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Quarterly Market Update
Second Quarter 2022
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Global Expansion Battered but Intact
- Rising bond yields and increased expectations of Fed tightening caused asset prices to stumble out of the 2022 starting blocks; the war in Ukraine exacerbated the volatility and led to higher commodity prices.
- The global economic expansion continued, with most countries in a mid-cycle phase and a low near-term risk of recession in the US.
- China's industrial cycle still appears to be bottoming, but COVID and political headwinds are hampering progress.
- Inflation rates should moderate from high levels, but increasing wage growth and inflation expectations could lead to persistently high inflation.
- The war in Ukraine is a stark reminder that we've shifted to a secular environment of higher geopolitical risk. A more unstable backdrop makes portfolio diversification as important as ever.
Market summary: Volatility spiked amid war, inflation, and rate increases
Rising bond yields and increased expectations of Federal Reserve (Fed) tightening caused asset prices to stumble out of the 2022 starting blocks. Russia's late-February invasion of Ukraine exacerbated these trends, propelled commodity prices even higher, and injected a stagflationary flavor into the global economic expansion. Near-term recession risk remains low, but multiple sources of uncertainty suggest market volatility may remain elevated.
High and rising inflation expectations during Q1 proved challenging for almost all major asset categories. Bonds suffered significant losses as projections for rate hikes rose. US stock prices experienced a correction, but they bounced back to post less severe losses and modestly outperformed non-US equities. Commodity prices jumped significantly and cemented their place as the best-performing category over the past one-year period.
Economy/macro backdrop: Global expansion intact but facing multiple challenges
The global economic expansion continues, but the outlook for the world's major economies has become more complicated and differentiated. Most countries are in a maturing mid-cycle phase. COVID poses risks to China's recovery, but the economic reopening should boost Europe. The European Union (EU) is most exposed to fallout from the war in Ukraine, including higher natural-gas prices.
High commodity prices support commodity producers but raise costs for consumers. Net commodity exporters such as Canada, Australia, and Brazil benefit from improved terms of trade. Households in emerging economies—such as India and China—spend more of their incomes on food and energy, implying a bigger headwind for emerging markets consumers. The US enjoys commodity self-sufficiency and relatively less consumer impact.
China's incipient recovery appears intact as industrial production expanded and fiscal and monetary policy eased. However, several headwinds stunted progress, including widespread weakness in the real estate sector, regulatory uncertainty amid a crackdown on some sectors, and COVID restrictions initiated late in the quarter amid a rising virus count. The upside for China's recovery appears more muted relative to prior cycles.
With energy prices rising, US consumers are spending more to drive cars and heat their homes. Despite the sharp upward move, consumers still spend much less on energy as a portion of their incomes relative to prior oil-price shocks in the 1970s or 2008. Consumers are also cushioned by strong employment markets, record-high net worth, and more than $2 trillion in excess savings accumulated during the pandemic. The near-term risk of recession in the US remains low.
With nearly 2 job openings for every unemployed person, the labor market remains very tight. While 6 million people have rejoined the labor force after departing during the pandemic, labor force participation remains below pre-pandemic levels. We expect worker shortages will continue to improve; however, some workers—especially older ones—might not return, implying tight labor-market conditions may persist.
Many businesses continued to struggle with the tight labor markets and unfilled positions, and wage growth reached multi-decade highs. This dynamic was particularly acute for small businesses, with the National Federation of Independent Business survey showing a rapid rise in the number of small businesses raising wages and prices charged to customers. The ability of businesses to pass along higher prices remains key to the profit outlook.
We expect consumer inflation rates to moderate over the next 12 months from the 4-decade high of nearly 8% posted in February. However, tremendous volatility and uncertainty in the commodity markets broaden the range of our estimates. We generally believe cyclical inflation risks remain on the upside.
There are some signs that the most extreme supply-related pressures are easing, but categories where price changes tend to be more persistent—such as housing and food—now account for a larger portion of inflationary pressures. Continued increases in wage growth and inflation expectations represent a worrisome trend that over time could become a self-reinforcing wage-price spiral that leads to persistently high inflation.
The Fed ended quantitative easing (QE) and raised interest rates for the first time since the pandemic began. It again raised its rate-hike guidance for 2022 and 2023, with the 2023 level now above its projected long-term rate. The market expects monetary tightening to be even more aggressive during 2022. With financial conditions already deteriorating, the Fed appears complacent that the economy can weather significant monetary tightening.
Bond yields spiked significantly higher across the curve, especially at the shorter end with 2-year Treasurys rising 160 basis points—their fastest 3-month pace since 1994. This resulted in a significantly flatter yield curve, which inverted at some points. Although an inverted yield curve has often preceded recessions, our preferred recession signal is the 10-year less 3-month yield spread, which remained positively sloped.
After pumping trillions of dollars of liquidity into financial markets during the past 2 years, global central banks have pivoted toward monetary tightening. So far, 20 central banks have raised interest rates to combat inflation. The European Central Bank (ECB) is tapering QE, and the Fed may begin to reduce the size of its balance sheet this year. Liquidity growth is transitioning to become a headwind, raising the odds of elevated market volatility.
After nearly $3 trillion of emergency stimulus in FY 2021, the US budget deficit is set to shrink considerably and offer less fiscal support in 2022. Legislation approved in 2021 provides more than half a trillion dollars of extra multi-year spending on infrastructure, which traditionally has a high multiplier effect on near-term growth. Any additional multi-year spending or tax increases will depend on negotiations among congressional Democrats.
Asset markets: Tough start across the board
Asset categories that benefited from higher inflation led the markets during a Q1 when most categories finished in negative territory. Commodities and energy stocks posted strong gains, and regional equities in Latin America and Canada registered positive returns. Value stocks and higher dividend payers held up better than other styles and factors. Shorter-duration leveraged loans and inflation-resistant Treasury Inflation-Protected Securities (TIPS) led fixed income assets.
Global earnings growth slowed to start the year, as growth moderated from the decade-high rates registered during the earnings recovery in 2021. More moderate growth is expected this year across all major categories of global equities—US, non-US developed markets, and emerging markets—with forward estimates in the single digits.
The broad equity selloff caused valuations for all categories of global stocks to decline during Q1. The price-to-earnings (P/E) ratios for both developed and emerging markets are below their long-term averages, while the US remains above its average. Trailing earnings valuations are now roughly in line with forward P/E expectations.
Cyclically adjusted P/E (CAPE) ratios for non-US equities remained below US valuations. During Q1, the US dollar rose against most major developed-market currencies, and the valuation of the dollar's real exchange rate remains expensive, particularly against the Japanese yen. These valuation metrics indicate a relatively favorable long-term backdrop for non-US stocks and currencies.
The potential for a sustained period of higher inflation presents risks for a multi-asset portfolio. Inflation-resistant assets, including commodities and commodity-producer equities, can help hedge against surprise increases in inflation while providing potential for capital appreciation in a high nominal-growth environment. Inflation-hedging fixed income assets, such as TIPS, have provided better diversification than Treasury bonds.
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