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In the second quarter, economic growth in the United States continued to slow in the wake of the torrid, stimulus-fueled growth seen last year. Early estimates are that U.S. Real (inflation-adjusted) Gross Domestic Product (GDP) declined another – 1.2% (annualized) in Q2 2022 after declining -1.6% in Q1 2022. While the eight-member Business Cycle Dating Committee of the National Bureau of Economic Research (NBER) is viewed as the official arbitrator of a “recession” determination, conventional wisdom is that two consecutive quarters of economic decline determines a recession. Therefore, it would be reasonable to conclude that we are already in a recession with the only questions remaining being “how long will it last?” and “how deep will it go?”
After such a dramatic spike, slowing economic growth was to be expected. However, the unfortunate slide into negative territory is attributable to other factors, most notably the on-going Russian military incursion into Ukraine which has significantly disrupted energy and agricultural markets in the midst of already fragile global supply chains.
Meanwhile, despite the high probability of entering a recession, the Federal Reserve Bank has been desperately fighting on the opposite front against inflation which at one point was viewed as transient, but now is considered a more persistent threat. Over the past 12 months, the bellwether inflation index, the Consumer Price Index (CPI), has jumped 8.6% which has caused widespread concerns as households face drastically higher prices in almost all categories, not the least of which are gasoline and good costs. As a result, the overnight Fed Funds Rate is now at up to 1.75% with more significant hikes to come as the Federal Reserve races to prevent inflation expectations settling into the general economic mindset. Further, Quantitative Tightening is underway as the Fed seeks to shrink is massive balance sheet.
Despite these economic headwinds, American workers are still sitting pretty at this point. Workers, for the first time in decades, find themselves with significant bargaining power given a very favorable labor market. The recently released jobs report showed 372,000 jobs were added to the economy in June and the unemployment rate remaining at a very low 3.6%, very close to its pre-pandemic reading of 3.5% (February 2020). Surprisingly, still after 30 months, the number employed is still below its February 2020 pre-pandemic level. This is due largely to labor supply constraints as the labor force participation rate, the share of adults working or seeking a job, remains stubbornly low (62.2% in June).
The international economy continues to follow that of the U.S. as both developed and emerging markets similarly face slowing economies, high inflation, and rising interest rates. As a result of the interest rate and inflation differentials, international currencies have been weakening versus the US dollar. This is beneficial for those countries’ export-focused industries, but also exacerbates inflationary pressures with higher priced imports and commodity prices.
Against this backdrop, going forward investors need to be alert to the significant risks of stagflation. Continued increases in inflation and interest rates will lead to lower bond prices and likely feed trough to repricing of equity valuations. Investors are left to discern when conditions will start to improve, and the bottom reached.
Bureau of Economic Analysis
Bureau of Labor Statistics
International Monetary Fund
The Conference Board
The second quarter saw an acceleration of the correction that began in the first quarter. The S&P 500 regained its leadership position but in the negative direction finishing the quarter with a loss of -16.11%. All the major US markets continued to fall and breached the -20% bear market threshold, on a year-to-date basis, during the middle of June, found a slight support rally, then finished the quarter with negative momentum. The notable exception was the S&P International 700 Index, which didn’t hit the bear market line yet. After raising interest rates in March by 0.25%, the Federal Reserve increased the velocity of their rate increases by raising rates by 0.50% in May and 0.75% in June. The probability of rate increases of 0.5% to 0.75% at each of the remaining Federal Reserve meetings this year has kept the equity markets on slippery ground this quarter. The high flying inflation numbers, the war against Ukraine by Russia, and a slowing economy only gave additional fuel to the “Correction Process” mentioned last quarter, pushing the markets into bear market territory. We may still have several months before seeing the light of day of the next bull market cycle, but we do not believe it is time to panic. The opportunity for positive returns over the next 12 months could be higher than more downside risk. Don’t let fear drive investment decisions that would be better served by patience.
The past 12 months have been an emotional and volatile ride for all markets. From the rise of the Omicron Variant in the 4th quarter of 2021, the pain of inflation during the last half of 2021 and continuing into the first half of 2022, the slowing economy and rising interest rates, and the invasion of Ukraine by Russia, it is amazing that the markets aren’t down more than they already are. In the past 12 months, the S&P 500 had a total return of -8.86%, the S&P 400 Mid-cap index was down -12.71%, and the S&P 600 Small-cap index was down -14.82%. The US markets won the trifecta against the international markets (again) that fell the most with a return of -17.32%. With so much negativity in the markets and the financial media, “contrarians” are seeing all this as a signal that the bottom may have been reached and positive returns in the next two quarters are more likely. With this added information, we would not be surprised if the US markets finished 2022 in positive territory.
