T. Rowe Price, a global investment management firm and a leader in retirement services, has released its midyear market outlook for 2022. It includes insights from three of the firm’s senior investment executives:
- Arif Husain, CFA, Head of International Fixed Income and Chief Investment Officer
- Sébastien Page, CFA, Head of Global Multi-Asset and Chief Investment Officer
- Justin Thomson, Head of International Equity and Chief Investment Officer
Key takeaways for the second half of 2022 include:
- The war in Ukraine, COVID-19 lockdowns in China, and central bank monetary tightening are likely to keep the investing environment difficult.
- In the near term, the war will likely continue to impact global commodity markets, keeping food and gas prices high, but over the longer term it could accelerate the shift to renewable energy.
- Rising interest rates punished equity valuations in the first half, and rising economic concerns could lead to a slowdown in corporate earnings and put further pressure on stock prices.
- U.S. Treasuries and other sovereign bonds didn’t offer many diversification benefits in the first half as correlations with equity returns soared, repeating a pattern seen in recent years.
Inflation Risks and Navigating Economic Headwinds
- Inflation can trigger a growth shock, given that (1) higher energy and food prices are, in effect, a tax on the consumer, who are the main engine of global economic growth; (2) with interest rates rising, continued earnings gains will be needed to support positive equity returns, but higher wage and input costs could cut into profit margins; and (3) inflation raises the risk that the Fed will hike rates too aggressively, increasing the cost of capital and causing a recession.
- Some investors now question whether inflation has already peaked. There have been anecdotal signs in some markets that price pressures are easing – such as a slowdown in home price appreciation and cooling demand for labor – but clearer evidence is needed.
- Even if inflation has peaked, many fixed income investors appear unconvinced it will quickly return to the Fed’s long-run target of 2%. The market has already priced in multiple future Fed rate hikes, yet it still expects inflation to overshoot the Fed’s target by a full percentage point per year over the next five years.
- A possible silver lining is that there is plenty of potential pent-up supply in the global economy, which could help bring inflation down if supply-chain bottlenecks can be unclogged. The question is whether fixing supply chains could do part of the Fed’s job for it.
Rising Interest Rates, Equity Valuations, and Earnings
- Although earnings momentum sagged in many non-U.S. markets in the first half, earnings per share growth in the U.S. remained surprisingly steady. But this strength may not last and U.S. earnings could likely decelerate in the second half, challenged by slowing economic growth.
- Supply-chain improvements could also impact earnings – but possibly not positively. While moving more products might boost sales and revenues, it also could limit pricing power and eat into profit margins.
- Poor earnings environments historically have tended to favor the growth style of investing over the value style, but this time could be different, given the heavy weight the technology sector now carries in the growth universe.
- There have also been some late-cycle economic effects that are detrimental to tech, such as skill shortages and salary inflation, and consumer-oriented technology platforms could be exposed to a cyclical slowdown in spending. These factors also suggest the style rotation has tipped in favor of value.
- Chinese equity valuations appeared potentially attractive. The regulatory climate in China, including treatment of the country’s domestic technology platform companies and its tough stance on foreign depository receipt listings, could ease and turn more market friendly in the run up to the Chinese Communist Party’s 20th Party Congress later in the year.
Flexible Fixed Income
- U.S. Treasuries and other developed sovereign bonds did a poor job of offsetting equity volatility in the first half, suggesting that investors may need to expand their search for diversification across fixed income sectors and geographic regions.
- It’s unclear whether the spike in correlations between stocks and bonds seen in early 2022 was temporary or if it can persist. If the latter is true, alternatives to the traditional 60/40 stock/bond allocation that include dynamic hedging and other defensive strategies could offer advantages to some investors.
- For U.S.-based investors worried about rising rates, global markets could offer diversification potential. While the Fed is tightening, other countries are further along in their interest rate cycles. Some have stopped raising rates, others have even started cutting them.
- As bond yields could be approaching a near-term peak – creating a potential opportunity to lock in portfolio income – this could be the most attractive point to buy bonds seen in several years.
- In volatile markets, duration management and yield curve positioning are important tools for managing risk. Following the steep downdraft in bonds, more aggressive bond investors can consider adding duration, which measures a bond’s exposure to interest rate risk, to their fixed income portfolios over the next several quarters.
