Macroeconomic Update - April 2022


Investment Perspectives for Insurance Companies

At an industry conference last month, Madison Portfolio Manager Jeff Matthias shared the following macroeconomic update, including the firm’s thoughts on monetary policy, inflation and unemployment, household and business outlook, risk of stagflation and/or recession, and a general outlook for both the economic and credit cycles. Overall, Madison believes the U.S. economy may face increasing challenges during the next 18 months, especially if the Federal Reserve finds it necessary to aggressively fight inflation while simultaneously reducing its balance sheet and contending with repercussions stemming from geopolitical tensions weighing on global growth prospects.

THE FED

The Fed continues to focus on effectively achieving its dual mandate – maximum employment and stable prices accompanied by moderate long-term interest rates. After months of foreshadowing possible rate hikes, the Fed increased short-term rates by 75 basis points (i.e. 25 basis points in March and an additional 50 basis points in May), resulting in a federal funds rate of 1%. Inflation is the Fed’s primary concern, a relentless issue that may persist until global supply/demand imbalances improve, energy prices stabilize, and geopolitical tensions ease. In general, investors anticipate the Fed will raise short-term rates to about 2.75% before year-end 2022 in concert with the central bank’s balance sheet reduction plan (an effort known as quantitative tightening).

Policy Tool Success Gauge1

There is mounting concern an overly aggressive Fed may prematurely stall economic growth, thereby leading to higher unemployment as well as higher interest rates across the maturity curve. Bond investors have quickly adjusted their expectations as seen by the considerable rise in rates for maturities less than five years. Since 2012 the Fed has targeted a 2% average inflation rate as measured by the Personal Consumption Expenditures (PCE) index, a threshold that proved to be extremely difficult to exceed until a year ago when shortages related to supply chain issues and rising energy prices led to a pronounced uptick in inflation. PCE was recently reported at 6.6% while Core PCE which excludes food and energy was reported to be 5.2%. Inflationary pressures have been uneven as annual price increases within the Goods category have climbed towards 10% while the prices of Services have risen to around 4%. Prices within the Services sector may ratchet upward in the coming quarters as the economy reopens more fully.

Personal Consumption Expenditures Deflator1

CONSUMER AND BUSINESS OUTLOOK

Madison revealed evidence that most consumers are in decent financial shape, supported by magnified bank account balances and plentiful untapped debt capacity. Inflation-adjusted wage growth is a budding concern as wages for the average worker are about 2% below the rate of inflation. This dynamic has caused many employees to seek higher paying jobs at a time when job openings exceed the number of unemployed workers by nearly a 2:1 ratio. The financial well-being of consumers owning a home has also improved as the median home price has appreciated 36% since February 2020. However, the median home price has dropped slightly since its peak in June 2021 and the recent upsurge in mortgage rates is apt to slow the housing market during the coming quarters.

Job vacancies1

Consumers, as well as businesses, seem wary about future economic conditions. On average, consumers project a 5% inflation rate during the next year, although their longer-term view indicates annual price increases will be about 3% per year. Surveys suggest both consumer and business optimism for a favorable economic environment has fallen dramatically in recent months. Supply chain disruptions remain a major impediment for businesses, a reality often impacting consumers in terms of product availability and/or higher prices.

LOOKING FORWARD

U.S. economic growth will undoubtedly slow as Fed rate hikes begin to influence consumer and business spending. Subdued growth along with elevated inflation could lead to a period of stagflation. Madison does not foresee stagflation as a probable outcome because the current situation is decidedly different than the mid-1970s when restrictive fiscal policies coupled with the U.S. abandoning the gold standard were catalysts for higher unemployment, loftier inflation, and suppressed economic growth. In contrast, a recession is more likely within the next 18 to 24 months should the Fed deem it necessary to forcefully increase rates to temper inflation. In the past, the Fed has always continued to tighten monetary policy until the federal funds rates exceeded the rate of inflation.

Madison anticipates the inflation rate will fall towards 3% during the next 12 to 18 months with the fed funds rate reaching a commensurate level. This view is substantiated by the “U.S. Treasury Actives Forward Curve” which indicates (as of April 2022) that the Fed could raise short-term rates to about 3% within the next 12 months. Given what is known at the end of April, Madison projects the 10-year Treasury yield will settle in around 3% over the short-to-intermediate term. This projection considers the forecast average federal funds rates during the next ten years plus a term premium (i.e., compensation for extending maturity). The forward curve shifts daily and has recently exhibited rates being equal along the yield curve or slightly inverted (i.e., short-term rates higher than long-term rates). Historically, an inverted yield curve is often a precursor to recession.

Treasury Curve Comparison

For life insurance companies, the rise in interest rates coupled with wider credit spreads has increased the possibility of locking-in yields near or above 4%. Currently, corporate risk premiums are approaching long-term averages. The creditworthiness of most investment grade corporate issuers remains positive, although changing economic fundamentals and shareholder-friendly activities may cause risk premiums within the more volatile sectors (e.g., energy, basic industry) to move wider. Barring a near-term recession, credit spreads for higher quality issuers should stabilize near current levels. Should recessionary conditions manifest, credit spreads would likely gap wider, thereby offering an opportunity to position high quality bonds at constructive risk-adjusted yields.

ABOUT MADISON SCOTTSDALE

Madison Scottsdale is the Insurance Division of Madison Investments and is responsible for managing over $3.5 billion in insurance client assets. Madison Investments is a boutique investment firm managing nearly $25 billion in assets comprised of fixed income, equity, and multi-asset strategies.

Jeffrey Matthias, CFA, CAIA, CIPM, CFP, serves as a portfolio manager for Madison’s Fixed Income Team, offering clients the necessary insights, knowledge, and perspectives to better understand financial markets as he collaborates with both clients and team members in crafting unique investment solutions. Formerly, Jeff managed $3.2 billion in fixed income assets at American Family Mutual Insurance. Immediately prior to joining Madison, Jeff devoted three years to CFA Institute by assisting professional societies around the world with developing business and funding models. He earned his B.S. in finance from the University of Wisconsin-Platteville and his MBA in finance from the University of Wisconsin-Whitewater.

“Madison” and/or “Madison Investments” is the unifying tradename of Madison Investment Holdings, Inc., Madison Asset Management, LLC (“MAM”), and Madison Investment Advisors, LLC (“MIA”), which also includes the Madison Scottsdale office. MAM and MIA are registered as investment advisers with the U.S. Securities and Exchange Commission. Madison Funds are distributed by MFD Distributor, LLC. MFD Distributor, LLC is registered with the U.S. Securities and Exchange Commission as a broker-dealer and is a member firm of the Financial Industry Regulatory Authority. The home office for each firm listed above is 550 Science Drive, Madison, WI 53711. Madison’s toll-free number is 800-767-0300.

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Although the information in this report has been obtained from sources that the firm believes to be reliable, we do not guarantee its accuracy, and any such information may be incomplete or condensed. All opinions included in the report constitute the authors’ judgment as of the date of this report and are subject to change without notice.