The Economy and Market from Here... at Hills Quarter 2 2022

The Economy and Market from Here... at Hills Quarter 2 2022

April 6, 2022

Tagged As: Wealth Management

On January 3, 2022 the S&P 500 closed at a record high. Since then, worries about inflation, rising interest rates, and, most recently, economic ramifications resulting from the ongoing conflict in Ukraine have driven markets mostly lower during the quarter. The future is always uncertain, but the level of uncertainty today feels more elevated than usual and is being reflected by financial markets. Since the beginning of the year, more than half the trading days have ended with the S&P 500 closing 1% higher or lower than the previous day - the majority of these days have been lower. This is twice the rate compared to a normal year. On March 8th, the S&P 500 was down more than 13% for the year. The index has recovered some since then – climbing nearly 9% since that March low. Year to date, the S&P 500 is off 4.60%. International stocks as measured by the MSCI EAFE are down 5.77% this year.

Interest rates are also higher this year, leading to disappointing results for fixed income investors. Inflation, which started due to supply chain constraints amid COVID lockdowns, has been exacerbated by higher energy prices. Oil peaked above $130 per barrel as a direct result of the conflict in Europe and the unprecedented level of sanctions imposed on members of Russian leadership in hopes to bring a swift end to the invasion. Consequently, the Consumer Price Index, a leading measure of inflation, has risen at the highest rate in generations. This backdrop leads many to expect that the Federal Reserve Open Market Committee (FOMC) will raise short-term rates several times over the next twelve to eighteen months, prompting short-term rates and long-term rates to shift higher. The first rate hike occurred as expected during the March FOMC meeting – a 25 basis point increase. 10-Year Treasury Notes closed the quarter yielding 2.33% - up from 1.51% at the start of the year. 2-Year Notes and 5-Year Notes yield 2.34% and 2.46% respectively. Bond investments have declined as a result of higher rates. The BarCap Agg, a leading index for the US Bond Market, is down 5.93% for the year.

Looking Forward

All eyes will remain focused on Eastern Europe as the war in Ukraine progresses. Supply chain congestion and inflation, which were expected to moderate at the beginning of 2022, may linger much longer as a result. Corporations, already responding to tight supply chains as a result of the pandemic, continue to invest to diversify their supply chains. Supply of labor is also a concern. Investment in automation will do much to alleviate the pressure, but, as with reconfigured supply chains, this will not occur for several years. In the meantime, we can expect inflation to remain somewhat elevated – assuming demand for goods remains high – though we do expect it to increase at a lower rate than we have seen in the last few months.

It is not all bad and there are still reasons to remain optimistic. The majority of corporations indicate their customers are stomaching the additional price increases, and inflation is not yet impacting profitability. This is to say, consumers and corporations remain healthy and the economy should continue to recover following the deep recession experienced in 2020. Demand for services and goods remains strong and the US and global economies are still emerging from disruptions caused by COVID-19. Earnings for companies are higher than six months ago though the market has remained relatively flat. This has resulted in more attractive valuations for stocks in general.

Expectations for continued strength in the US Economy, full employment, and very high near-term inflation will likely cause the FOMC to raise interest rates several times this year. The question now centers on the pace and size of the increases. Will it be every meeting? Will it be 25 or 50 basis points? Communication from the Committee sends mixed signals. Indeed, members of the Committee likely do not yet know. Their decisions remain data dependent and there will be considerable data in the coming months to depend on. A major risk to continued economic expansion in the US hinges on the FOMC’s ability to navigate the tightrope. Long-term expectations for inflation are more benign, as expressed through the yield of the 10-year US Treasury at 2.33%. The FOMC needs to be cognizant of the effect of external factors on the economy and cautious not to over-tighten.

Volatility is likely to remain elevated over the next several months, as the myriad of risks discussed could result in a short-term decline in stock prices. While we still prefer stocks over bonds, the bond side of the portfolio can be used as a pool of funds to provide for regular distributions during times of stock market stress. It can also be a source from which to make investments during market dislocations, turning the event into an opportunity that will pay dividends in the future when markets recover. We can make tactical changes to the portfolio and use the changes in the bond market to our advantage. At our February meeting, the Hills Bank Trust and Wealth Management Investment Committee voted to shorten the duration of our fixed income portfolio in order to take advantage of the flatness of the yield curve and to reduce interest rate risk without surrendering income. In addition, while remaining overweight risk, the Committee decided to reduce exposure to those stocks that are sensitive to rising interest rates and increase exposure to those benefiting from higher commodity prices.

Thank you for allowing us to serve you, it is an honor we do not take for granted. As always, we are here to answer your questions and make sure your current asset allocation is still appropriate for your circumstances. If it has been a while since you have visited with us, please do not hesitate to call or email and set up a meeting with your Hills Bank Trust and Wealth Management Officer.

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