Each week, we present our featured topics in the context of the major themes listed below from Nuveen's 2022 Outlook:Nuveen's 2022 Outlook
- U.S. economy: No recession this year, although market risks persist.
- Global economy: Both headline and core inflation likely peaked in March.
- Policy watch: Fed signals aggressive tightening, but we think fewer rate hikes will be needed.
- Fixed income: Strong credit fundamentals and attractive valuations favor taking credit risk over duration risk.
- Equities: Despite further bouts of volatility ahead, equity returns should be positive for 2022 as a whole.
- Asset allocation: We’re leaning toward “risk-on” positioning. Rebalance prudently.
Quote of the week:
"We can never know about the days to come, but we think about them anyway.” – Carly Simon, Anticipation
A recession? Not in this economy
Just as the 6.9% U.S. GDP annualized growth rate in the fourth quarter of last year wasn’t as strong as it appeared on the surface, the -1.4% advance estimate for the first quarter of 2022 is considerably better than it looks.3
Contributors to GDP included:
- Household consumption, which came in a bit below expectations but still stronger than it had been in the prior two quarters despite the recent drop in incomes (adjusted for inflation).
- Private investment, particularly fixed investment in intellectual property and equipment.
Among the detractors from GDP:
- Net exports had a large negative impact. Because GDP is an estimate of the economy’s output, imports (which are consumed domestically but produced outside the U.S.) are subtracted from consumption, while exports are added back in. In the first quarter, imports grew significantly as exports shrank due to weakness abroad.
- Inventory growth slowed from its rapid pace in the fourth quarter of last year. Firms encountered difficulty meeting consumer demand while also keeping inventories well-stocked. In other words, most of what was being produced was being consumed.
- Federal government spending fell, acting as a moderate drag on overall GDP.
Of course, examining an economy’s output is not the only way to assess its health, particularly in a supply-constrained environment. Final sales to private domestic purchases, our preferred gauge for determining domestic demand, grew at a 3.7% annualized rate, a far more encouraging number than the -1.4% GDP rate.4 Because this metric tracks how much U.S. residents actually spend, regardless of where the product or service is produced, it’s a better leading indicator for future growth than headline GDP. Households and businesses continued to spend at an elevated clip, even when adjusting for unusually high inflation. Firms did their best to replenish inventories and invested in productivity-increasing measures to offset the shrinking pool of available workers.
Meanwhile, the personal savings rate declined from 7.7% in the fourth quarter of 2021 to a still-respectable 6.6%, despite a 2% fall in real (i.e., after inflation) disposable income.5 Households also continued to draw down their accumulated savings from the COVID-driven stimulus payments.
Now that the U.S. has recorded its first quarterly contraction since mid-2020, when pandemic lockdowns kept consumers at home and shuttered businesses across the country, investors may wonder if a recession is in store.
Technically, a recession is defined as two or more consecutive quarters of negative GDP growth. We don’t think that will happen any time soon. Our interpretation of the first-quarter report is that the underlying fundamentals of the U.S. economy remain quite strong, held back only by economic weakness in the rest of the world, federal fiscal tightening and higher energy costs. Barring an unforeseen exogenous shock, the U.S. should comfortably avoid recession by generating solid second-quarter growth.
And indications are the U.S. economy is entering the second quarter with decent momentum. The monthly personal income and consumer spending reports for March (released this past Friday) are timelier than the quarterly GDP data, and both topped forecasts. Moreover, the slow shift away from spending on goods to spending on services — especially once adjusted for inflation — continues. (Services spending, which to date has been less challenged by inflationary supply constraints, made up nearly 70% of U.S. consumer spending before the pandemic but has been slower to return to its prior peak.)
In addition, the core PCE price index, the Fed’s preferred inflation barometer, was not only revised lower for February but is also is showing signs of peaking. That said, inflation still has some wind in its sails. Employment costs accelerated unexpectedly in the first quarter, with private-sector wage and salary growth climbing at an annualized rate of nearly 5%.6 Persistently high wage inflation is likely to force companies to raise prices to protect their margins, if they haven’t done so already.
Growth in labor costs needs to decelerate before we see a gradual deceleration to a 2% inflation rate, the Fed’s long-term target. But for now compensation is still rising rapidly, despite the first quarter’s notable increase in the size of the labor force and rapid job creation. Against that backdrop, the market priced in even more aggressive Fed hikes on Friday after the inflation data was released. Powell will certainly offer his viewpoint on these elevated inflation readings at his post-meeting press conference this Wednesday.
Monthly jobs report comes out this week — but first, the Fed
While investors will pay close attention to April’s U.S. employment report (due on Friday), the job numbers will be preceded — and maybe even overshadowed — by Wednesday’s Federal Reserve meeting. We think we’ll see some significant policy changes from the Fed, the anticipation of which have helped drive bond market volatility of late.
Let’s start with our expectations for what’s in store.
50 is the new 25. Look for the Fed to hike its fed funds target range by 50 basis points (bps), double the 25 bps increase announced at the March meeting. Such a move would lift the Fed’s policy rate to 0.75%-1.00%. At his post-meeting press conference, we think Fed Chair Jerome Powell will strongly hint that markets should plan on hikes of similar magnitude for the time being. (The Fed will not release new economic or policy forecasts until its June 15 meeting.)
And by “time being,” we mean at the June and July meetings, which will likely feature another 50 bps hike each, bringing the target range to 1.75% - 2.00%. After that, we think the Fed may decide that a slower rate-hike trajectory is once again appropriate.
Taking their foot off the brake entirely, though, may not be in the cards. Since March, public comments from virtually all of the Fed’s voting members seem to point to a swift return to a “neutral” fed funds rate of 2.5%, given white-hot inflation and low unemployment. (“Neutral” represents the Fed’s estimate of the rate at which monetary policy is neither accommodative nor restrictive.) At the same time, because fed futures have already priced in a return to 2.5% this year, the Fed would likely stoke further market volatility were it to hike more aggressively. (Fed futures are used by traders to bet on the direction of interest rates.) Just a few days ago, that possibility seemed remote, but following hotter-than-expected employment cost data last week, some investors believe a 75 bps move can’t be ruled out. To date, however, only one member of the Federal Open Market Committee — the Fed’s monetary policymaking body — has publicly supported such a move.
Time to trim. In addition to raising rates this week, the Fed will announce that it is starting to shrink its balance sheet, a process known as quantitative tightening, or QT. This involves unwinding the quantitative easing (QE) asset purchases it has made in response to the pandemic over the past two years by allowing maturing assets to roll off without replacement. As outlined in the minutes from the Fed’s March meeting, these maturities will reach up to $60 billion/month of U.S. Treasuries and $35 billion/month of agency mortgage-backed securities, phased in over a few months.
Markets have already priced in these policy changes, judging by the tightening of financial conditions in recent weeks: Stock valuations (such as the price/earnings, or P/E ratio) fell in April, corporate bond spreads widened and Treasury yields rose across all maturities.
Even with a lot of rate hikes priced in, conditions may tighten further from here. Futures markets show the Fed taking its policy rate beyond neutral in 2023, signaling a return to restrictive monetary policy for the first time since the mid-2000s. This possibility may be contributing to growing recession fears. Whether we actually see a return to 3% or 4% interest rates will depend on the state of inflation and the labor market entering 2023. If inflation cools quickly or the labor market seems to be suffering, the Fed may be elect to temper its pace of tightening or stop hiking altogether. But if the labor market stays hot and wage increases keep inflation running high, investors’ unpleasant start to 2022 may endure well into the summer.