Quarterly Commentary Q2 2022: Interest Rates Increase
Rising wages and other inflationary factors spurred the U.S. Federal Reserve to raise short-term fed funds interest rates by 1.5% so far this year, with another 1.5% rate increase expected by year-end.
This projected 3% rise in interest rates would be the fastest increase since 1994. In the past, when the fed funds rate increased by 3% or slightly more in one year, a recession typically occurred between 21 and 28 months later. Therefore, a recession in late 2023 or in 2024 would not be unexpected.
The first quarter of 2022 showed a mild U.S. economic contraction, mostly as a result of retailers having too much inventory and a decrease in exports. If the same thing happened in the second quarter, then we are already in a mild recession. U.S. and foreign stocks appear to be priced for a brief recession.
U.S. households are generally in good financial shape (low debt load) and employment conditions are still strong. Therefore, any current recession is expected to reverse in the upcoming months and many financial assets are expected to rebound in price. Nevertheless, this may be a temporary respite given the 2023-24 recession outlook as a direct result of projected Federal Reserve interest rate policy.
The path of inflation over the coming months will play a huge role in what actually happens with interest rates and the economy. Energy and some other prices are expected to moderate soon, with the critical inflation factor likely becoming wage growth and productivity.
We will be monitoring economic and investment conditions for either improvement or deterioration and act accordingly. Meanwhile, we expect volatility of risk assets to remain elevated, and thus a more cautious stance is warranted, a policy unchanged from 3 months ago.
The growth-stock-heavy S&P 500 Index and the S&P 1500 Growth Index lost 16.1% and 20.5%, respectively, over the second quarter. The S&P 1500 Value Index had a smaller loss of 11.4%. Small-cap stocks (Russell 2000), foreign (EAFE) and emerging markets stocks (MSCI), decreased 17.2%, 14.5%, and 11.5%, respectively. Diversified worldwide stock and bond asset allocation mutual funds (Morningstar World Allocation funds) dropped 10.6%.
The rise in interest rates hurt bonds as well. The U.S. 20+ Year Treasury Index lost 12.7% last quarter. The Bloomberg U.S. High Yield Index lost 9.8% and the Emerging Markets Dollar Bond Index lost 8.7%, respectively, the last quarter.
As always, please feel free to contact WESCAP at (818)563-5170 or contactus@wescapgroup.com if you would like to discuss any of this further.