What Advisors, Investors Can Expect in Second Half of 2022

A poor first half of the year ended with major equity indexes in bear market territory and bond prices falling at the fastest pace in decades. Concerns about inflation and the implications for monetary policy were at the top of investors’ “wall of worries.”

With no end in sight to the war in Ukraine and doubts about the outlook for Chinese growth, there was not much good news in the second quarter. The risk of recession is higher than it was at the start of the year, with considerable debate about the potential timing and severity of recession in the U.S. 

June’s Federal Reserve rate increase of 0.75% was the largest single-meeting move since 1994, a response to inflation that reached a four-decade high in which headline inflation reached 8.6%. The Fed acknowledged that tighter policy will likely lead to higher unemployment and lower economic growth, a necessary consequence of the need to keep inflation expectations from becoming unanchored. 

The Fed is justifiably being held accountable for being “behind the curve” on raising interest rates and shrinking the size of their balance sheet. The Fed, however, is not the only culprit for painfully high inflation. The Fed has limited influence over the rising food and energy costs that strain consumer budgets. Rate increases may reduce energy demand, but tight supplies will continue to be the dominant factor driving energy prices.

The tightness in labor markets may be partially attributable to government assistance that has undermined incentives to return to work, as well as the understandable fear of contracting a COVID-19 virus that refuses to fade away.

Inflation is likely to ease later in the year. There are early signs of an easing of wage pressures, a shifting of spending from goods to services, and gradually recovering supply chains. The Fed, however, is not likely to slow the pace of tightening until inflationary pressures recede or a growth slowdown turns into recession. It is quite possible that the “new normal” for inflation will be higher than the Fed’s target rate of 2%. 

There has been rapid adjustment in financial conditions, in contrast with past Fed tightening cycles. two-year Treasurys yielded approximately 0.25% last June; Yields were nearly 3% at quarter-end. Ten-year Treasurys yielded 1.45% last June and have more than doubled in the past year. The tightening of financial conditions that has already happened may have reduced the typical lag between Fed policy changes and economic activity. 

Consumers remain in good shape despite a lot of negative news. The job market remains strong. Wage growth is strong but is slowing from the elevated levels from the post-COVID economic reopening. There is still a significant gap between the number of jobs available and the number of job-seekers. Households have more than $2 trillion in excess savings in comparison with the pre-pandemic trend, a cushion against rising food and energy costs.

Debt servicing costs are near multi-decade lows, in stark contrast with the conditions leading up to the global financial crisis of 2007-2009. Consumer sentiment has declined dramatically, but so far there is a disconnect between what people are saying and what they are doing. 

Mortgage rates have surged, creating concerns about the outlook for housing. The 30-year mortgage rate has increased in the past six months by the largest amount in decades, contributing to a slowdown in new and existing home sales. Housing, however, is likely heading for a slowdown rather than a meltdown, given pent-up demand, undersupply and major differences to the backdrop in the 2000s.

In comparison with the housing bubble that formed in the mid-2000s, the subprime home loan market is minimal and home equity lines of credit are a fraction of their size during the housing bubble. And most loans are fixed rate, so homeowners will not face the rate shock that destroyed the market during the global economic crisis. 

Continued market volatility is likely, with a tightening Fed, war raging in Ukraine and COVID representing a continuing threat to Chinese growth and global supply chains. The risk of recession is undeniably higher than it was at the start of the year, with the Fed facing the daunting challenge of trying to tighten policy enough to slow demand avoiding tipping the economy into a severe recession.

Alpine Macro’s Chen Zhao recently wrote that “controlling an economy is like taming a wild animal,” a vivid description of the challenge the Fed faces. It is understandable to react with a full range of emotions to the market downturn and to a steady stream of unsettling headlines. Nevertheless, it is important to remember that equity markets typically hit bottom while the economy is still getting worse.

Being patient in this challenging environment is difficult but important. Advisors should consider “harvesting” losses in taxable accounts, creating tax losses that can offset current or future capital gains.

There may be more value and less risk in short-term bonds than in intermediate and long-term bonds. Investments such as real estate and infrastructure may be attractive to income-oriented investors looking for protection against persistent inflation.

Advisors should consider focusing on holdings that may “bend but not break” in times of elevated economic stress. Cash flow, strong balance sheets and pricing power will be highly valued in an uncertain environment. Among struggling growth-oriented investments, companies with a clear path to positive cash flows that don’t need to tap capital markets are likely to be better positioned for this investment environment than more speculative growth names.

Daniel S. Kern is chief investment officer of TFC Financial Management, an independent, fee-only financial advisory firm based in Boston. Prior to joining TFC, Daniel was president and CIO of Advisor Partners. Previously, Daniel was managing director and portfolio manager for Charles Schwab Investment Management, managing asset allocation funds and serving as CFO of the Laudus Funds.

Daniel is a graduate of Brandeis University and earned his MBA in finance from the University of California, Berkeley. He is a CFA charterholder and a former president of the CFA Society of San Francisco. He also sits on the board of trustees for the Green Century Funds.