Stephen M. Mills, CIMA®Partner
Chief Investment Strategist
Brad Bays, CIMA® Partner
PIM Portfolio Manager
- The first quarter brought several new developments that could impact U.S. economic growth for 2022.
- In March, the U.S. Federal Reserve shifted monetary policy to a tightening mode.
- Inflation continues to surge potentially threatening the economic recovery.
- The Russia-Ukraine war has disrupted both the energy and commodity markets causing significant increases in the price of several commodities.
- The U.S. economy remains resilient despite near-term headwinds, in our view.
Plenty has changed in the financial markets and in the minds of investors since we published the TCM 2022 Investment Outlook & Strategy on January 10, 2022.1 As we began the year, Covid-19 cases had started to wane, the economy was poised to regain its reopening momentum, and the stock market was hitting new highs. There were concerns about rising inflation and potential monetary tightening on the part of the Federal Reserve but these issues were not having much of a negative impact on investor sentiment or behavior. Investors remained mostly positive toward the near-term future for economy and the financial markets. Money was still flowing into the stock market, consumers were beginning to boost spending, and businesses were poised to ramp up capital investment. As we indicated in our January 10 letter, we believed the setup for the U.S. economy looked very good and we were positive on the U.S. stock market for 2022. Although we thought we could see as much as a 10-15% correction in stock prices, overall, we felt 2022 would be another positive year for the major stock market averages.
Fast forward three months and a lot has changed. Several developments occurred during the first quarter that could potentially impact U.S. economic growth and the financial markets in 2022. First, war broke out in Europe as Russia invaded neighboring Ukraine on February 24. Russia’s invasion of Ukraine has disrupted both the energy and commodity markets causing significant increases in the prices of oil, natural gas, iron ore, wheat, corn, and other commodities. These price spikes only added to the already high inflation rates we have seen both here and abroad. As the war persists, the disruption to the commodity markets will likely continue driving prices higher, in our view. Of course, the humanitarian crisis caused by the largest invasion of a foreign country since WWII has been unprecedented. Our thoughts and prayers go out for the Ukrainian people.
Second, the U.S. Bureau of Labor Statistics (BLS) reported on March 10 that the Consumer Price Index (CPI) surged 7.9% for the previous 12 months ending February 28.2 Items such as food, energy, and clothing were the primary drivers of the highest twelve-month inflation rate in 40 years, according to the BLS report. Prices of these items have been impacted by supply chain bottlenecks created by the pandemic. Inflation could have a big impact on consumer buying behavior especially if the rate of inflation is outpacing wage growth. Since consumer spending is about two-thirds of U.S. Gross Domestic Product (GDP), investors fear that any near-term slowing of consumer spending activity could have a meaningful impact on GDP growth this year. We will further address this concern later on in our letter.
Third, the U.S. Federal Reserve (the Fed) implemented it’s first Fed fund rate increase in over two years on March 16 and indicated it will hike rates several more times this year as part of their effort to combat inflationary pressures.3 The Fed also ended the bond purchase program it put in place in early 2020 to provide liquidity for the financial system that had been stressed by the coronavirus pandemic.3 In addition to this bond purchase program, the Fed lowered the fed funds rate to nearly zero to combat the pandemic induced recession which hit the U.S. economy in the second quarter of 2020. We believe these monetary measures were largely responsible for the quick recovery in the economy and the strong rebound in stock prices after nearly a 35% decline in the major stock market averages in February and March of 2020.
In our view, the Fed’s new monetary tightening approach is already impacting what businesses and consumers pay for loans. For instance, the average 30-year fixed rate mortgage has surged past 4% for the first time in three years and risen nearly 1.6% this year from 3.1% to 4.67% as illustrated in the chart provided by Freddie Mac. On a $250,000 conventional loan, that rate increase bumps up the monthly payment by $224, a 21% increase.4 This increase in rates may have something to do with the recent decline in mortgage applications for the week ended March 25th of 6.8%, the lowest level since December 2019.5 Rising mortgage rates typically reduce mortgage refinancing and home purchases because fewer homeowners can save money by refinancing their homes and higher rates can discourage potential buyers. This potentially translates into a slowdown in the housing industry which could negatively impact home pricing for the rest of 2022 and perhaps 2023, in our view. Home prices rose a record 18.8% on average in 2021. Home price growth has decelerated somewhat in recent months and is expected to slow further in 2022 with higher mortgage rates.6 But for now, the housing market remains strong with surging prices, ultralow inventories and persistent demand around the country. That is good news for the home building industry and the economy in the near term, but rising mortgage interest rates could further reduce affordability at a time when consumers are feeling the pinch from rising commodity prices.
