July brings joy to investors after a frightful first half of the year

The last week’s market highlights:

Each week, we present our featured topics in the context of major themes from Nuveen’s most recent global investment outlook:Opens in a new window

• U.S. economy: Recession has become a 50/50 proposition by the end of next year.
• Global economy: High commodity prices threaten emerging markets and energy importers.
• Policy watch: Central banks are tightening but now risk going too fast, too far.
• Fixed income: Corporate credit and municipal bonds offer some recession protection and compelling value.
• Equities: Too soon to call a market bottom with recession risks looming, but U.S. growth stocks have cheapened a lot.
• Asset allocation: Plenty of opportunities for investors with a tolerance for volatility.

Quote of the week:

"Wild waves rise and fall when they arrive/And that’s what makes the calm sea alive.”  –  Munia Khan

The Fed’s “Summer of ‘75” continues

Last week, as expected, the Fed raised its target fed funds rate range by 75 basis points (bps) for the second consecutive meeting, to 2.25% -2.50%. This action brings the policy rate close to the Fed’s estimate of “neutral,” the level at which interest rates neither stimulate nor restrain the economy. In mid-July, markets had briefly priced in a 100 bps hike after the release of Consumer Price Index (CPI) data for June, but the Fed hadn’t endorsed such an outsized move, nor had economic data strengthened enough to warrant it. Rates are nearly certain to move significantly higher before year-end, although the pace should slow. Markets are pricing in a total of 100 bps of increases over the remaining three Fed meetings of 2022.

At his post-meeting press conference, Fed Chair Jerome Powell was vague about the Fed’s tightening plans when it gathers next on September 21. He and his colleagues will examine incoming data, which will include two monthly employment reports and several inflation readings. But rather than provide specific forward guidance, Powell stated that any decisions will be made on a “meeting by meeting” basis.

Why didn’t Powell offer guidance, as he has at prior meetings? Perhaps it was a case of “once bitten, twice shy.” His decision to avoid any predictions may have been driven by the Fed’s assurances that a 50 bps hike was in store for June, only to have that projection fall by the wayside as inflation continued to spike, leading to a market-rattling 75 bps increase instead. This undermined the very purpose of forward guidance: to allow the Fed to shape expectations for monetary policy, thereby minimizing surprises and the market volatility they often trigger.

But the Fed’s not the only central bank to say “adieu” to forward guidance — for the time being, at least. High inflation led the European Central Bank (ECB) to scupper it as well, raising rates by 50 bps on July 21 rather than the 25 bps that investors had anticipated. In addressing the press, ECB President Christine LaGarde simply stated that “we are not offering forward guidance of any kind.”

Without forward guidance, expectations for central bank policy over the balance of 2022 will be hard to pin down. This may be unavoidable, given the difficulty the Fed (and ECB, for that matter) have had in accurately forecasting inflation. Meanwhile, prices have kept rising. In the eurozone, headline inflation hit a fresh all-time high of 8.9% in June.² In the U.S., the headline Personal Consumption Expenditures (PCE) price index also reached a new peak (+6.8%).³ Core PCE, which strips out volatile food and energy costs and is the Fed’s preferred inflation barometer, remained elevated as well (+4.8%).⁴

In a somewhat surprising turn from the dominant trend in 2022, U.S. equity markets followed inflation higher in July. The S&P 500 Index jumped 9.2% last month, while investment grade (+3.2%) and high yield bonds (+5.9%) also rallied.⁵ In our view, the best explanation for the synchronous rally is that markets, like us, doubt that a severe U.S. recession is likely, even if monetary policy tightens a bit more from here. (More on the second quarter’s recession rumblings follow.) We think a slowdown in economic growth is inevitable at this point, but strong private-sector balance sheets and surprisingly persistent hiring growth should prevent a steep rise in the unemployment rate.

Another quarterly contraction — but is the U.S. in recession?

According to the government’s “advance” estimate released last Thursday, the U.S. economy contracted at a 0.9% annualized rate in the second quarter, below consensus expectations for a modest expansion.

Among the detractors from GDP:

• Weaker private investment growth, especially for structures
• Decreasing state and federal government spending
• Sharply falling purchases of consumer goods

This last item is of particular interest, as it confirms what we’ve been seeing in data releases over the past several months: U.S. consumers have been spending less on goods and more on services. And their desire to “have more fun” rather than “buy more stuff” showed up clearly in the GDP data.

Net exports were another key contributor. Because GDP is an estimate of the economy’s output, exports are added to consumption, while imports (which are consumed domestically but produced outside the U.S.) are subtracted. In the second quarter, exports grew significantly, while imports rose only modestly.

Overall, the world’s largest economy continued to produce less than its citizens wanted to buy, though this imbalance was smaller than it was in the first quarter thanks primarily to weaker demand. Whenever we note a supply-demand mismatch of this sort, we like to look at a metric called final sales to private domestic purchasers (“final sales”). This number tracks how much U.S. residents actually purchase, regardless of where the product or service is produced – making it a better gauge of the demand side of the economy than headline GDP.

In the second quarter, real growth in final sales was 0%, a sharp decline from the first quarter’s impressive 3%.⁶ This is a sign that high inflation has likely contributed to softer demand as households and businesses scramble to make ends meet. And it’s a worrying sign of what’s to come in future quarters absent a material decline in that inflation.

So here’s the $64,000 question: With GDP contracting 1.6% in the first quarter and 0.9% in the second, has the U.S. already fallen into recession?⁷ (A recession is often colloquially defined as two consecutive quarters of negative GDP growth.) The answer doesn’t really matter to us. To paraphrase an old saying, “The economy is what it is.” To be more precise, when the dust settles, we doubt the National Bureau of Economic Research — the organization that keeps track of official business cycle dating — will characterize the first half of 2022 as a recession. Why not? Because:

• Private sector incomes (excluding transfer payments such as unemployment benefits) grew faster than inflation over most of the first half of the year
• Orders for durable goods (big ticket items designed to last at least three years) rose
• The job market stayed strong, with the unemployment rate falling to ultra-low levels and employers maintaining their brisk pace of hiring

For his part, Chair Powell said last week that he doesn’t think the U.S. is in recession. In his post-meeting press conference, he acknowledged the economy is slowing but countered with “there are too many areas of the economy that are performing too well.”

Whether the U.S. is in the midst of a recession doesn’t materially affect our outlook. The economy is, to some degree, still tangled in the web of a global pandemic, which has taken a devastating human and economic toll. What we will watch most closely is how consumer demand, which carried the economy in the first half of 2022, fares in the face of rising interest rates, diminished savings, eroding job security and high food/energy costs.