- The U.S. economy is moving at a slower pace in 2022 than was the case in 2021.
- The Federal Reserve’s efforts to curtail a persistently high inflation rate may increase the risk of a recession.
- Yet many key economic indicators continue to demonstrate strength.
In the closing months of 2022, there seem to be more questions than answers about the direction of the U.S. economy. A mix of developments – from spiraling inflation to a dramatic shift in Federal Reserve (Fed) monetary policy to the fallout from Russia’s invasion of Ukraine, and persistent issues related to COVID-19 – fanned concerns that a recession may be on the horizon.
While recessions are difficult to forecast, the economic environment in 2022 is markedly changed from 2021. As measured by Gross Domestic Product (GDP) growth, the economy in 2021 grew at an annualized rate of 5.7%, the fastest rate of growth in a calendar year since 1984. In the first quarter of 2022, GDP declined by an annualized rate of 1.6%, followed by a 0.9% annualized decline in the second quarter.1 Despite the negative movement in GDP, consumer spending remains solid and corporate profit growth is generally strong.
Nevertheless, there are questions about the direction of the economy going forward. “The key reason economic growth moved backwards is a contraction in inventories held by companies,” says Rob Haworth, senior investment strategy director, U.S. Bank. “We expected inventories to rebuild in the second quarter after a first quarter decline, but that didn’t occur.”
Under some definitions, two consecutive quarters of declining GDP growth represent a recession, though Haworth notes that other factors will determine if the U.S. officially reaches that threshold. “The National Bureau of Economic Research (NBER) assesses a variety of measures to determine if a recession has occurred,” says Haworth. “It’s hard to know whether we’re actually in a recession today, but there are signs that the economy is still in reasonable shape.” The timing of a recession, as determined by NBER, can take several months to quantify as the organization awaits the release of more detailed data.
The current state of the job market is one indicator that seems contrary to speculation that we may be in a recession. Haworth points out that based on recent data, employers have nearly twice as many job openings as there are available workers.2 Recent job market reports show very strong job growth continuing into the summer months of 2022.
How should investors assess the state of the economy today and what should they expect from here?
The primary economic issue dating back to early 2021 is the re-emergence of inflation as a threat to the nation’s economy. The inflation rate, as measured by the Consumer Price Index, rose 7% in 2021 and peaked at 9% over previous 12-month periods by June, 2022.3 This was the highest level in more than four decades and exceeds by a wide margin the inflation target established by the Fed as it sets its monetary policy. Although the inflation rate has moderated slightly since June, the Fed’s targets an inflation rate that averages 2% over time.
“The key reason economic growth moved backwards is a contraction in inventories held by companies.”
- Rob Haworth, senior investment strategy director, U.S. Bank
Given the persistence of higher living costs, the Fed made a dramatic pivot in its strategy. In March, it raised the primary interest rate it controls, the fed funds rate, for the first time since 2018. In July, the Fed set the target fed funds rate to 2.25% to 2.50%, up from near zero percent before the March rate hike. The Fed also ended its bond buying program and began reducing its bond holdings. The Fed’s altered strategy is designed to push interest rates higher in the broader bond market as a way of tempering the pace of economic growth. “The Fed has made clear its first target is to soften inflation,” says Haworth. The Fed’s new policy direction is aimed at bringing the inflation rate back to its 2% target range.4 Haworth says that while the Fed’s 2% target goal appears unattainable this year, he anticipates the inflation rate will recede from current high levels.
Investors have justification to be concerned about the risk of persistently high inflation, says Eric Freedman, chief investment officer, U.S. Bank. He’s closely monitoring whether “we’ll continue to see higher commodity costs as well as higher borrowing costs structurally trickle into the economy and stay there for some time.” He thinks investors need to remain cautious about the impact of that potential development, although commodity price inflation slowed over the summer months of 2022.
