Adjusting to an Uncertain Future

The following is a debrief from a Midyear Market Outlook conversation with Head of International Fixed Income and CIO Arif Husain, Head of International Equity and CIO Justin Thomson and me.

Heading into the second half of 2022, Arif, Justin, and I agree that higher inflation and rising interest rates remain the most serious threats to global financial markets.

Russia’s invasion of Ukraine has added fire to these risks by pushing food and energy prices sharply higher and further disrupting global supply chains.

This 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.

In my view, the three biggest challenges for investors over the next few months will be inflation, inflation, and inflation. It’s the transmission mechanism for all the other risks we are facing. The key question now is whether those risks will cause a sharp deceleration in growth or push major economies into full‑blown recessions, dragging corporate earnings down as well.

Beyond the cyclical risks, investors need to consider that global markets may have reached a structural inflection point—an end to the era of ample liquidity, low inflation, and low interest rates that followed the 2008–2009 global financial crisis (Figure 1). Arif believes that this regime is over and that investors can throw away that playbook. 

Justin notes that central bank liquidity was critical for stabilizing economies and markets during both the financial crisis and the coronavirus pandemic. But it helped push valuations for many risk assets toward historical extremes, and we’ve learned from history that those extremes are never permanent. The new paradigm could, however, offer potential opportunities for investors with the skills and research capabilities needed to seek them out. Justin adds that in volatile markets, active management can be your friend.

THEME ONE—Navigating Challenging Currents

The three of us predict that inflation expectations are likely to dominate financial market performance in the second half of the year, just as they did in the first half.

Although investors must contend with other economic headwinds—the war in Ukraine, COVID‑19 lockdowns in China, and central bank tightening—inflation is the risk that channels those pressures into financial asset prices.

• Higher energy and food prices are, in effect, a tax on the consumer, the main engine of global economic growth.
• 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.
• Inflation raises the risk that the Fed will hike rates too aggressively, increasing the cost of capital and causing a recession.

These are three ways in which inflation can trigger a growth shock.

The key questions investors face now are whether inflation has already peaked and, if so, whether it will decelerate quickly enough to limit the need for a prolonged monetary tightening campaign by the Fed.

While there have been some anecdotal signs in some markets that price pressures are easing—such as a slowdown in home price appreciation and cooling demand for labor—Arif argues that clearer evidence is needed. He says that until we see a meaningful decline in inflation toward the targets that central banks have set, the burden of proof hasn’t been met.

How Will Central Banks Respond?

Even if inflation has peaked, fixed income investors appear unconvinced it will quickly return to the Fed’s long‑run target.

Figure 2 shows the spread, or breakeven, between yields on the nominal five‑year U.S. Treasury note and on five‑year Treasury inflation protected securities (TIPS). The breakeven is widely viewed as an estimate of investors’ inflation expectations. 

Although inflation expectations eased somewhat after surging in the wake of Russia’s invasion of Ukraine, the breakeven remained close to 3% as of the end of May—almost a percentage point higher than the Fed’s long‑term target for the U.S. consumer price index (CPI).

The market has already priced in a number of 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.

With the CPI up more than 8.5% year over year through May, the market consensus also could prove too optimistic. I wonder, what if the CPI gets stuck on the way down at 4% or 5%? How committed is the Fed to its 2% target?

Justin agrees that the answers to these questions could be critical, not just for the bond markets but for global equity markets as well.

He points out that 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. However, if it’s over 4%, he worries it could be [Paul] Volcker time—a reference to the Fed chairman of the early 1980s who hiked rates to double‑digit levels to break an inflationary spiral, pushing U.S. equities into a deep bear market. 

The Supply Chain Factor

Arif notes that inflation pressures are coming from both supply and demand and are being driven by both cyclical and structural factors, which makes the forecast exceptionally cloudy.

He says this means the Fed is going to keep raising rates. There may come a point where they’ll want to pause and see what effect they are having. But his view is that we should be prepared for much higher rates going forward over the next few months.

I can, however, find a possible silver lining to those clouds. 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. If it happens soon enough, maybe they won’t have to push demand off the cliff.

THEME TWO—Fundamentals Matter

A spike in bond yields largely drove global equity losses in the first half of the year. In the second half, stock market performance is likely to depend on the outlook for corporate earnings.

