Today’s geopolitical climate, exacerbated by continued supply chain issues, inflation, and rising interest rates, has created a volatile market. We believe a laddered portfolio can still provide value to both municipal and corporate bond investors.
The first half of 2022 will be remembered for a rapid surge in consumer prices, a sharp increase in rates, and a dramatic pivot by the Fed to an active inflation-fighting stance. The steep rise in the year-over-year consumer price index (CPI) from an already high 5% to over 8% has disproved the notion that any postpandemic inflation would be transient.
A surprising resurgence in geopolitical risk—with Russia invading Ukraine and China intensifying rhetoric around Taiwan—has exacerbated market concern. War-related increases in energy, industrial commodities, and food prices have increased pressure on consumers and further disrupted supply chains. Notably, the national average of gasoline prices exceeded $5 per gallon for the first time in US history. Couple this with sharp increases in food prices, and consumer finances have deteriorated markedly, resulting in the University of Michigan Consumer Sentiment Survey hitting a historic low in May.
Not surprisingly, economic data shows clear signs of deterioration. First-quarter GDP unexpectedly printed negative, and early projections like the Atlanta Fed’s GDPNow suggest second-quarter GDP may also be negative. If that’s the case, the economy may already meet the technical definition of a recession. In June, 10-year Treasury rates dropped below two-year rates, inverting the yield curve. Inversions of this sort have been a reliable precursor of recessions in the past.
Despite economic deterioration, the rapid rise in inflation to a 40-year high is causing the Fed to react forcefully. It’s possible that massive amounts of liquidity injected to support the economy during the pandemic has cost them the luxury of gradually normalizing rates. Three consecutive greater federal funds target rate increases of 0.25%, 0.50%, and 0.75% underscore how determined the Fed is to get in front of the problem. The 0.75% increase at the Fed’s June meeting was the largest since 1994. June also saw the Fed begin the runoff of securities from its balance sheet, a process known as quantitative tightening (QT). While this should help tighten financial conditions, market participants have limited experience with QT, which could contribute to elevated volatility and increased risk premiums.
Over the second half of the year, markets and interest rates will be extremely sensitive to progress on inflation. The Fed is aiming to engineer a soft landing, but given the complex dynamics, a gradual glide path will be difficult to achieve. On one hand, the economy appears to be slowing, which should constrain demand, decrease pricing pressures, and therefore reduce interest rates. But on the other, energy and food prices—two of the largest drivers of inflation—have global demand and may fall outside the Fed’s control. The odds of stagflation, in which inflation is consistently higher than economic growth, are higher than at any time since the 1970s.
There are positives, however, and we’re unlikely to see a repeat of the 1970s. Employment remains strong, wage growth is good, and consumers still have substantial gains in housing and investment portfolios. In addition, there’s reason for optimism that the worst of the pandemic is over and supply chains will continue to untangle. If a recession does unfold, particularly if it severely disrupts credit conditions, the Fed has the tools and flexibility to implement decisive, significant measures to restore investor and consumer confidence.
Meanwhile, municipal and corporate returns are suffering through the worst bond market since 1842. While most of the decline to date has resulted from rising rates, IG corporate spreads and municipal ratios have also widened modestly. Granted, there have been brief periods of recovery, like in May, when rates moved lower for a period, but assessing the environment as anything short of challenging would be difficult.