Other clouds on the horizon
While investors and consumers are more attentive to inflation’s spike, other factors could complicate efforts by the Fed to manage the economy. For example, COVID-19 continues to create problems in pockets of the world. The Chinese government’s attempts to manage the ongoing spread of the virus caused it to shut down major cities this year. Chinese factory production slowed as a result, affecting global supply chains.
Another factor is the economic fallout from Russia’s invasion of Ukraine. Russia is a significant energy supplier, particularly for much of Europe. Both Russia and Ukraine are notable agricultural exporters. Supply disruptions raise concerns about the potential impact on commodity prices. Oil and natural gas prices moved higher after the start of the war in February 2022, though by mid-summer, prices for both commodities dropped from peak levels. Prices on agricultural products and metals also declined from recent highs.
Freedman notes that outside pressures like the continued imbalance between supply and demand put the Fed in a challenging position. “The Fed has to thwart inflation,” says Freedman. “Their bias will be to keep tightening monetary policy. That means more interest rate hikes this year and the potential that they keep raising rates into 2023.”
Despite the Fed’s monetary tightening actions since March 2022, it’s notable that in July, the economy added a stunning 528,000 jobs, far exceeding projections. The unemployment rate stood at a historically low 3.5%. “We don’t see signs of the labor market being disrupted,” says Haworth. This fact seems to contradict rising concerns that a recession is already underway.
Can the economy hold its ground?
A key question is whether the Fed’s aggressive posture allows it to successfully tackle the inflation threat while steering the economy toward a “soft landing,” and avoiding a recession.
“The Fed would love to achieve a soft landing, but it’s first priority is to stem the inflation threat,” says Haworth. “It is determined to ‘normalize’ the fed funds rate (by raising it to the 3.0% level and possibly higher) and then calculate its next steps.”
Haworth says despite increased chatter about the possibility of a recession and record low consumer sentiment (based on recent surveys),5 much of the economic data remains positive. “Retail sales are holding up. It doesn’t appear that consumers are pulling back. We see it reflected, for example, in faster growth in the travel and hospitality industries.” Along with consumer activity, Haworth is also keeping an eye on corporate earnings reports. “Second quarter earnings held up better than some expected,” says Haworth. “Businesses, however, do seem to be exercising more caution in terms of their own spending.”
The housing market is another key indicator of economic health. Housing prices soared in the immediate aftermath of COVID-19’s onset in early 2020. The Fed’s interest rate hikes are reflected in the market for mortgage loans. Mortgage rates rose significantly in the spring and summer of 2022. That slowed activity in the housing market. Yet it does not appear to be a crippling blow for the economy as a whole. “Housing demand is softening,” notes Haworth, “yet underlying fundamentals of consumer finances and the housing market both remain favorable, even as higher mortgage rates affect home affordability.”
Implications for investors
Both stock and bond markets have experienced negative returns in 2022. As the Fed laid out its planned policy shift in the early part of the year (raising interest rates and ending its sizable bond market investments), investors became more wary. “When the Fed says they’re going to raise rates, generally other asset classes will reprice lower in response,” says Freedman.
Interest rates moved up rapidly across the board in the bond market. Rising rates also put pressure on equity markets. “If investors can earn higher interest rates now than they did in 2021, it makes stocks less attractive,” says Haworth. “Investors are less willing to bid up stock prices in that kind of environment.” The result, says Haworth, is a more volatility for stocks that may persist through much of the year.
Haworth cautions that corporate earnings could be under more pressure if the economy slows and consumers pull back. Yet in the current cycle, that scenario has yet to develop. “Keep an eye on the jobs market,” says Haworth. “If that starts to weaken, it may mean the economy is about to face more headwinds.” Yet to this point, the strong jobs market appears to be bolstering the broader economy.
Consider reviewing your current portfolio with your wealth management professional to determine if it is consistent with your long-term goals and positioned to meet the challenges of what continues to be an uncertain market and economic environment.
Have questions about the economy, the markets and your finances? Your U.S. Bank Wealth Management team is here to help.
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