- A Challenging First Half. Financial markets struggled to their worst start to a year in decades. Accelerating inflation and rising interest rates, combined with growth fears, have fueled a broad retreat in both stocks and bonds. Equity markets have seen considerable selling pressure, with few places to hide. Bonds have also fallen in value as interest rates have risen.
- Higher Prices. Inflation continues to run hot, both in the US and overseas, and remains the number one challenge facing the global economy. We believe a good deal of the present inflation is the result of pandemic dynamics (i.e., a “perfect storm” of massive government spending, supply chain problems, and low interest rates) creating excess demand in a supply-constrained environment. Food has suffered from a slew of higher input costs, and housing costs also remain elevated. We do expect headline inflation to moderate. Elsewhere, though, energy markets remain tight, pushed higher by the conflict in Ukraine, and by years of underinvestment in drilling and refining capacity.
- Supply Chain. The global supply chain continues to recover from pandemic disruptions, but remains challenged by snap shutdowns in China due to its zero-covid policy. Although some goods remain in short supply, in other markets we have shifted to supply gluts, most notably at retailers, many of which are dealing with bloated inventories. On the whole, we are upbeat regarding supply chain improvements.
- Fed is Focused on Inflation. The Fed has committed to cooling inflation pressures by undertaking a rate hike cycle. In its June meeting, the Fed hiked rates by 0.75%, and another meeting is on tap for later July, when we expect a hike of similar magnitude. The Fed appears willing to tolerate a lower economic growth rate to tame inflationary pressures. In addition to raising rates, the Fed will soon begin to reduce its $9 trillion balance sheet, representing another tightening measure.
- A Moderating Economy. Changes in Fed policy impact the broader economy with a lag, but interest-rate sensitive sectors are already seeing some impact on demand. The housing market has seen a sharp increase in mortgage rates, which has weakened mortgage and refinancing originations. In contrast, the tight labor market continues to be a bright spot for the economy, with job openings still far outpacing available workers at present.
- Market Outlook. In contrast to a jittery market, corporate earnings remain firm, with few signs of an imminent economic slowdown. The market’s decline, so far, is largely due to lower stock prices, but not tied to lower earnings. Our expectation is for moderating growth from the economy’s present strength. Consumers are shifting their spending patterns, and we are fast-cycling the economic adjustments to bring down inflation. We expect the inflation story to improve organically as the extraordinary money growth of the past two years abates, while supply chains improve. We see the greatest continuing risk in energy and food costs remaining volatile here at home. Additionally, we are mindful of a looming recession in Europe, brought on by the energy price shock and the prospect for continued supply tightness.
