Since our last writing, the Fed has begun what we expect to be a relatively aggressive economic tightening process by way of raising benchmark interest rates. These policy efforts are intended to slow inflation and may in turn impede economic growth. The Fed’s outlook to continue down the path of steadily increasing interest rates will likely lead consumers and businesses to reduce borrowing and spending, therefore reducing total output (GDP). It is important to understand that although upside growth in the underlying economy is expected, shifting expectations in the pace of growth compared to previous outlooks leads to volatile market conditions. These rapidly changing prospects for the post-COVID economy are exactly what we are experiencing at present.

 

As interest rates creep higher, consumers may delay or forego large purchases altogether as prices along with borrowing costs increase. According to the Bureau of Labor Statistics, wages recovered and grew at an accelerated pace during the second half of 2021. The March CPI figure of 8.5% compared to nominal year-over-year wage growth of 6.7% leaves the average American worse off, down 1.8% in “real” terms.  This may have sweeping effects across the economy as consumer spending accounts for nearly 70% of economic output and even minor changes in spending behavior can have large effects on economic growth. For example, although there remains a shortage of supply in the housing market which has pushed prices ever higher, we expect the skyrocketing prices of homes to cool over the coming months as borrowing rates rise. As of April 21, the national average for fixed 30-year mortgage rates hit 5.11%, up from 2.97% just one year ago (Source: Freddie Mac). For a typical $250,000 mortgage, this increases the monthly payment by over $300, and a total of over $100,000 in interest paid over the life of the loan. Perhaps the silver lining is the fact that many Americans were able to take advantage and lock-in historically low interest rates over the past few years – either through purchasing or refinancing – meaning costs for existing borrowers will not change.

 

Businesses have been forced to increase wages to attract and retain employees during a very tight labor market. Like consumers, many businesses were able to borrow or refinance existing debt at very attractive interest rates in recent years, having a net positive effect on profitability. Uncertainty around higher future financing (borrowing) and operating (labor & materials) in general and the potential for slowing consumer demand creates a difficult backdrop for business conditions in general. In order to survive, businesses constantly need to balance the risks of raising prices to protect margins versus potentially driving away customers to seek lower-priced alternatives. Those that fail to maneuver these conditions appropriately will soon find themselves out of business. This ultimately weighs on near-term investment implications as conditions have become increasingly cloudy very quickly.

 

Further headwinds to growth and inflation due to the Russia-Ukraine conflict have exacerbated an already precarious economic picture. Ukraine is a major global exporter of corn, wheat, and seed oils – key foodstuffs especially for many in the developing world. Russia is also a major supplier of natural gas and petroleum – used for energy and many industrial/manufacturing components. Both countries produce raw materials needed in the production of fertilizer, further placing upward price pressures on food costs for all of us. Sanctions by the west against Russia and questionable output forecasts for much-needed materials is placing further stress on an already strained supply chain struggling to recover from government mandates and public health directives. There is the potential for these factors to spark protectionist trade policies, creating rippling effects and further choking global supplies (Indonesia largely banned the export of palm oil in late April, used in over half of all US consumer packaged products according to the World Wildlife Fund).

 

To summarize, we expect near-term uncertainty to continue driving market volatility and investors should temper return expectations compared to what we have delightedly experienced over the past few years. Equity (stocks) investors have been handsomely rewarded beyond expectations for most of the past decade and should be prepared for less attractive returns for 2022 as corporate profit outlooks face fairly strong headwinds. Fixed income (bonds) will continue along a rocky path ahead as interest rates will likely resume lifting off from all-time lows. Recall that as interest rates increase, bond prices typically fall. Further, we expect the Fed’s tightening process to begin once again moving us back toward normalcy in terms of financial market conditions. We may expect a gradual move toward positive returns on cash equivalent and money market vehicles for instance – a taste of which we last experienced briefly in 2019.