There were few places for investors to hide (again) as a mostly familiar slate of worries about the global economy in 3Q22 fueled sharp declines in stocks and bonds. Sticky and uncomfortably high inflation led to aggressive Fed rate hikes and increasingly hawkish rhetoric, raising concerns over the ultimate impact of sharply higher rates on the U.S. economy. The effort to combat inflation has been global; roughly 90 central banks around the world have raised rates in 2022, and more than 40 have hiked by at least 75 bps. As a result, the prospect of a global recession has emerged. China’s woes and fears of recession in Europe further contributed to dismal sentiment. And the war in Ukraine, which has driven up energy and food prices, showed no signs of ending. Add to this mix the late-quarter “mini-budget” fiasco in the U.K., which put further pressure on bond markets and buoyed an already strong U.S. dollar.
Inflation, Rate Hikes, Strong Dollar Challenge Global Economy in 3Q22
While headline inflation in the U.S. moderated over the summer as gas prices declined, core inflation climbed, mostly due to increased shelter costs. The Consumer Price Index (CPI) jumped 8.3% in August (year-over-year) and Core CPI (which excludes food and energy) rose 6.3%. The Personal Consumption Expenditures (PCE) Index gained 6.2% and Core PCE increased 4.9% (YOY), well above the Federal Reserve’s long-run inflation rate objective of 2% for the Core PCE Index.
The Federal Reserve has been explicit in its intent to aggressively fight inflation and is willing to see the economy slow and unemployment rise to bring it down. Following the June 75 bps hike, the FOMC again raised the Fed Funds target by 75 bps in July and in September, the first time for three consecutive 75 bps rate hikes. The Fed Funds target is now 3.0 – 3.25%, the highest since 2008. The median projection from the Fed for the rate at year-end is 4.4%; in June the year-end projection was 3.4%. More significantly, the Fed’s outlook for 2023 unemployment was revised from its June forecast of 3.9% to 4.4%, up sharply from the current 3.7% unemployment rate. At the same time, the real GDP projection for 2022 fell to just 0.2%, down from 1.7% in June. Notably, both the markets and the Fed expect inflation to fall over longer periods. The Fed’s 2025 projection is 2.0%. Five-year breakeven spreads, which reflect the market’s expectations for inflation over the next five years, were 2.1%, down from 2.6% at the end of 2Q.
Shelter costs have been one of the key contributors to core inflation. As mortgage rates have risen sharply, approaching 7% as of quarter-end, there have been signs of market cooling. Housing starts have moderated, mortgage applications have dropped, and permits for homebuilding have fallen to the lowest level since 2020. Housing prices have begun to decline in some areas. The median house price, which hit a record high of $413,800 in June, fell to $389,500 in August (according to the National Association of Realtors) but is still nearly 8% higher than one year ago. Higher mortgage rates have not helped with affordability, which remains at the lowest level since 2006.
The U.S. dollar is at a two-decade high, as measured by a basket of currencies of major trading partners. The dollar has benefited from relatively high interest rates in the U.S. as well as its perceived safe haven status. The euro is at its lowest since 2002 vs. the dollar. The Bank of Japan was forced to intervene in currency markets for the first time since 1998 to bolster its currency. The yen lost nearly 11% vs. the dollar in 3Q and is down more than 18% over the last 12 months. While a strong dollar helps to temper inflation in the U.S., it is bad for U.S. exports and hard on other economies, especially those in emerging markets that may issue debt in U.S. dollars.
The labor market remained strong through the quarter. Unemployment ticked up to 3.7% but job gains were robust and the ratio of job openings to job seekers also stayed elevated, with roughly twice as many openings as seekers at the end of August. Most expect the job market to cool as inflation and higher rates take a toll on profits.
Rates rose broadly outside of the U.S. as central banks embarked on an unusually synchronized global effort to fight inflation. The European Central Bank hiked rates by 50 bps in July, emerging out of negative territory, and 75 bps in September. It increased its forecast for 2022 inflation in the euro zone from 6.8% (in June) to 8.1% given high energy and food costs as well as supply shortages. Its growth forecast for 3Q22 is 0.1% and -0.1% in 4Q as rising prices hurt consumer spending and confidence, and uncertainty over gas supply reductions and rising rates constrain activity. Full-year growth is expected to be a tepid 0.9% in 2023. The economic effects of the Russian invasion of Ukraine have been especially painful in Europe, which has relied heavily on Russia for its energy needs. Annual inflation in the euro zone was 10.0% in September, up from 9.1% in August and ahead of expectations. The Bank of England raised rates by 50 bps in September from 1.75% to 2.25%, the largest increase in nearly 30 years, to combat inflation. In Britain, the CPI rose 9.9% in August from one year earlier.
China continued to languish in relative terms due largely to its policies to combat COVID (mass lockdowns) but also a falling yuan and a collapsing property sector that accounts for about 30% of economic activity. Weakness among its trading partners has also played a role. The World Bank expects growth in China to be 2.8% in 2022, sharply lower than its 8.1% in 2021 and slower than developing countries for the first time in 30 years. As the second-largest economy in the world, China’s slowdown weighs heavily on the prospects for global growth.
In the U.K., a late-September announcement from Chancellor Kwasi Kwarteng of a “mini-budget” that included the largest tax cuts in 50 years (with no offsetting revenue) spurred a sharp sell-off in government bonds and caused the pound to plummet. Versus the U.S. dollar, the pound fell to an all-time low. Ten-year government bond yields climbed 100 bps on the news, and ultimately the Bank of England had to intervene with a temporary bond-purchase program to help stabilize markets. The International Monetary Fund issued a rebuke, warning that the suggested tax cuts would likely fuel inflation and heighten inequality, and Moody’s warned the unfunded tax cuts would be a “credit negative” event. The “mini-budget” has since been modified to reverse the planned cuts to the highest tax rates, and the plan is currently undergoing further analysis by the U.K.’s Office for Budget Responsibility.
Markets have been both punishing and humbling in 2022, and the ability of central banks to dampen high and widespread inflation without causing recessions remains a key question for investors. The war in Ukraine and its ultimate implications also weighs heavily. Stock and bond markets have undergone significant corrections, and both represent much better forward-looking opportunities than we have seen in some time, but we expect volatility to continue to be a key theme given significant tail risks. As always, Callan continues to advise adherence to a disciplined investment process that includes a well-defined long-term asset allocation policy.
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