Year to date through May 2022, four key issues continue to drive a historically turbulent period for both stock and bond investors: the combination of inflation at multidecade highs, the U.S. Federal Reserve continuing to tighten monetary policy by raising interest rates, the ongoing war between Russia and Ukraine, and the lingering impact of the global pandemic.

Since the start of the second quarter, the S&P 500® Index registered losses for seven consecutive weeks before rallying over 6% in the final week of May. The nearly two-month stretch was its longest losing streak since March of 2001. During the same period, bond investors did not fare much better, as yields rose and the Bloomberg U.S. Aggregate Bond Index fell 3.2%.

As the end of the first half of the year nears, Mutual of America Capital Management LLC continues to see volatility in both equities and bonds as uncertainty surrounds the consequences and outcome of the war in Ukraine and the ability of the Fed to tame inflation by raising interest rates—and, at the same time, to reduce the Fed’s balance (through quantitative tightening) without tipping the economy into recession.

Investors Continue to De-Risk

Given the elevated levels of uncertainty, most stocks struggled during the first five months of 2022. Year to date through May 31, the S&P 500 declined 12.8%, the Nasdaq slumped 22.8% and the Dow Jones Industrial Average fell 8.4%. Since peaking in early January 2022, the S&P 500 was off 14%, the Nasdaq had declined 24% and the Dow was down 10% heading into June.

During the same period, the Russell 1000® Value Index (down 4.5%) outperformed the Russell 1000 Growth Index (down 21.9%) by 17.4%. Given that higher interest rates make future earnings less valuable, it was not surprising to see the value sector continue to outperform the growth sector among large cap and small cap equities, as was the case in the first quarter.

Bond Prices Facing Pressure

As we noted in the April issue of the Economic & Market Perspective, interest rates have been trending downward since the early 1980s, meaning that bond prices have been in a prolonged bull market. This bull market trend is continuing to reverse in 2022, as a host of crosscurrents are making for a volatile year in the U.S. bond market thus far. Year to date, interest rates across the Treasury curve increased anywhere from 60 to 182 basis points. This dramatic move comes in the wake of historically high inflation and the Fed’s pledge to combat higher prices with a series of rate hikes and balance-sheet normalization. The projected pace of monetary tightening, along with hawkish rhetoric from the Federal Open Market Committee (FOMC), has induced a flattening of the yield curve. The spread between 2-year Treasury and 10-year Treasury yields narrowed by 49 basis points, to just 28 basis points. Sometimes this can be a precursor for potential economic weakness. On May 5, the Fed approved a 0.50 percentage-point rate hike, the second increase this year and the largest in 22 years. This brought the Fed Funds target to a range of 0.75% to 1.00%.

Year to date, the 10-year Treasury rose 134 basis points, to 2.84%, after finishing 2021 at 1.51%. With interest rates rising aggressively, bond prices fell during the first five months of the year. The 10-year Treasury was down 10.6%, the 30-year Treasury declined 22.1%, the Bloomberg U.S. Corporate Bond Index fell 11.9% and the Bloomberg U.S. Aggregate Index declined 8.9%. Although this data reflects just the first five months of 2022, it’s worth noting that bonds finished 2021 with a negative return and that it’s extremely unusual for bonds to have negative returns in back-to-back years. In fact, the last time that happened was in 1956.

High Inflation Persists

Taking a closer look at inflation, it continues to be problematic in the U.S., and its persistent rise is being caused by a variety of factors. These include increases in global commodities, rising consumer demand, wage pressures and supply-chain bottlenecks. All three well-known inflation gauges slowed modestly in April from prior periods but continued to show levels well over the Fed’s average target of 2.0%: 1) the Bureau of Economic Affairs’ Personal Consumption Expenditures (PCE), the Fed’s preferred inflation gauge, was up 6.3% year over year; 2) the Producer Price Index, which sometimes predicts the direction of consumer prices, was up 11.0%; and 3) the Consumer Price Index (CPI), the most widely recognized gauge, was up 8.3%—which continued to be a multidecade high. The CPI provides a statistical measure of the average change in prices in a fixed-market basket of consumer goods and services. The April CPI came in at 8.3%, marking the 14th consecutive month that inflation was above the Fed’s target rate.

Consumers Hit Hard by Inflation

The ongoing effect of inflation continues to directly impact consumers’ purchasing power. During 2022, gas prices continue to climb nationwide, with a national average of $4.63 per gallon on May 30, 2022. Just a year ago, the national average sat at $3.03. In many states, the current average price was above $5.00, including California, which came in at $5.99. It is interesting to note that 60% of the cost of gas is a function of the price of crude oil, with the other 40% coming from refining (17%), distribution and marketing (11%) and taxes (11%). As of now, it doesn’t appear that the Biden administration’s March 31 announcement that the U.S. would release one million barrels of oil per day from the Strategic Petroleum Reserve has helped to cut gas prices and fight inflation.

In addition to gas, food prices also continue to rise. The U.S. Department of Agriculture’s (USDA) Economic Research Service updated its April report, which indicated that food prices continue to rise. USDA forecasts for consumer food price inflation were increased again in April, with all food prices rising 5% to 6% (compared to 4.5% to 5.5% in March) and grocery store prices expected to rise 5% to 6% (compared to 4.5% to 5.5% in March). The forecast increase in restaurant prices was held at 5.5% to 6.5%. Taking the midpoint of the USDA’s forecast ranges, all food price inflation would be at its highest point since it was 5.5% in 2008. The 20-year average for food price increases—2.4% for all food, 2.9% for restaurant prices and 2.0% for grocery store prices—means the current outlook is for costs that are at least double those averages.

