reversing course.
The threat of a crisis is also rising in some emerging market countries that have high levels of debt denominated in U.S. dollars. The dollar has appreciated significantly this year which increases the outstanding debt level proportionally and increases
the risk of a default.
Increasing government regulation of technology companies—Several of the leading technology companies have established dominant market positions and have few competitors. As the power of these companies continues to increase, government regulators
are placing them under greater scrutiny by assessing their privacy policies, acquisition plans, and competitive practices.
Geopolitical risks—Conflicts in many parts of the world have escalated or have near-term catalysts that may result in a change in dynamics. We are closely monitoring developments in the war between Russia and Ukraine as well as relations between
the West and China.
Cybersecurity—Cybersecurity remains a significant issue as evidenced by persistent attacks on governments, businesses, and individuals worldwide.
Read more Outlook articles.
Originally posted on October 14, 2022