After spending most of 2021 in deep negative territory, the real, or after‑inflation, 10‑year Treasury yield (as measured by the 10‑year TIPS yield) turned positive at the end of April. Figure 3 (left panel) shows the effect this had on U.S. equity valuations, which fell closer toward the middle of their recent historical range.

Now, with growth concerns rising, the focus is shifting to the “E” side of the price/earnings (P/E) ratio. Everybody’s wondering if this will be the next shoe to drop.

Although earnings momentum sagged in many non‑U.S. markets in the first half, earnings per share (EPS) growth in the U.S. remained surprisingly steady (Figure 3, right panel). However, I doubt this strength will last. I’m concerned that U.S. earnings are likely to decelerate in the second half, challenged by slowing economic growth. 

Supply chain improvements also could impact earnings, but maybe not in a good way. While moving more products might boost sales and revenues, it also could limit pricing power and eat into profit margins. 

Sector and Style Leadership

Poor earnings environments historically have tended to favor the growth style, which typically is less threatened by cyclical downturns. But Justin warns that this time could be different, given the heavy weight the technology sector now carries in the growth universe.

He contends that the pandemic pulled forward digitization, so we’re going to be lapping some very strong 2021 earnings comparisons in the second half. We’re also seeing some late‑cycle effects that are detrimental to tech, such as skill shortages and salary inflation.

Consumer‑oriented technology platforms, such as streaming media, also could be exposed to a cyclical slowdown in spending.

These factors suggest that the back‑and‑forth style rotations seen since the pandemic recovery have tipped in favor of value. Justin suggests that a shift in market leadership appears to be underway, and as we’ve seen from history, these cycles have tended to last a long time.

China Could Offer Opportunities

With the Morgan Stanley Capital International (MSCI) China Index down almost 50% from its early 2021 peak as of the end of May, Justin thinks that Chinese equity valuations appear potentially attractive. However, Beijing’s “zero COVID” strategy has been a key obstacle to a growth revival.

He observes that China has the capacity to stimulate, but there’s no point in stimulating while locking down. It’s like stepping on the accelerator and the brake at the same time.

Whether Chinese policymakers will be able to boost growth in the second half is not yet clear, Justin concedes. In addition to the coronavirus, sagging property values and credit defaults could challenge any stimulus efforts. But in a world where many central banks are withdrawing liquidity to fight inflation, and governments in many developed countries are running deep fiscal deficits, China at least has scope to focus policy on supporting growth.

Justin adds that another key factor for Chinese equities in the second half could be the regulatory climate, including Beijing’s treatment of the country’s domestic technology platform companies and its crackdown on foreign depositary receipt listings.

He believes regulatory policies are likely to turn more market friendly in the runup to the Chinese Communist Party’s 20th Party Congress later in the year. Although this regulatory cycle has been particularly drawn out and deep, he expects these issues to get better from here.

Notably, Justin is 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, he thinks the relative performance of non‑U.S. equity markets should at least improve.

THEME THREE—Flexible Fixed Income

U.S. Treasuries and other developed sovereign bonds did an exceptionally poor job of offsetting equity volatility in the first half. Investors may need to expand their search for diversification across fixed income sectors and geographic regions.

A key question is whether the spike in stock/bond correlations seen in early 2022 was just temporary or reflected a “regime change” that could keep correlations high for an extended period. If the latter explanation is correct, alternatives to the traditional 60/40 stock/bond allocation that include dynamic hedging and other defensive strategies could offer advantages to some investors.

Stock/bond correlations have switched from positive to negative several times in recent years (Figure 4). T. Rowe Price research suggests that these shifts typically were caused by economic shocks—sudden spikes in unemployment, inflation, or interest rates.

Treasuries still have a role to play in portfolio allocations—especially if the next leg of the crisis is a recession. But I also think investors are going to want to consider other approaches to downside risk mitigation. 

Is It Time to Extend Duration?

A more immediate issue for fixed income investors is whether bond yields have peaked, creating a potential opportunity to lock in portfolio income.

Arif claims that this is the most attractive point to buy bonds that he’s seen for several years. He thinks that over the next several quarters investors should consider adding duration.

However, Arif also predicts that the Fed will continue tightening until it has pushed its key market rate—the federal funds rate—into positive territory in after‑inflation terms. That would leave considerable room for further rate hikes. As of early June, Arif does not think we’re quite at the peak for yields.