Geopolitical Headwinds: Spotlight on Russia/Ukraine
- Russia’s invasion of Ukraine had several global market consequences: economic sanctions on Russia and the closure of Ukraine’s ports on the Black Sea sent prices of key commodities soaring; fears about the impact on Europe’s economies pushed the euro and the British pound sharply lower against the U.S. dollar; financial sanctions made Russian equities essentially un-investable for foreign investors and pushed Russia’s foreign currency debt to the brink of default. The war has also pushed food and energy prices sharply higher and further disrupted global supply chains.
- The war has exposed Europe’s overdependence on Russia for oil and natural gas supplies. This will likely have implications not just for energy security, but for issues related to energy equity—such as consumer subsidies.
- The energy shock has the potential to create investment opportunities as well as risks. The transition to renewable energy sources, such as wind and solar, could be one of them.
- Higher oil and gas prices could also spur investments throughout the energy supply chain. These could include upgrading electrical grids and developing more efficient energy storage technologies – which in turn could boost demand for the raw materials used in those projects.
- The financial penalties imposed on Russia in response to the invasion could accelerate another longer-term transition – toward a less centralized global financial system.
Arif Husain, CFA, Head of International Fixed Income and Chief Investment Officer
“With inflation pressures coming from both supply and demand, and driven by cyclical and structural factors, the forecast is exceptionally cloudy. I think that means that the Fed is going to keep raising rates. There will come a point where they’ll want to pause and see what effect they are having. But my view is that we should be prepared for much higher rates going forward over the next few months.”
“Over the medium term, I think there will be a level of yields that will make clients happy with the income they’re getting from their bond portfolios,”
“The threat of recession is real. So, investors need to do their homework. For T. Rowe Price fixed income portfolio managers, this will mean relying on the firm’s extensive research capabilities and independent credit ratings to help navigate risks.”
“The regime of ample liquidity, low inflation, and low interest rates we’ve experienced since the global financial crisis of 2008/2009 is over. You can throw away that playbook.”
Sébastien Page, CFA Head of Global Multi-Asset and Chief Investment Officer
“The inflationary ‘shock on shock’ has put more pressure on the U.S. Federal Reserve and other major central banks to tighten monetary policy, while making it more difficult for them to tame inflation without choking off economic growth.”
“Although investors must contend with various headwinds, inflation is the risk that channels those pressures into financial asset prices. The three biggest challenges for investors over the new few months will be inflation, inflation, and inflation. It’s the transmission mechanism for all the other risks we are facing.”
“Now, with growth concerns rising, the focus is shifting to the “E” side of the P/E ratio. This could be the next shoe to drop in a challenging market.”
“Risk tolerance doesn’t usually get tested in normal times. You only truly understand your risk tolerance during regime shifts.”
Justin Thomson, Head of International Equity and Chief Investment Officer
“The new paradigm could offer potential opportunities for investors with the skills and research capabilities needed to seek them out. In volatile markets, active management can be your friend.”
“For global equity markets, the inflation outcome is absolutely key. If inflation settles around 3%, that could be a reasonable backdrop for equities. If it’s between 3% and 4%, things could get a bit more difficult. But, if it’s over 4% it could be [Paul] Volcker time, which is to say interest rates could go much higher in order to break an inflationary spiral.”
“I’m reluctant to predict a leadership shift to non-U.S. equities in the second half, given the U.S. market’s extended outperformance over the past decade. However, if the U.S. dollar appreciation seen in the first half subsides, and the technology sector continues to struggle, the relative performance of non-U.S. equity markets should at least improve.”
“Disappointing financial performance in the oil and gas sector had led many equity investors to underweight energy stocks heading into this year. But the Russian invasion was a wake-up call. It’s as if the market suddenly realized that energy is a strategically important sector, and that it probably has been undervalued. A lot of portfolios are feeling the consequences.”
Conclusion
The shocks inflicted on markets in the first half of 2022 required global investors to adjust their expectations for inflation, interest rates, earnings growth, and volatility. But a longer-term adjustment also may be necessary.
- New conditions may force many investors to unlearn some old ideas, like the notion that the Fed and/or the other major central banks can be counted on to pump liquidity into the markets if asset prices fall too far or too fast. If anything, investors face the potential for an inflation-wary Fed to respond by hiking interest rates more aggressively if risky assets rally too exuberantly in the second half, choking off any rebound.
- The new paradigm could signal a regime shift from one that has favored the growth style of investing to one that may favor the value style going forward. Regardless, investors would be well served to pay close attention to make sure their time horizons and their tolerance for risk are in sync.
- Above all, investors should understand the risks of remaining passive in a fast-changing market environment. Capitalization-weighted indexes may be poorly positioned for structural change, making skilled active management a critical tool for identifying risks and opportunities.
