It is with little remorse that we close the book on the first half of 2022. Whereas the first quarter could be characterized by—among other things—a crisis of confidence in valuations and a historic adjustment in expectations for Federal Reserve policy tightening, investor attention in the second quarter shifted toward the prospects for an economic recession. Inflationary pressures continued to defy gravity, not only in the U.S. but also around the world, and stocks and bonds alike suffered. The S&P 500 returned -20% in the first six months. Perhaps more shocking for diversified investors was the -8% and -18% returns for investment-grade fixed income and a 60/40 stock/bond portfolio, respectively.
The great inflation debate
Where do we go from here? The answer depends on when inflation peaks and the pace at which it subsides, the key determinants of just how aggressive the Fed needs to be in fighting inflation. This in turn will stand as a primary driver of whether the U.S. experiences a recession in the next 18 months—and if so, how long and how deep that contraction may be.
The Fed has a dual mandate: price stability and maximum employment. However, with inflation raging, Chair Powell has made clear that the priority is eventually returning inflation to the Fed’s 2% target, even if it means job losses and recession along the way.
While June’s CPI report confirmed headline inflation has yet to peak, in our view, core inflation (prices excluding food and energy) has passed its peak growth rate and is now slowing. Looking under the hood, the signs are encouraging that core inflationary pressures will recede.
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