Summary, First Quarter of 2022:
The beginning of 2022 featured the headwinds of higher inflation and rising interest rates following a year of growth. Economies were recovering from the Covid-19 pandemic but faced the possibility of additional variant outbreaks. Meanwhile, supply chains were continuing to normalize. But Russia’s invasion of Ukraine roiled markets and sharply added to inflationary pressures, introducing an unexpected dimension of risk to the investment environment. Unemployment continued to improve, although many companies have struggled to find and retain workers due to the ongoing “Great Resignation.” Meanwhile, the U.S. Federal Reserve (the Fed) began to hike interest rates to tamp down inflation. The Fed will have a delicate balancing act on its plate to rein in inflation without pushing the economy into a recession.
In our view, the first quarter’s stock market correction was overdue given elevated valuations and rising inflation. Inflation and interest rates are joined at the hip, because interest rates are the main tool that central banks use to influence an economy’s inflation rate. Therefore, higher growth generally means higher interest rates. The results of higher rates ripple across the economy, because higher rates mean greater costs to businesses and consumers as borrowing, such as through business loans and mortgages, gets more expensive.
After raising rates in the first quarter, the Fed expects to make six more rate hikes this year. While this may sound like a large number of increases, it is important to remember that the Fed is starting from a historically low level. If rates were raised six more times at 0.25% per hike, the resulting yield on the 10-year Treasury bond would fall in the range of 3–3.5%, which isn’t exceptional by historical standards. Mortgage rates, meanwhile, would stand around 6%, which is also low by historical standards.
Corporate earnings remain strong today, although companies will face higher borrowing costs going forward. Much has been said about the high level of turnover in the U.S. labor market today, also known as the “Great Resignation.” This phenomenon may be more aptly named the “Great Reordering.” To put it simply, workers are leaving their jobs for higher-paying ones. One key question is how much of this higher cost of labor companies will be able to pass on to consumers. Companies with greater pricing power and other competitive moats will have advantages over weaker counterparts in this environment.
While rates are rising, mortgages are still low on a historical basis. Rising mortgage rates should slow the increase of home prices, which would be welcomed by home buyers but would also dampen GDP growth. We expect inflation to normalize in the latter half of the year as the economy continues to recover from the shutdowns imposed during the pandemic. We will continue to emphasize investments in companies with attractive valuations and defensible competitive advantages in this environment.
Until next quarter,
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