The recent rise in interest rates has now pushed the two-year U.S. treasury note yield above 2% for the first time since June 2019.7 As of the date of this letter, the two-year note was yielding nearly 2.5%, up from an all-time low yield of .11% reached in January 2021 and up from a yield of .73% at the end of last year. The ten-year U.S. treasury note yield has also risen this year from 1.5% to 2.78%, as of the date of this letter. Not to get too technical but we are approaching a condition called an inverted yield curve where short-term yields exceed longer term yields. This has been much talked about recently by economic strategists and by the financial news media. As you can see, the two-year treasury note yield is still below the ten-year treasury note yield and but is closer to becoming inverted. Historically, yield curve inversions often occur before recessions. An inverted 2s-10s yield curve has historically only been useful as a recession signal when it inverts and remains that way for more than a week, according to a recent Wall Street Journal article.8 However, the article points out that the time between inversions and the following recessions have varied widely in length from as short as 6 months to as long as 24 months, according to a 2018 paper from the Federal Reserve Bank of San Francisco.8 Although we are not too concerned at the moment about a potential yield curve inversion indicating the imminent onset of a recession, it is something we will continue to observe closely.
We believe the developments cited above will present near-term challenges for the U.S. economy. They have created a cloud of uncertainty that hangs over the economy and the financial markets until some of these issues begin to get resolved. We feel this uncertainty has increased the chances a recession in the U.S. economy over the next 12-18 months. However, while we must admit that the probability of a recession occurring within that timeframe has risen, we still believe that a contraction in U.S. GDP for two quarters in a row this year (the technical definition of a recession) is a low probability.
In fact, we remain optimistic that the U.S. economy will avoid recession this year and achieve modest growth.
Here’s why: First, we believe the fundamental underpinnings of our economy remain strong as demonstrated by its remarkable resilience since the pandemic began in early 2020. Once we got past the pandemic induced collapse of the U.S. economy in the second quarter of 2020, the U.S. economy has been a juggernaut despite several major surges of Covid-19. Last year, U.S GDP grew at a rate of 5.7% according to the U.S. Bureau of Economic Analysis released March 30.9 Both businesses and consumers have adapted to the pandemic and have largely reengaged in normal activities. It appears to us that the coronavirus pandemic is close to running its course and will progress to the epidemic stage for most countries. Covid-19 and its variants will likely be with us for many years, but we believe the availability of vaccines and therapeutics will mitigate the impact on society. We view our economy’s ability to deal with the worst pandemic since the Spanish flu pandemic in 1918 as a show of strength and resilience.
Second, jobs growth remains strong. The most recent jobs report released by the U.S. Bureau of Labor Statistics (BLS) on April 1, showed U.S. employers added 431,000 jobs in March and the unemployment rate declined by .2 from the previous month falling to 3.6%.10 For the year, the economy has added an estimated 1.7 million jobs according to the BLS. We believe job growth will be an important factor for the U.S. economy to avoid a recession and help drive the next leg of the recovery. In addition, wages grew 5.1% year over year as of February 28, 2022 according a Department of Labor report released on March 4. Although the pace of wage gains has slowed in recent months, higher wages are helping to offset rising inflation. Job growth is a key underpinning for the economy and we view these reports as sign of continued economic strength.
Third, we believe consumer financial health remains strong. As we discussed in our January 10 letter, U.S. consumers are in great financial shape having paid down debt and increased savings over past couple of years. As a result, total household net worth (assets minus liabilities) has reached an all-time high at $150 trillion, according to the Federal Reserve fourth quarter 2021 Household Balance Sheet report.11 Total consumer debt has only increased slightly over the past two years and is currently only 11% of total household assets, the Fed report showed. In addition, according to a separate Fed report, American households added an additional $4.2 trillion savings during the pandemic.12 Savings increased from $10.6 trillion at the end of 2019 to $14.7 trillion at the end of last year.12 Since personal consumption accounts for over two-thirds of U.S. GDP, we believe the financial health of the consumer will help bolster the economy in the coming months.13
Fourth, business capital spending on technology and other business investments grew 7.4% in 2021, a trend that appears could remain strong for 2022 according to the Wall Street Journal.14 The Journal article cited a recent manufacturing firms survey by the Institute of Supply Management that indicated a potential increase of capital expenditures of 7.7% in nominal terms in 2022. Such investment helps increase productivity and boost economic growth.