On the housing front, the most recent Standard & Poor’s CoreLogic Case-Shiller Home Price Indices, from March 2022, reported a 21.2% annual gain. This was an acceleration from the December 2021 reading of 19.1%. These are very strong numbers, which will continue to keep the CPI elevated in the coming months.

Commodity Prices Surging

At the start of 2022, commodity prices were already elevated; however, the war in Ukraine exacerbated the problem. With fears of potential supply disruption in the oil markets due to the ongoing war, crude oil prices surged above $100 per barrel for the first time since 2014. As of this writing, the West Texas Intermediate (WTI) price was $120 per barrel, and the Henry Hub Natural Gas Spot price was $9.32. To put this in perspective, natural gas was $2.91 in May 2021. Similar to gas prices for consumers, natural gas prices will start to weigh on the industrial sector—which relies on the commodity as a raw material input—as well as companies that use it as their primary energy source.

In addition, prices of the following major commodities significantly rose in the 12-month period ending June 6, 2022: aluminum (+13%); nickel (+65%); coffee (+45%); corn (+11%); wheat (+50%); sugar (+9%); and cotton (+62%). All of these are major inputs in the products Americans use every day, and consumers will continue to feel the pain of these increases as manufacturers pass the costs along in the form of higher prices.

The Federal Reserve Must Tame Inflation

Faced with this commodity-driven inflation spike, the Fed is now headed for its most aggressive monetary policy tightening in almost three decades. Over the past few months, the Fed has switched from an extraordinarily accommodative monetary policy to a hawkish stance. The Fed Funds Rate has increased 1.25% so far this year, and the Fed has given forward guidance that more rate hikes are coming in 2022. The market expects the Fed Funds Rate to end the year at roughly 2.75%. The Fed’s balance sheet, which has expanded to almost $9 trillion, will begin to shrink at a pace of up to $47.5 billion per month starting in June, and then double to $95 billion per month starting in September. At this point, the Fed’s main priority is to fight inflation, given its elevated level, since the labor market seems close to full employment. If inflation does not come down in the coming months, the Fed will be forced to tighten monetary policy beyond expectations, thus creating more market volatility and increasing the probability of a recession.

Jobs and Savings Lower Recession Risk

The first release of the U.S. Gross Domestic Product (GDP) for the first quarter of 2022 showed a decline of 1.4%, which was below expectations. While the danger of a downturn has risen as growth has slowed, most economists believe a recession in the immediate future is unlikely, given the continued strength of the job market and the more than $2 trillion in excess cash on household balance sheets.

A tight labor market should make it harder for the economy to spiral into a recession. This has the potential to give the Fed some breathing room as it embarks on its tightening cycle with the hope of guiding the economy to a soft landing that avoids a recession. In the first five months of 2022, the labor markets continued to report job growth, as they did in 2021. In the May report, nonfarm payrolls increased by 390,000, and the unemployment rate was little changed at 3.6%—just slightly above the pre-pandemic level (and a 50-year low) of 3.5% in March of 2020. The total number of unemployed people is 5.9 million, which is close to the 20-year low. (February 2020 was the low, at 5.7 million.) May’s participation rate held steady at 62.3% (the rate was at 60.2% in April of 2020) and is almost back to its 63.4% rate measured in January and February of 2020. Looking at the BLS’s Job Openings and Labor Turnover Survey (JOLTS) for April showed that the number of job openings nationwide was 11.4 million. This is an indication that the labor market is tight, with a greater supply of jobs than demand for jobs.

Equity Valuations Contracting

Investors are requiring a substantially higher risk premium due to the higher interest rates and heightened economic uncertainty. Higher rates are causing equities’ price-to-earnings (P/E) multiples to contract, as future cash flows are less valuable when discounted to their present value. This is especially true for longer-duration assets such as growth companies. Growth stocks have experienced a significant reduction in their P/E multiples. The 2023 forward multiple on the S&P 500 Index has contracted from 21.5 times at the start of the year to 16.6 times today. This is getting closer to the historic range of 14 to 15 times for forward multiples. Volatility is likely to continue as a result of decelerating earnings growth, high valuations and an interest-rate tightening cycle.

Outlook

The financial markets continued to experience downward swings in prices due to the heightened level of uncertainty over the first five months of this year. As a result, the overall short-to-intermediate outlook remains uncertain, and there are several issues impacting the markets and economy worth keeping an eye on through the second half of this year. On the positive side, the country continues to see strong jobs growth, near-record-low unemployment rates, robust corporate earnings, healthy consumer spending from excess savings, and still relatively low interest rates. On the negative side, inflation continues to rise to levels not seen in decades, as supply-chain disruptions persist and the war between Russia and Ukraine intensifies. Further, rising prices for food and commodities (such as gas), as well as the Federal Reserve’s ongoing interest-rate hikes, continue to affect consumers’ purchasing power.

With all of this in mind, the Fed clearly recognizes that inflation is a major problem, and it is expected to use all the tools in its arsenal to cool the economy, engineer a soft landing and avoid a recession. We will continue to monitor this and other issues that might impact our outlook in the coming months.

Jamie Zendel is EVP, Head of Quantitative Strategies, and Erik Wennerstrum is VP, Quantitative Research, at Mutual of America Capital Management LLC.

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