Summertime is here, but the living isn’t easy for investors

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:

"You need special shoes for hiking — and a bit of a special soul as well."  – Terri Guillemets

The Fed turns up its tightening

Last Wednesday, the Federal Reserve gathered during a particularly tumultuous period for financial markets and raised its benchmark federal funds rate by 75 basis points (bps), to a target of 1.50%-1.75% — the largest such increase at a single meeting since 1994.

Less than a week before, investors were confident that a 50 bps hike was in store. But that was before they learned on June 10 that May’s Consumer Price Index (CPI) headline inflation jumped 8.6% (year-over-year), its highest level in more than 40 years and well above the Fed’s 2% target. Meanwhile, core inflation, which strips out food and energy costs, moderated slightly compared to April but was still elevated at 6%.² These white-hot numbers drove a dramatic selloff in stocks and bonds. For example, the yield on the bellwether 10-year U.S. Treasury soared 28 bps on June 13 alone, to 3.43%.³ (Bond yield and prices move in opposite directions.)

Inflation hasn’t eased as much as either the Fed, markets or we had expected over the first five months of the year. This is largely because the ongoing war in Ukraine has pushed up prices of goods and services that are sensitive to food and energy costs, such as gasoline and, in turn, airfares.

In his post-meeting press conference last week, Fed Chair Jerome Powell noted that a 50 bps or 75 bps rate hike is likely when the Fed meets next month. He also acknowledged that a 75 bps increase “is an unusually large one,” and that he doesn’t expect moves of that size “to be common.” Despite these comments, the Fed anticipates lifting rates to a 3.25%-3.50% range by year-end. We think we’ll see a relatively rapid series of hikes until the Fed’s policy rate reaches around 3%, at which point Powell and his colleagues might pause.

Looking further ahead, fed funds futures indicate that this tightening cycle should top out near 4% in mid-2023. (Traders use fed funds futures to bet on the direction of interest rates.) But we doubt the Fed will have to be quite that aggressive in light of recent slowing in the labor and housing markets.

Both the Fed and investors recognize that tighter financial conditions are needed to dissuade employers from hiring and raising pay, thereby nipping any wage-price spiral in the bud. Data showing fewer job openings and smaller gains in average hourly earnings would be welcome from that perspective.

How effective was the Fed’s messaging? One view is that the central bank sacrificed the credibility of its forward guidance in exchange for burnishing its reputation as an effective inflation fighter. After all, back in April, Powell was talking up “only” 50 bps increases at the Fed’s June and July meeting.

In the meantime, recession fears have remained front and center in investors’ minds, evidence by last week’s plummeting stock prices. Fueling the malaise was a series of disappointing economic data releases for May:

• Retail sales declined 0.3%.⁴
• Housing starts missed forecasts, slipping to a 13-month low.⁵
• Building permits, a proxy for future home construction, also undershot expectations.⁶

All told, that’s a lot of dispiriting new to digest. Still, we found some bright spots in the markets’ reaction to the Fed’s heavy hand. Among these encouraging signs:

• The 10-year U.S. Treasury yield, which reflects investors’ long-term outlook for future economic growth, continued to rise.
• A recession doesn’t seem imminent, based on the nominally positive slope of the 2-year/10-year Treasury curve. (A steepening yield curve signals expectations for a healthy economy, whereas a flattening of the curve and, beyond that, an inversion, flashes concerns about an economic downturn.)
• The 5-year/5-year breakeven rate of inflation remained solidly anchored at around 2.3%, far below May’s CPI print and nearly in line with the Fed’s inflation target.⁷ (This rate measures the expected inflation rate (on average) over the five-year period that begins five years from a given date.)