- Asset Allocation Insights
- Economic Risks Are Rising
- 2022-04-07 18:12
- Key Insights
- Investors have become concerned about stagflation, an environment characterized by high inflation and economic weakness.
- Given heightened economic risks, we believe investors should consider adding exposure to assets that may benefit from higher inflation or potentially hedge against recession.
Following a very volatile first quarter, investors have become increasingly concerned about a potential “stagflationary” environment, which is typically characterized by very high inflation and economic weakness.
For most of the past 15 years, inflation has been a nonissue, but this is no longer the case. At the height of the pandemic in March 2020, the five‑year forward inflation expectation—derived from the five‑year Treasury inflation protected securities’ break‑even yield—was close to zero (Fig. 1) amid fears that the coronavirus would cause a severe global recession. However, by the end of August 2020, inflation expectations had rebounded to pre‑pandemic levels.
Since then, the inflation outlook has progressively worsened. As economies reopened in 2021, labor shortages and a mismatch in timing between the sharp recovery in demand and a more gradual ramp‑up in supply caused shortages and drove up prices. The emergence of COVID variants and Russia’s recent invasion of Ukraine have further exacerbated supply chain disruptions and accelerated inflationary pressures.
Meanwhile, the global economy faces near‑term headwinds from rising interest rates and higher oil prices (Fig. 2). Determined to curb inflation, many central banks have communicated their intentions to raise interest rates over the coming two years. Rate hikes typically increase borrowing costs and dampen economic growth. Moreover, oil prices have surged more than 450% from April 30, 2020, to March 29, 2022, imposing a significant tax on consumers and economic activity.
We believe that economic activity is likely to slow down considerably in the near term due to elevated inflation and economic weakness. Given this expected shift, investors should, in our view, consider increasing their exposure to asset classes that could benefit from higher inflation—including “real assets” like energy, materials, and real estate equities—and to longer-duration1 fixed income assets, such as U.S. Treasury bonds, that could potentially provide a hedge against recession.
Rising Inflation Has Defied Expectations
(Fig. 1) The inflation outlook, from afterthought to major concern
January 1, 2020, to March 29, 2022.
Source: Bloomberg Finance L.P.
Five‑year forward inflation expectation is derived from the five‑year Treasury inflation protected securities’ (TIPS) break‑even yield, calculated as the difference between the five-year U.S. Treasury yield and the five-year TIPS yield.
Higher Oil Prices and Rising Rates Present Economic Headwinds
(Fig. 2) Oil prices at multiyear highs and a hawkish Fed may stifle growth
Past performance is not a reliable indicator of future performance.
Sources: Bloomberg Finance L.P. T. Rowe Price analysis using data from FactSet Research Systems Inc. All rights reserved.
Fed hiking expectations calculated as the difference between the two-year U.S. Treasury yield and the Fed funds rate.
1 Duration measures a bond or other debt instrument’s price sensitivity to a change in interest rates.
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 April 2022 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
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. Investments in certain industries that involve activities related to real assets may be more susceptible to adverse developments affecting one or more of these industries and may perform poorly during a downturn in any of those industries. Commodities are generally subject to increased risks such as higher price volatility, geopolitical and other risks. Fixed-income securities are subject to credit risk, liquidity risk, call risk, and interest-rate risk. As interest rates rise, bond prices generally fall. All charts and tables are shown for illustrative purposes only.
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