Markets suffered their worst first half since the 1970s, with the S&P 500 down over 20% on higher interest rates and fears about economic growth. Both stocks and bonds sold off, a relatively rare occurrence in recent times.

There has been something of a recurring narrative in the last few months: surprisingly high inflation data, the markets selling off in anticipation that the Federal Reserve will need to raise rates more rapidly, and the Fed following through with rate hikes. Market and Fed expectations of interest rates have adjusted rapidly to the view that central banks misjudged the risk and magnitude of inflation, threatening the economic recovery.

This newsletter will take a closer look at the Fed’s guidance on interest rates, the topic of possible recession, and the shifting sentiment in markets.

Fed Warnings

The Fed takes note not only of inflation, but also consumer expectations of inflation. Trying to prevent expectations from rising too rapidly is part of keeping actual inflation from becoming unanchored.

In discussing the rate hike cycle, Fed Chair Jay Powell warned, “The process is highly likely to involve some pain, but the worst pain would be from failing to address this high inflation and allowing it to become persistent.”

Over the course of the month, members of the Fed continued to reiterate their commitment to fighting inflation by lifting rates until prices are under control, even if that causes a recession. Hiking interest rates increases borrowing costs, which can cool demand and temper rising prices. However, this also risks an economic slowdown, a risk that is magnified by supply chain disruptions and the Russia-Ukraine war, both of which are difficult to predict.

So far, the Fed has been relatively aggressive with rate hikes, raising its target federal funds rate three times to a range of 1.5%-1.75% after delivering a 0.75% hike in June. They’ve signaled that another 0.75% rate hike is on the table for the July 26-27 meeting of the Federal Open Market Committee.

After the June policy meeting, the Fed released projections of longer-term interest rates. The projected median federal funds rate has moved up to 3.4% by the end of 2022 and 3.8% by the end of 2023. That’s a significant shift in policy even compared to March, when the projections were 1.9% and 2.8% for 2022 and 2023 end-of-year rates, respectively.

Of course, it’s important to remember that these projections are still subject to revision, especially considering that the Fed has emphasized being “nimble” when reacting to incoming economic data.

Recession Talk

Policymakers are also keeping a close eye on the economic impact of inflation and rate hikes. One indicator to watch is consumer spending, which makes up over two-thirds of the U.S. economy. Spending since the pandemic has shifted more from goods to services, but Americans are also generally pulling back spending. For the first time this year, the U.S. reported a drop in consumer spending in June.

In fact, in the first 3 months of the year, the U.S. economy, as measured by gross domestic product (GDP), unexpectedly shrank. According to the Federal Reserve Bank of Atlanta, the economy continued to shrink in the second quarter, which means we could already be tipping into a recession.

The National Bureau of Economic Research is the official arbiter of recessions, and it considers several factors in addition to shrinking GDP, such as the unemployment rate. The job market has remained strong in recent months, with unemployment in May at 3.6% for the third month in a row. We will, of course, see how this develops in light of the rate hikes—in any case, the risk of recession is certainly still there.

Shifting Narratives

Given recession fears, markets have continued to experience volatility. The S&P 500 snapped a 3-week losing streak to climb over 6% for the week ending June 24. Some market participants have begun to speculate that the Fed would need to reverse current policy and actually cut rates to mitigate an economic slowdown.

Signs of a slowdown have also led investors to buy safe-haven Treasury bonds, pushing yields lower. U.S. Treasury yields signal expectations for short-term rates set by the Federal Reserve, and the benchmark 10-year U.S. Treasury yield dropped back below 3% after retreating from a recent high of 3.5%.

Investors may even be hoping for soft economic data to provide a reason for the Federal Reserve to be less aggressive with rates. The path of the economy, along with the market’s reaction, remains far from certain.

Bottom Line

The Fed has turned increasingly hawkish over the first half of the year in an effort to tame inflation, pushing most asset prices lower. However, they have stressed being nimble in the face of changing economic conditions. July will provide further key data to guide markets, including corporate earnings, inflation data, and another Fed meeting.

This communication is distributed for informational and educational purposes only and is not an offer to sell or a solicitation of an offer to buy any security. The information herein has been derived from sources believed to be accurate, but no guarantee can be made as to its accuracy or completeness. All investments include the risk of loss and nothing herein should be construed as a guarantee of any specific outcome or profit. Past performance is no guarantee of future results. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. All market indices discussed are unmanaged and are not illustrative of any particular investment. Indices do not incur management fees, costs and expenses, and cannot be invested into directly. All economic and performance data is historical and not indicative of future results. All opinions expressed herein are those of WealthSource® Partners, LLC and do not necessarily represent the opinions or views of WealthSource’s affiliates, are current only as of the date of this communication and are subject to change without notice. WealthSource does not have any obligation to provide revised opinions in the event of changed circumstances.

The Dow Jones Industrial Average is a price-weighted index of 30 actively traded blue-chip stocks. The Bloomberg Barclays U.S. Aggregate Bond Index measures the investment-grade U.S. dollar-denominated, fixed-rate taxable bond market and includes Treasury securities, government-related securities, corporate securities, residential and commercial mortgage-backed securities, and asset-backed securities. The S&P 500 Index is an unmanaged, market value-weighted index of 500 stocks generally representative of the broad U.S. stock market. The MSCI All Country World Index (ACWI) is designed to represent the performance of large- and mid-cap stocks across 23 developed and 26 emerging markets and represents approximately 85% of the free float-adjusted market capitalization of each market. The MSCI Europe Index captures large- and mid-cap representation across 15 developed market countries in Europe and covers approximately 85% of the free float-adjusted market capitalization across the European developed market equity universe. The MSCI Emerging Markets Index captures large- and mid-cap representation across 26 emerging market countries and covers approximately 85% of the free float-adjusted market capitalization in each country.

Chris Shea

Chief Investment Officer

As Chief Investment Officer, Chris finds and vets state-of-the-art investment choices for WealthSource clients — and explains important but complex investment concepts.

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