Key takeaways

• Expectations for real growth have fallen while inflation worries have increased.
• COVID, war, inflation and a hawkish message from policymakers are making upside surprises less likely.   
• Markets still feel fully priced and are likely to remain unsettled.   
   

The first quarter unfolded like a three-act play

Act one was the realization that inflation had gone vertical and was stickier than expected. Anxious investors priced in a stronger policy response, and volatility, and rates, rose. In Act two, geopolitics took center stage, as war in Ukraine destabilized markets and added further to inflation concerns, pushing market volatility higher. Finally, Jerome Powell’s press conference led Act three, and markets calmed as he reassured investors that the economy could handle inflation fighting. Whether or not policymakers can navigate slower growth while vigorously fighting inflation remains to be seen. Buyers may have gotten ahead of themselves as COVID, war, inflation and slowing growth all remain very much in the mix.

Rates rose across the board during the quarter, and the yield curve flattened as investors priced in a more aggressive Federal Reserve (Fed). The two-year treasury climbed 160 basis points (bp) to 2.34% while the 30-year treasury yield increased over 50 bp (2.45%), both ending the quarter at a level last seen before the pandemic. Markets were jittery and performed poorly with most major asset classes producing negative returns. Commodities, one of the few asset classes to benefit from inflation, was the outlier with a positive total return of over 25%.¹ Higher rates caused fixed income to underperform stocks, despite rising fear. Rates weren’t the only problem as spreads widened, but the increase was orderly as demand for lower rated bonds never became a significant problem. The S&P 500^® total return ended the quarter down a little more than 4.5%, recovering from correction territory (down more than 12%) in mid-March. This performance masked a big shift in leadership as higher rates eroded the value of future growth, and value stocks produced positive returns.   

Corporate earnings and economic growth ended last year on a strong note, but 2022 is likely to be tougher. Full year revenue and earnings estimates have pushed higher despite spreading cost pressure and falling consumer incomes, adjusted for inflation. This sounds like a recipe for disappointment given a starting point that was well above average to begin with. Higher rates may also challenge valuations, compounding market challenges.  

The good news is that the economy is facing these headwinds from a position of strong growth. Real GDP increased by 5.7% last year, the fastest rate since the mid ‘80s. While inflation has squeezed workers’ spending power, the jobs situation is the best in years. Savings, socked away during the pandemic, continues to support demand for key durables like housing and autos for now. That effect will likely wear off, a trend that will be accelerated by higher rates. The squeeze in real earnings is beginning to put the brakes on spending, and consumer confidence has suffered. Forecasted growth is still above normal, but projections have declined steadily over the quarter, as inflation continues to surprise to the upside. 

Expectations for real growth (adjusted for inflation) have fallen steadily after peaking in Q3 2021 while inflation forecasts have skyrocketed

While the tightening cycle might mark the beginning of the end, the “end” might be drawn out

Jerome Powell continues to express confidence that the Fed can tighten monetary policy enough to slow inflation without tipping the economy into a recession. Fed guidance, and market expectations, are for eight rate hikes this year which would put the Federal Funds rate at nearly 2.5% at year end.  

Investors aren’t so sure that this process will go smoothly, though. The flattening curve indicates that buyers are pricing in an overshoot by the Fed and recession risk ahead. These concerns stem partly from a debate about the true underlying strength of the economy. Investors continue to have to navigate noisy data that are distorted by continuing supply chain issues, COVID, and now, the war, among other factors. Inflation remains the biggest concern, both for growth and valuations. Monetary policy works on a lagged basis, and inflation itself will also act to temper demand as real earnings erode. The uncertain timing and magnitude of these effects create more downside than upside to current valuations.

While the tightening cycle might mark the beginning of the end, the “end” might be drawn out.  A recession in the next 12 months still seems unlikely. We expect the Fed to be responsive to evolving data, but we recognize that monetary policy is an imprecise tool, especially in the current environment. This certainly increases the risk of a misstep. 

Manufacturing activity remains strong and far above contractionary levels

2022 is unlikely to hold a repeat of last year’s strong performance.  Markets are likely to remain unsettled as wary investors navigate the worrisome mix of tighter financial conditions, high inflation and slowing growth.  The stronger tone in the later part of the quarter was welcome, but volatility will probably persist until the “all clear” sounds on inflation, and investors have more confidence about the script for the next act.