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Economic and Financial Market Outlook Q2 2022

Tuesday, April 12, 2022

Entering the second quarter, the outlook for the global economy is uncommonly uncertain. The result is above average volatility in financial markets and rapidly shifting investing trends. In the US, the key issue is rising inflation and the response of the Federal Reserve as it attempts to pilot a soft landing (raising interest rates without causing a recession). In our March 2 blog and January 13 Outlook, we expressed confidence that the Fed would be successful. We still adhere to this view but acknowledge that inflation has proved to be more intractable and economically disruptive, which makes the Fed’s task more difficult. In addition to rising inflation, international markets will need to cope with the negative economic consequences of the Russian invasion of Ukraine as well as potential hurdles impeding a pickup in China. Although our forecast carries less conviction than usual, the most probable scenario is that 2022 US GDP will remain positive in the coming quarters, inflation will gradually subside below 5.0% by year-end, corporate profits will rise around 10.0%, and the S&P 500 will be higher at year-end than it is now. 

The US economy currently faces persistently high inflation. Monthly readings of core CPI (ex-food and energy) have risen each month since last September, with the latest reading at 6.5%, the highest in 40 years. In response, the Fed has indicated that it is ready to push through faster rate hikes and balance sheet reductions, which will slow the economy in hopes of dampening upward price pressures. We are intensely focused on the success of this course of action. Achieving a soft landing will enable the economy to continue its growth trajectory and prolong the post-pandemic recovery. However, if inflation continues at a high pace without relief, consumers and businesses will have to curtail spending and the Fed will take even more aggressive measures, increasing the likelihood of recession. 

The exceptional strength of the US economy has thus far blunted the negative impacts of high inflation. The unemployment rate of 3.6% has only been lower once in the past 50 years (3.5%, Oct. 2019). GDP grew 5.7% in 2021, the fastest year since 1984. The US consumer, the backbone of the economy, is solid; balance sheets are healthy, credit utilization is low, and wages are rising. Household cash exceeds debt for the first time since the early 1990’s. Nevertheless, two recession indicators occurred in the first quarter: a spike in oil prices and the inversion of the yield curve (when short-term rates go above long-term rates). Of these two, we are less concerned about oil as it has already stabilized well below the peak. The yield curve inversion, on the other hand while a more reliable predictor, has in the past delivered false signals and on other occasions preceded recession by as long as three years. The robust US economy, in particular the consumer, provides some room for error to navigate a soft landing or, at worst, fend off recession for at least 12-18 months. We expect GDP growth to remain positive every quarter this year, measuring 3.5% for the year. 

US stock markets swooned in the first quarter in response to escalating threats to the burgeoning economic expansion. Major benchmark indices are still mired in a correction, with the S&P 500 producing the first negative quarterly returns in two years. The forward P/E ratio of the S&P 500 index has dropped to 19.0 from the 21.3 recorded at the end of last year, with growth stocks experiencing an especially large multiple contraction. This indicates that current equity valuations are not alarmingly high considering the expected double-digit rise in 2022 corporate profits. If investors gain confidence in the resilience of corporate earnings and/or a successful soft landing, stock markets should make a sharp advance. However, if the Fed makes a policy error and leads the US toward recession, additional negative returns can be assumed before equities begin a new bull market cycle. 

Investing in international equity markets carries additional uncertainties and risks. In the EU, in addition to a more acute impact on consumption from higher energy and food prices, Russia’s invasion of Ukraine has dragged down sentiment, even while economies enjoy a boost from the lifting of COVID-19 restrictions. Alternatively, China is still imposing a “zero COVID-19” policy, which is negatively impacting growth. Encouragingly, however, China policymakers have pivoted to stimulating the economy and committed to achieving a 5.5% GDP growth rate in 2022. This stimulus may serve as the bedrock for a continuation of a strong global economic expansion. China and the US, in combination, account for 42% of global GDP. Our projection is that global GDP will slow to 3.8% in 2022 from 5.9% last year. The concern is that some economies may experience hard landings though the consensus view remains optimistic. The most recent forecasts cited in The Economist (04/09/2022) are encouraging: 

Region           4Q2021 GDP         2022 GDP
China                    6.6                          5.5
Euro Area            1.0                          3.3
Japan                    4.6                          2.8
Canada                 6.7                          3.8

If the forecasts are correct, policymakers will have avoided a hard landing scenario and equity markets will rise.  

In the bond markets, the strong economy, surging inflation, and anticipation of aggressive Fed rate hikes has swiftly pushed yields higher. The benchmark 10-year Treasury rocketed from 1.52% at the beginning of the year to 2.77% on April 11. Many investors fear that high inflation will result in a further updraft in interest rates, which could result in negative real (inflation-adjusted) returns on bond investments. In our view, bonds still do not offer a competitive return profile compared to inflation and stocks, though if held to maturity they offer portfolios protection from volatility. We normally emphasize quality and short duration in bond selection, and we think this advice is especially relevant now in order to protect principal in these uncertain times.