ECONOMIC GROWTH & INFLATION
The U.S. economy and financial markets have taken numerous unexpected twists and turns since the onset of the pandemic, and 2022 was no exception. Surging inflation and global central banks’ response to it were the predominant economic stories last year. Inflation in the U.S. reached the highest levels since the early 1980s. Year-over-year inflation as measured by the Consumer Price Index peaked at 9% mid-year, but the question remains how quickly inflation will move close to the Federal Reserve’s (Fed) 2% target. History suggests a durable decline in inflation will require a material slowdown in economic growth and consumer demand.
As inflation surged, real U.S. economic growth stalled during the first half of the year but surprised to the upside during the second half. Despite efforts to redefine the term, the U.S. experienced a recession — two consecutive quarters of negative real growth — during the first half of the year. The 2022 recession was brief and shallow, exhibiting unusually strong labor market conditions. Job gains averaged nearly 450,000/month during the first half of the year.1
The U.S. consumer entered the year with record-strong balance sheets benefiting from the pandemic-driven government stimulus and full employment. However, broad-based strength in consumer spending in 2022 led to a significant drawdown in savings and the largest increase in credit card balances in more than 20 years. The savings rate in the U.S. recently moved to the lowest levels since the Global Financial Crisis.2
Despite signs that economic growth is beginning to moderate and recession fears are on the rise, labor market conditions remain historically tight. New job openings continue to run above the 10 million mark — more than 3 million higher than openings before the pandemic. The U.S. housing market has been the first sector to feel the pinch of higher interest rates, as housing affordability has plunged to the lowest levels in over four decades.3
The tragic war in Ukraine and China’s “zero-COVID” policy also contributed to last year’s challenging global growth and inflationary environments. European economies were particularly hard hit by the energy supply shock. Consumer discretionary spending was squeezed by high food and energy costs, forcing numerous countries to implement energy price caps.
MONETARY & FISCAL POLICY
The Fed’s failure to recognize the durability and severity of the inflation spike forced the most aggressive monetary tightening since Paul Volcker led the central bank in the early 1980s. After years of low and stable inflation, Fed policymakers became too focused on the full-employment side of its dual mandate. Chair Jerome Powell now recognizes failure is “not an option” in the Fed’s fight against inflation.4
After four consecutive 75 basis-point (bps) rate hikes from June to November, the Fed started the process to reduce the size of hikes with a 50 bps increase in December. An eventual pause in rate hikes is expected to occur during the first quarter of 2023 as labor market strength and high inflation begin to reverse course. An eventual pivot in policy toward lower interest rates is unlikely unless labor markets weaken materially. Fed policymakers fear a self-sustaining inflation dynamic may develop, where rising income fuels higher spending and prices.
The Fed’s aggressive monetary tightening led to a significant rally in the U.S. dollar during the first three quarters of 2022.5 But the dollar gave back more than half the year-to-date gains in the fourth quarter as global central banks started to tighten more aggressively, while the Fed moved closer to the end of its tightening cycle. Recent dollar weakness was welcome news for struggling emerging-market economies with dollar-denominated liabilities. In a sign of the stress being put on developing nations, the United Nations called for global central banks in wealthy nations to end their aggressive tightening and austerity policies.
INTEREST RATES AND CREDIT
Treasury yields moved materially higher and the yield curve shifted steadily deeper into inversion for the majority of the year. Ten-year Treasury yields peaked in late October near 4.25%, approximately 275 bps above where they started the year. Signs that inflation had peaked brought buyers of long-duration bonds back during the fourth quarter, which is also when Treasury bill yields reached the highest point on the yield curve, as more points on the curve moved into inversion.
Despite the recent rally, the bond market is on pace to deliver its largest annual loss on record. The broad IG bond universe as measured by the Bloomberg U.S. Aggregate Bond Index will close the year with losses of approximately 13%, four times the previous record loss of 2.9% in 1994.
Despite the high inflation readings, Treasury Inflation-Protected Securities (TIPS) also registered losses as real yields rapidly transitioned out of deeply negative territory to the highest levels in more than a decade. The Fed’s aggressive monetary stance contributed to lower long-term inflation expectations, as the 10-year breakeven inflation rate declined from 2.6% at the beginning of the year to 2.3% at year-end.
After the relative calm of 2021, credit markets also experienced heightened volatility last year. Investor concerns mounted that the Fed’s aggressive hiking campaign would lead to a policy error and eventual recession. Investment-grade (IG) corporate credit underperformed duration-matched Treasuries by 111 basis points (bps) during 2022, while the high yield market registered a loss of more than 11.0%. The Fed’s quantitative tightening program and elevated interest-rate volatility also weighed on valuations for agency mortgage-backed securities, which underperformed duration-matched Treasuries by 226 bps.
Exhibit 1. 2022 Bond Market Performance
Equity markets also experienced extreme volatility last year as the historic increase in interest rates weighed on valuations for all financial assets. The impact was most significant for the market-leading growth stocks.
Growth stocks — with a longer-duration earnings profile — benefited for years from the prolonged low-interest-rate environment. After years of outperformance, growth gradually moved out of favor as investors shifted toward value stocks. The previously high-flying growth stocks yet to generate profits were particularly hard hit, with numerous names plunging more than 90%.6
International equity market performance was also challenged last year by tightening financial conditions and dollar strength. Looking ahead, the Russia-Ukraine conflict and slowing growth in China pose additional risks to an already uncertain global economic outlook.
Exhibit 2. 2022 Financial Market Performance
1Source: CNBC- November Job Growth Likely Slowed but Will Still Show Strength Despite Layoffs, Hiring Freezes; 12/1/22
2Source: Bloomberg- US Savings Rate Falls to 17-Year Low Amid Relentless Inflation; 12/1/22
3Source: National Association of Retailors- Housing Affordability Index; as of 1/6/22
4Source: Politico- Failure 'not an option': Fed Vows All-Out Fight on Inflation; 6/15/22
5Source: Bloomberg- Relentless Dollar Rally Raises Bets on Interventions, Investors Say; 10/2/22
6Source: Investor’s Business Daily- Stocks Plunge, Break Key Levels As Tech Titans Tumble; 12/22/22