For U.S.‑based investors worried about rising rates, he suggests that global markets could offer diversification. 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.

Arif explains that by taking advantage of monetary policy divergence, investors can diversify their interest rate exposures on a currency‑hedged basis. Recent valuation levels potentially make emerging markets (EM) U.S. dollar bonds particularly attractive, although both country selection and underlying security selection will be critical. 

The Upside Potential of Higher Yields

If yields do continue to rise, Arif thinks that at some point they should reach levels that offer attractive income opportunities for investors who understand how to manage duration—or who can rely on skilled investment professionals to do it for them. Over the medium term, he believes yields will reach levels that will make clients happy with the income they’re getting from their bond portfolios.

Some credit sectors, such as high yield corporate bonds, may have reached that point.

Arif warns, however, that the caveat to the bullish case for high yield is the uncertain economic outlook. As of May, high yield default rates remained near historical lows, and rating upgrades were more than twice as high as downgrades. But a growth shock could quickly change that picture.

He cautions that the threat of recession is real. So, investors need to do their homework. For T. Rowe Price fixed income portfolio managers, he adds, this will mean relying on the firm’s extensive research capabilities and independent credit ratings to help navigate risks.

In volatile markets, duration management and yield curve positioning also could be important tools for managing risk, Arif suggests. Fixed income is a relatively liquid asset class, so investors could potentially benefit by using that liquidity to stay active.

THEME FOUR—Managing Through Geopolitical Risks

Russia’s invasion of Ukraine has shaken the global political landscape. Beyond the destruction and human suffering inflicted by the war itself, the conflict threatens to worsen hunger in the world’s poorest countries, spur a new arms race, and block cooperation on problems like climate change and nuclear proliferation.

While those shocks could be felt for years, the consequences for global markets were more immediate: 

• Economic sanctions on Russia and the closure of Ukraine’s ports sent prices of key commodities soaring (Figure 5, left panel).
• 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 uninvestable for foreign investors and pushed Russia’s foreign currency debt to the brink of default. 

The war’s inflationary impact will be magnified in the developing world, where food products typically have a much heavier weight in consumer price indexes than in the developed world (Figure 5, right panel). 

Arif points out that not only are Russia and Ukraine the breadbaskets of Europe, but they export many of the chemicals that go into fertilizers and other agricultural inputs around the world.

Justin adds that the war also has exposed Europe’s overdependence on Russia for oil and natural gas supplies. This will have implications not just for energy security, but for issues related to energy equity—such as consumer subsidies.

He notes that 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. The market suddenly realized that energy is a strategically important sector that we’ve probably been undervaluing. As a result, a lot of portfolios are feeling the consequences.

A Boost for Renewable Energy

Like most economic disruptions, 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, Justin suggests.

As the saying goes, the cure for high prices is high prices—in this case, Justin argues, high prices for hydrocarbons. It reduces the relative costs of switching to other sources, so the transition to renewable energy should accelerate.

He adds that higher oil and gas prices also could spur investments throughout the energy supply chain, not just in renewable projects such as wind and solar farms. This 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 Impact of Sanctions

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 contends.

The initial round of sanctions included several unprecedented steps, such as freezing Russia’s foreign currency reserves at the Fed and other cooperating central banks and banning some Russian banks from the SWIFT (Society for Worldwide International Financial Telecommunications) financial messaging system.

While these measures have imposed heavy costs on Russia, they also could motivate other countries to seek alternatives to an international payments system dominated by the U.S. and the other major financial powers.

Arif notes that some countries may be concluding that they need to find another way of moving their money and transacting on a global basis.

As long as sanctions remain limited to Russia and its closest allies, they appear to pose limited risks to the global economy. But that might not be the case if secondary sanctions were imposed on other countries, particularly China, in response to actions perceived as aiding the Kremlin’s war effort.

The biggest unknown for Chinese markets is geopolitical risk. If there is a further spillover from Russia’s invasion and the Western democracies extend sanctions to China, Justin warns that we would be in a very difficult situation.

He adds that although secondary sanctions on China appear to be a “tail” risk—i.e., a relatively low‑probability outcome—that risk is likely to weigh on Chinese equity valuations in the second half.

Summary

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.

We are in the midst of a paradigm shift. We’re moving from a low‑yield, low‑inflation, low‑volatility environment to one of higher inflation, higher rates, and probably higher volatility.

