Uncertainty and turmoil marked the first quarter of 2022. The U.S. economy began the year with solid momentum. Last year ended with GDP growing at a nominal rate of 14.6% (6.9% adjusted for inflation), more than three times the long-term average.[1] Then the proverbial wheels started coming off. First, the Omicron variant of the covid virus peaked at more than 800,000 cases a day in mid-January, far worse than earlier waves of infection. Absenteeism from isolating workers caused significant business disruptions, from cancelled flights to lengthening delays in supply chains. Then, Russia invaded Ukraine on February 24th. Sanctions against Russia and interrupted production in Ukraine reduced the supplies of oil, gas, grains, metals, and other commodities, aggravating an already bad global inflation problem. With the threat of even higher levels of price increases, the Federal Reserve laid the foundation for raising interest rates and quantitative tightening, which will slow economic growth.[2] Mortgage rates are almost double what they were last year.[3] Borrowing costs for companies and governments have also jumped.
Higher interest rates slow economic growth in many ways. Companies wanting to expand will face higher financing costs, making some projects no longer viable. Home buyers will have to spend more on mortgage payments and less on discretionary purchases. The higher cost of borrowing against home equity will discourage some homeowners from remodeling. Governments will need to spend more of their budgets on interest expense, potentially “crowding out” other important expenditures.
The effects of higher interest rates have delayed full recovery from the pandemic-induced recession, and the strength of the rebound will be less robust. However, consumers and businesses, with high levels of savings and strong balance sheets, are in good financial shape to withstand higher rates. Continuing high demand for workers will support economic growth, but at a reduced pace. First quarter nominal economic growth should still be more than 8% annualized (1% after inflation).[4] The receding covid virus has allowed for more normal economic activity and large numbers of people to return to work.
Stock and bond prices declined during the first quarter, adjusting to higher interest rate expectations. Higher rates are necessary to compensate bond investors for the reduced purchasing power of their principal, but as rates rise bond values will decline. For stocks, the present value of future earnings declines as rates increase. Higher interest rates should now be fully reflected in stock prices and future performance should be supported by rising earnings. Bond prices, however, will continue to suffer as rates ratchet higher.
Slower growth and reduced demand should eventually allow supply chain problems to heal and the upward pressure on prices to abate. Businesses will, over time, hire enough workers and improve the productivity of existing workers to solve current capacity constraints. We do not expect an economic recession this year or next.
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March 31, 2022 | Average Annual Total Returns[5] | ||||
Index | Last Quarter | 1 Year | 3 Years | 5 Years | 10 Years |
S&P 500 (Large Cap) | -4.6% | 15.7% | 18.9% | 16.0% | 14.6% |
Russell 2000 (Small Cap) | -7.5% | -5.8% | 11.7% | 9.7% | 11.0% |
FTSE All World ex U.S. | -5.1% | -0.9% | 8.1% | 7.1% | 6.0% |
Bloomberg U.S. 5-10 Year Corp Index | -7.0% | -4.7% | 2.9% | 3.3% | 3.9% |
Bloomberg Municipal Bond | -6.2% | -4.5% | 1.5% | 2.5% | 2.9% |
This commentary contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this commentary will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.
[1] U.S. Bureau of Economic Analysis, February 22, 2022
[2] Federal Reserve Minutes, March 15-16 2021
[3] Federal Reserve Economic Data, St. Louis Fed
[4] Federal Reserve Bank of Atlanta, GDPNow
[5] Vanguard Benchmark Returns, https://personal.vanguard.com/us/funds/tools/benchmarkreturns