Outlook and Market Review - First Quarter 2022

The U.S. economy shrank 1.5% in the first quarter of 2022 following growth of 6.9% in the fourth quarter, according to the Bureau of Economic Analysis. Growth for the second quarter is likely to be positive but may fall below 1%. There is talk of a pending recession later in the year but very slow growth is more likely. Nevertheless, the combined impact of higher rates of inflation and falling real disposable income will continue to take a toll on spending and asset values. Real disposable income fell 7.76% in the first quarter following a decline of 4.5% in the fourth quarter. The stock market, a leading indicator of economic activity, is now in bear market territory and consumer confidence measured by the University of Michigan Survey of Consumers is at a decade low. Households are especially hard hit by rising food and energy prices. The saving rate has already dipped to 5.6% from 7.9% in the prior quarter.

The labor market continues to be strong with unemployment steady at 3.6% in May. Approximately six million unemployed workers are looking for work and the participation rate is stable at 62.3%. The unemployment rate and number of unemployed is comparable to conditions prior to the COVID shutdown. Average hourly earnings increased 5.2% over the past year but did not keep up with inflation. Overall, unit labor costs gained 8.2% over the past 12 months, which is the largest increase since 1982. Rising unit labor costs squeeze business profit margins unless costs can be passed along in higher prices. Concerns are growing that the tight labor market may generate a wage-price spiral and accelerating inflation.

Both the consumer price index (CPI) and personal consumption expenditure (PCE) inflation measures are reaching forty year highs. Inflation pressures have been building since the economy began to open up early in 2021 following massive fiscal and monetary stimulus linked to COVID shutdown relief. Efforts to backtrack on monetary stimulus may now need to be extreme to slow inflation. The Fed is expected to raise the Fed Fund rate in both June and July by 50 basis points, resulting in a 1.75% to 2% range by August. The Fed will then likely pause to evaluate the ultimate impact of the rate hikes, but additional increases seem inevitable. A neutral Fed Fund rate is generally believed to be about 2.5%, suggesting that the Fed must go higher than that to cool inflation. The Fed may receive help if policymakers allow a return to energy independence and promote more domestic energy production to meet demand. The demand for oil is relatively price inelastic in the near term, leaving only an increase in supply as an answer to rising oil prices in the near term. Such a return to energy independence through pipeline construction, regulatory reform, and expansion of drilling leases will depend on the outcome of upcoming elections.

Long term interest rates have been very slow to adjust to inflation expectations. The “breakeven” inflation rates, which are market derived estimates of expected inflation premiums, are less than 3% for maturities ranging from ten to thirty years. Once higher longer term inflation pressures are built into expectations, long term rates may increase significantly. For this reason, market analysts are paying very close attention to the persistence of inflation and the ability of policy initiatives to curb longer term price pressures. To keep long term interest rates from climbing and hurting longer term economic growth, the Fed may need to be much more aggressive later in the year if inflation does not subside. This scenario is consistent with a shorter term recession later in 2022 or early 2023. While less extreme, the current situation facing policy makers is similar to the early 1980s leading up to the 1982 recession.