Economic Indicators and Calendar
Inflation hit the 1.20% number (month-over-month) in March, in line with expectations, and fell to only 0.30% (month-over-month) in April. This relief was short lived as inflation spiked again in May to 1.0% and 1.3% in June (month-over-month). It appears that we may see the month-over-month numbers start to fall in the last half of 2022 as energy prices have peaked and the strong housing market is showing signs of slowing as mortgage rates have nearly doubled since the start of the year.
Source: Bloomberg (A= Advance; S= Second: T= Third)
GDP growth came in weaker than the initial expectation of +0.8% for the 1st Quarter, with an actual -1.6% for the quarter in the Third revision. There has been a debate among economists and market pundits during the 2nd quarter whether we are already in a recession or if we will avoid the recession with a positive GDP number in Q2. Although there are valid arguments on both sides of this issue, we will have to wait until the end of July when the Advance number will be released for the 2nd Quarter.
The Unemployment rate has remained steady at 3.6% for the past three months and is not expected to fall for June due out on July 8th. It is possible we may see unemployment start to rise in the last half of 2022 as the economy slows and layoffs increase; however with so many jobs still open and unfilled in the US those laid off may not add to the unemployment roles for long if at all.
Nonfarm Payrolls continue to have strong monthly numbers and may remain strong in the face of a recession as those that are laid off in the coming months may be able to fill some of the 7 million job openings in the US. It is also possible that if the economy slows too much, many of those open jobs may evaporate like the memory of gasoline at $3 a gallon from this time last year.
With elevated inflation and strong employment, the Fed has indicated it will focus on curtailing inflation, even amid geo-political turmoil and negative 1q2021 GDP. It raised the Federal Funds rate 0.25% in March, 0.50% in May, and 0.75% in June (the largest increase since 1994). Based on Chair Powell’s recent comments, we should expect a rate hike in the 0.50% to 0.75% range in July. The Fed Funds rate is now expected to finish the year above 3.0%.
—Matt Melott, Manager
—Jacob Chandler, Manager
THE YIELD CURVE RISES - Although the yield curve stayed relatively flat in the 2nd quarter it rose in a parallel fashion across all maturities. Interest rates from 1 month to 30 years all went up in the 2nd quarter as the Federal Reserve accelerated the interest rates increases from 25 bps in March to 50 bps in May and 75 bps in June.
As of the end of the 2nd quarter, the 1-year US Treasury yield increased from 1.607% to 2.777 (a 117 bps increase) vs the 10-year US Treasury which rose from 2.341% to 3.016% (for a 67 bps rise). Some analysts are now predicting that the 10-year rate will hit 4% before the end of 2022.
The 2-year U.S. Treasury yield increased from 2.337% to 2.957%, the 5-year yield rose from 2.462% to 3.04% and the 30-year treasury rose from 2.45% to finish the quarter at 3.185%.
The recent talk about the “Yield Curve Inverting” has subsided as the debate continues on whether we are already in a recession or if the recession is still something we will have to deal with in the next 6 to 12 months. The probability of a recession has increased as the economy is slowing and although consumer demand has not abated there is a significant increase in inventories as the supply chain issues have started to see resolution.
The markets remain solidly involved in the correction process and finished the quarter with negative performance even after bouncing off the “Bear Market” level as support. Markets can’t go down forever, and we may have several more months to run before we start the next bull market. We are facing the same headwinds from last quarter for the foreseeable future – inflation, rising interest rates, War in Ukraine, and slower economic growth. However, we need to remain patient. The more negative sentiment we see in the media, the higher the probability is that they are wrong, and this bear market may be over sooner than most pundits expect. Whatever may come, our Lord is still in control. We remain thankful for the provision, protection, and blessings that we received from our Heavenly Father and are looking expectantly to what God has in store for the remainder of 2022.
We thank each of you for bringing Glory and Honor to our Heavenly Father and our Savior Jesus Christ through Biblically Responsible Investing.