August 2022

Stephen Zielinski

U.S. Economic and Market Highlights

THE ECONOMY

  • The consensus forecast is that U.S. real GDP growth will return to positive territory following declines in the first and second quarters of 2022.
  • August’s Consumer Price Index (CPI-U.S.) came in at 8.3% from a year earlier, down from 8.5% in July and 9.1% in June. Gas prices and airline fares were lower and food prices continued to climb. This rate far exceeds the Fed’s 2% target, and while inflation is expected to continue decelerating, the medium-term outlook is uncertain.
  • Strong job growth throughout the first seven months of 2022 and the July unemployment rate of 3.5% in the U.S. are inconsistent with recessionary conditions.
  • In response to rising interest rates, the housing sector continued to weaken, and equity prices declined sharply through late August.
  • As the Fed continues to hike rates, each hike takes roughly 9-months to work its way through the economic system. Therefore, the rate hikes from March 2020 won’t show up in the economic data until December.
  • The Fed’s subsequent and more aggressive rate hikes won’t be fully reflected in the economic data until early to mid-2023, which could lead to recessionary conditions in 2023. This creates concern that the Fed will over-tighten monetary policy, turning an economic slowdown into a more severe economic contraction.
  • Longer term, inflation should be restrained because economic growth should be below average due to poor demographics, heavy government debt burdens, less central banks stimulus, continued globalization, and technology adoption.  As a result, the next up cycle could be an extended period of expansion.
  • August inflation jumped in the Eurozone to 9.1% driven by soring energy costs and higher prices for food, alcohol, tobacco, and continuing supply chain delays. Core inflation increasing from 4% to 4.3% concerned the European Central Bank (ECB) enough to raise interest rates by 0.75% last week.
  • Eurozone household consumption is well below pre-pandemic levels and retail sales have in fact been on a declining trend since November 2021.
  • Eurozone negotiated wage growth data for 2Q came in at 2.1%, which means there is no evidence of a wage-price spiral at this point, but that the eurozone is mainly facing an unprecedented squeeze in real incomes (after factoring in inflation).

FIXED INCOME

  • The fixed income futures market is pricing in a September rate hike of 0.75% by the Fed. The Treasury yield curve has not been this inverted since year 2000. (the 2-year Treasury yield is more than 0.20% higher than the 10-year Treasury yield versus the long-term average of it being more than 0.90% lower.) Generally, an inverted yield curve is a recessionary indicator.
  • The ECB raised interest rates by an unprecedented 0.75% last week, to address high rates of inflation, even as a recession is now increasingly likely with the bloc having lost access to vital Russian natural gas.
  • The ECB vowed to continue to raise rates to try to tame inflationary pressures, even with the rising threat of a slowing economy and recessionary environment. Currently, the Eurozone yield curve is not inverted yet because the ECB has taken a cautious approach to increasing short-term interest rates.
  • Rising long-term interest rates in 2022 have significantly depressed valuations of previously issued bonds in almost all sectors as most bond prices trade inversely to interest rate changes. All fixed income categories have negative returns year-to-date, and most were negative in August as rates continued to rise.
  • Although previously issued bond prices have declined, the prospect for future returns have improved with rising interest rates. Investors do not need to take on as much risk to earn a decent yield on new/current fixed income issuances. Investment opportunities in fixed income have improved.
  • Credit spreads in Europe are wider than in the U.S. meaning that prices on investment grade bonds have declined more, mainly from the pressure from volatile energy prices. This sell off has created some opportunities for investors to buy high quality companies whose bonds are selling at significant price discounts.
  • In the U.S., agency Mortgage-Backed Securities underperformed in August because of the negative impact of rising interest rates on the housing market. Rising interest rates in Europe have had less of an impact on mortgages because of fewer rate increases thus far, fewer homeowners relying on mortgage loans, and fixed rate rents on many residential properties.

EQUITIES

  • After the stock market bounced back in July, almost halving the negative performance year to date, most equity categories had negative returns in August 2022, except for emerging market stocks. (See Market Tracker below.)
  • The primary reason for the negative stock performance was investors’ concern about the Fed’s increased vigilance on keeping monetary policy tight “for some time” in an effort to tame inflation.
  • In the U.S. and Eurozone, information technology, healthcare, and real estate experienced some of the sharpest declines, along with retail stocks as rising prices prompted consumers to cut back on household items. Energy stocks achieved a robust performance amid ongoing strong demand and a curtailment of supplies following Russia’s invasion of Ukraine.
  • Overall, Emerging Market (EM) returns were slightly positive in August, but performance varied from country to country. Turkey delivered double digit stock market returns after it announced a surprise interest rate cut in August. China was slightly positive also because of an accommodative monetary policy with more Covid-19 lockdowns. Stock markets in Brazil, Thailand, and Chile also finished ahead of the index.  
  • Negative returns from some EM countries in August included Hungary, Poland, and Czech Republic because of the deteriorating outlook for energy supply, high inflation, and rising interest rates. Furthermore, currency weakness compared to the USD negatively impacted the Korean market and geopolitical concerns added to the negative impact in Taiwan.
  • The direction in the movement of interest rates, not the level of interest rates, is what is most associated with stock returns. Even though interest rates are still low by historical standards, equity prices often respond to changes (or anticipated changes) in interest rates and not the absolute level of rates.
  • Even with recent negative performance, stock price valuations remain relatively high. Bear markets normally witness widespread selling resulting in households reducing exposure to stocks. This has yet to occur. Markets are likely to remain volatile for some time as inflationary pressure gradually declines and the Federal Reserve eases up on interest rate increases.
  • We continue to pray for peace and victory for the Ukrainian people who have suffered so dearly from the war. Ukraine has recaptured more than 1,000 square miles in the Kharkiv region over recent days as it handed Moscow one of its biggest setbacks since Russian troops invaded.

This communication was prepared for informational purposes only and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security/instrument or to participate in any trading strategy. Past performance is not indicative of future results.