Lastly, we don’t believe that the Federal Reserve will tighten monetary policy to the point of causing a recession. We believe, based on our observation of the Jerome Powell led Fed since his appointment 8 years ago, the Fed will err on the side of allowing higher inflation rather than tightening monetary policy to the point of recession. We see the Fed raising the Fed funds rate to 2-2.5% by the end of this year or early next year. That would be about 1% above the 1.25-1.5% Fed funds rate range at the beginning of 2020 before the pandemic started.16 We believe the Fed will pause their rate increases at that point and give the economy time to digest the rate hikes and observe how inflation reacts to the higher interest rate environment.
There are several other positive economic indicators as illustrated in the chart below. ClearBridge Investments tracks 12 economic indicators and compiles a “Recession Risk Dashboard” as shown in the chart. As of March 31, 10 of the 12 indicators pointed toward continued expansion for the U.S. economy while one (wage growth) was flashing recession and one (money supply) was indicating caution. Of course, economic conditions can change quickly but for now this recession risk indicator is suggesting continued expansion for the U.S. economy.
In summary, we believe the U.S. economy will avoid a recession this year and continue to grow moderately for the rest of 2022. However, Fed monetary tightening, the war in Ukraine and the inflation problem will likely slow global economic activity somewhat for the rest of the year, in our view. We see the U.S. GDP growing closer to 2.5%-3% in 2022 instead the consensus forecast of 3.8% growth at the beginning of the year.17 We see corporate earnings continuing to expand as companies adapt to the current economic environment. In turn, we believe corporate earnings growth will help support stock prices. We have little doubt that the equities markets will remain volatile in the near term. Stocks fell on average 13.6% from January 4 to March 14, as measured by the S&P 500 Index.18 As noted earlier, in our January 10 letter we felt the major stock market averages could experience a 10-15% correction in 2022.1 The S&P rallied nearly 9% over the last two weeks of March and closed the quarter with a 5% loss. Although we could see the stock market averages retest their March lows at some point, we believe we have seen the lows for the year and think we could still end up with a positive year for stocks.
The current situation in the financial markets can be unnerving and stressful. We believe the key to navigating a highly uncertain and volatile investment environment is patience and diversification. As always, we greatly appreciate your continued trust and confidence in us and we will continue to work to keep you informed of economic and market developments.
Your Trinity Capital Management Team
Trinity Capital Management, 821 ESE Loop 323, Suite 100, Tyler, Texas 75701. 903-747-3960.
- Wall Street Journal, “Home Price Growth Hit Record in 2021, February 22, 2022.
- WSJ, “The Yield Curve Briefly Sent a Recession Warning. Here’s What That Tells Us.” 3-31-22
- Wall Street Journal, “U.S. Employers Added 431,000 Jobs in March,” April 1, 2022
- Bloomberg.com, “Americans Added $4/2 Trillion in Pandemic Savings,” March 31, 2022
- Federal Reserve Economic Data (FRED), https://fred.stlouisfed.org/series/DPCERE1Q156NBEA
- Wall Street Journal, “Capital Spending Boom Helps Raise Productivity, Contain Costs, March 27, 2022
- Reuters, Goldman Sachs cuts 2022 GDP forecast to 3.2% vs 3.8% consensus
- Thompson Charts
The indices presented in this material are to provide you with an understanding of their historic performance and are not presented to illustrate the performance of any security. Investors cannot directly purchase any index.
Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations. Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility.
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S&P 500 Index: The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market value weighted index with each stock's weight in the Index proportionate to its market value.
The Consumer Price Index (CPI) is a measure of the cost of goods purchased by average U.S. household. It is calculated by the U.S. government's Bureau of Labor Statistics.
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