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—a concept popularly known as the “Fed put.”

I think the Fed put is either gone or deeply out of the money. If anything, investors face the potential for a “Fed call.” If risky assets rally too exuberantly in the second half, an inflation‑wary Fed might respond by hiking interest rates even more aggressively, stopping any rebound.

Lessons From the Past

Previous paradigm shifts offer some unsettling examples of markets caught off guard either by valuation excesses or external shocks—or both, Justin adds. These past episodes include:

• The 2000–2002 dot‑com crash, which illustrated the enduring importance of basic valuation fundamentals like cash flow and earnings.
• The highly concentrated U.S. large‑cap market of the early 1970s, which was slammed by oil supply shocks and rampaging inflation.

But history doesn’t have to repeat. Justin observes that the way central banks are dealing with inflation is more sophisticated this time, and he thinks that will lead to better outcomes than we saw for the duration of the 1970s.

The new paradigm also will require investors to pay close attention to their time horizons and tolerance for risk.

In my view, risk tolerance doesn’t usually get tested in normal times. You only truly understand your risk tolerance during regime shifts.

Above all, we believe 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.

In the middle of a paradigm shift, doing nothing can be a very dangerous thing.

Additional Disclosures

MSCI and its affiliates and third party sources and providers (collectively, “MSCI”) makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI. Historical MSCI data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such.

Copyright © 2022, S&P Global Market Intelligence (and its affiliates, as applicable). Reproduction of any information, data or material, including ratings (“Content”) in any form is prohibited except with the prior written permission of the relevant party. Such party, its affiliates and suppliers (“Content Providers”) do not guarantee the accuracy, adequacy, completeness, timeliness or availability of any Content and are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, or for the results obtained from the use of such Content. In no event shall Content Providers be liable for any damages, costs, expenses, legal fees, or losses (including lost income or lost profit and opportunity costs) in connection with any use of the Content. A reference to a particular investment or security, a rating or any observation concerning an investment that is part of the Content is not a recommendation to buy, sell or hold such investment or security, does not address the suitability of an investment or security and should not be relied on as investment advice. Credit ratings are statements of opinions and are not statements of fact.

Information has been obtained from sources believed to be reliable, but J.P. Morgan does not warrant its completeness or accuracy. The index is used with permission. The Index may not be copied, used, or distributed without J.P. Morgan’s prior written approval. Copyright © 2022, J.P. Morgan Chase & Co. All rights reserved.

IMPORTANT INFORMATION

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of June 2022 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

Risks: International investments can be riskier than U.S. investments due to the adverse effects of currency exchange rates, differences in market structure and liquidity, as well as specific country, regional, and economic developments. These risks are generally greater for investments in emerging markets. Small‑cap stocks have generally been more volatile in price than the large‑cap stocks. The value approach to investing carries the risk that the market will not recognize a security’s intrinsic value for a long time or that a stock judged to be undervalued may actually be appropriately priced. Sustainable investing may not succeed in generating a positive environmental and/or social impact. Fixed‑income securities are subject to credit risk, liquidity risk, call risk, and interest‑rate risk. As interest rates rise, bond prices generally fall. Investments in high‑yield bonds involve greater risk of price volatility, illiquidity, and default than higher‑rated debt securities. In periods of no or low inflation, other types of bonds, such as US Treasury Bonds, may perform better than Treasury Inflation Protected Securities. Investments in bank loans may at times become difficult to value and highly illiquid; they are subject to credit risk such as nonpayment of principal or interest, and risks of bankruptcy and insolvency. Diversification cannot assure a profit or protect against loss in a declining market. Derivatives may be riskier or more volatile than other types of investments because they are generally more sensitive to changes in market or economic conditions; risks include currency risk, leverage risk, liquidity risk, index risk, pricing risk, and counterparty risk.

This information is not intended to reflect a current or past recommendation concerning investments, investment strategies, or account types, advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Please consider your own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. Actual future outcomes may differ materially from any estimates and forward-looking statements made. All charts and tables are shown for illustrative purposes only

T. Rowe Price Associates, Inc.

© 2022 T. Rowe Price. All Rights Reserved. T. ROWE PRICE, INVEST WITH CONFIDENCE, and the Bighorn Sheep design are, collectively and/or apart, trademarks of T. Rowe Price Group, Inc.

202206 -2254235