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The first quarter was impacted by a hawkish Federal Reserve, a war in Ukraine, global supply shocks causing rampant inflation, and global risks intensifying.

The Federal Reserve’s tightening cycle is now fully underway, with the futures market predicting as many as 5 more rate hikes this year following a one-quarter point rake hike on March 15^th. The Fed is tightening monetary conditions into a U.S. slowdown, which is quite the contrary of what happened between 2016 and 2018.

Furthermore, the Fed announced an end to their “quantitative easing” program, which means that they will be draining $95 billion of assets from their balance sheet every month starting in May and reaching its full impact in July. Recall that in the past, the Fed would buy Treasury and mortgage bonds with printed money to keep bond yields low, thus stimulating the economy. This has been conducted as policy since 2008, and has swelled the Fed’s balance sheet to nearly $9 trillion from $1 trillion. Now, the Fed has gone from being the largest buyer of U.S. Treasury bonds to a net seller, all while the U.S. government is issuing record amounts of debt amid the worst inflation in 40 years. U.S government debt is now a third larger than its pre-pandemic level. Compounding the problem is that there will be a record amount of bond issuance by the US government:

Source: Federral Reserve

Accordingly, investors should expect bond yields to continue rising.What is the cost to the U.S. to service its debt if interest rates rise? According to the Office of Management and Budget, it will cost 5% of GDP in 2022, moving up to 11.1% of GDP by 2031. Servicing higher interest rates on U.S. debt will be close to $1 trillion per year at that point. That leaves less money for government spending to stimulate the economy.Inflation began vaulting higher in the first quarter due to the dual supply shocks of Covid and the invasion of Ukraine by Russia. It was also due to the reopening of the economy, pent up demand, and huge government stimulus. To stop that inflation, the Fed needs to aggressively suppress it by suppressing the economy. Two measures of inflation, the Consumer Price Index and the Producer Price Index, hit a 40 year high in March at 8.5%, and 11.2%. It remains to be seen if inflation will peak in the near future, but the 5-year inflation expectation rate in five years, projects only 2.5%, meaning a return to normal. Its worth noting that any slowdown in the economy or increasing inventories will begin to bring down prices.In anticipation of higher interest rates, bond yields have been rising sharply. The ten-year US Treasury bond yield rose nearly 1% in the first quarter. Furthermore, the bond yield curve “inverted” briefly earlier this month, meaning that the two-year bond yield was briefly higher than the ten-year bond yield.Fed tightening cycles have a 75% chance of triggering a recession, and when the bond yield curve inverts, the probability becomes 100%. Recall that the last time inflation was this high, in the late 1970’s two recessions ensued in the 1980’s. Between 1976 and 1980, the Federal Reserve increased interest rates 31 times.However, the Fed has never started tightening monetary policy under such conditions as we find presently. A pandemic, a war, an overvalued stock market, a flat bond yield curve, and rampant inflation are only the beginning of the bad news. The Russian invasion and subsequent sanctions on Moscow have reduced the production of crops and fertilizer in Russia and Ukraine, both major agricultural producers, which is leading to scarcities and high prices for wheat, corn, and barley. Supermarket prices are expected to rise by at least 20% in this country, and the U.N. predicts famine for 44 million people worldwide. Crude oil hit $130 a barrel on March 7^th, and natural gas prices rose 90% in the first quarter.Financial stress results from higher interest rates, and Vladimir Putin now risks putting the entire global economy into a recession. The following is a ten-year chart of real (inflation adjusted) disposable income in the US:

Source: Federal Reserve

US manufacturing indices are turning down, albeit from a high level, as short-term interest rates rise. Oil price spikes are acting as a brake to the world economy. Financial conditions are tightening. The Eurozone looks set to enter into a recession. Energy and food inflation are negatively impacting consumers, particularly with lower incomes. To demonstrate that, here is a chart of Consumer Sentiment, with GDP growth on the bottom, and recessions in grey:

Source: Advisor Perspectives

Business confidence is turning weaker, which is a bad sign for corporate profits. As GDP growth slows, corporate revenues suffer as well. Combining both together and an earnings slowdown is in the making. Manufacturing inventories are rising, underlying a slowdown in new orders, and inventory-to sales ratios are well above pre pandemic levels.Other bearish economic signals:

• Trucking demand indices have turned down significantly since January.


• $20 billion of imports are waiting to be delivered off the port of L.A., which will further boost inventories.


• Personal saving rates are way down after spiking throughout Covid.

Unemployment has come down to 3.6% and is at its lowest level since before the pandemic. Tightness in the labor market is exacerbating inflation, although rising salaries are not keeping up with inflation. That is important because real Income (inflation adjusted) has an impact on stocks. In the following chart, we compare real earnings with P/E ratios in the stock market. As the chart implies, imflation leads to lower real disposable income, which leads to lower stock market multiples, because consumption represents 70% of the US economy.

Source: Bloomberg

GDP growth in the US will clearly be impacted this year. The Federal Reserve estimates that the economy will expand at 2.8% this year, although certain investment banks like Goldman Sachs put that number as low as 1.8%The oil market has spiked. Already expensive in December, Putin’s war has caused prices to ramp up as much as 71% in the first quarter. As a “wartime bridge”, the Biden administration has announced the unprecedented release of 180 million barrels from the U.S. Strategic Petroleum Reserve, which has helped to bring prices down to $102 today from $130 in early March. Unfortunately, this won’t last long. China is on lockdown at the moment, and will restart its economy in the near future. Marginal demand for Crude and Brent is outstripping supply, while inventory levels in Europe and the US are very low. Both regions are still importing Russian oil, which may not last much longer, either by choice or by Russian imposition.The largest US banks have reported last week some of the biggest slowdowns in investment banking revenue seen in years, down some 30-50%. Concerns about recession, higher interest rates, and credit quality have depressed the sector some 20% this year.A great deal of discussion is taking place over supply chain security in the United States. As a nation, we have become dependent on foreign nations to supply our economy with sensitive parts and raw materials. Some of these nations are considered friendly, others less so, particularly China. The threat of a supply shock in semiconductors, for example, is now considered a strategic threat. “Just in Time” inventories are now switching to “Just in Case” inventories, meaning that a renaissance in American manufacturing is on the horizon. This will also be driven by the fact that China’s cost advantages aren’t what they used to be. The US now has lower corporate tax rates, is less exposed to pandemic supply chain interruptions, and tariffs. The so-called “onshoring” of US manufacturing will no doubt result in a profusion of capital expenditure in this country at the expense of China’s. In the medium to longer term, this should benefit “capex” stocks, particularly manufacturing equipment stocks and semiconductor manufacturing equipment stocks.There have been a number of negative warnings coming out of corporate earnings conference calls, most recently from Netflix, which lost 200,000 subscribers in the first quarter, and subsequently lost $50 billion of value in a day. This was the first time in ten years that Netflix lost subscribers over a full quarter. Elsewhere, first quarter earnings could disappoint based on the fact that 73 companies in the S&P 500 have pre-announced negative earnings vs only 26 positive pre-announcements.To conclude, there is a strong likelihood of further adjustment downward in both the stock and bond markets.The Dow fell 9.1% in the first quarter, the S&P 500 was down 5%, and the Nasdaq fell 9.1%.



Grant Rogers

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