June 2022 / MARKET OUTLOOK
2022 Midyear Market Outlook
Adjusting to an uncertain future
- Russia's invasion of Ukraine, COVID-19 lockdowns in China, higher energy prices, and rising interest rates could make the second half difficult.
- A spike in bond yields punished equity valuations in the first half. The question now is whether an earnings slowdown will be the next shoe to drop.
- U.S. Treasuries and other core bonds didn’t offer much diversification in the first half as equity correlations jumped. New approaches may be needed.
- War in Ukraine and sanctions against Russia could continue pushing commodity prices higher but also could accelerate a shift to renewable energy.
Adjusting to an Uncertain Future
Heading into the second half of 2022, higher inflation and rising interest rates remain the most serious threats to global financial markets, T. Rowe Price senior investment leaders say.
Russia’s invasion of Ukraine has added fire to those 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, according to Sébastien Page, Head of Global Multi‑Asset and Chief Investment Officer (CIO).
“The three biggest challenges for investors over the next few months will be inflation, inflation, and inflation,” Page says. “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, Page warns.
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).
“I think that regime is over,” says Arif Husain, Head of International Fixed Income and CIO. “You can throw away that playbook.”
Central bank liquidity was critical for stabilizing economies and markets during both the financial crisis and the coronavirus pandemic, notes Justin Thomson, Head of International Equity and CIO. But it helped push valuations for many risk assets toward historical extremes. “I think we’ve learned from history that those extremes are never permanent,” he says.
However, the new paradigm also could offer potential opportunities for investors with the skills and research capabilities needed to seek them out, Thomson adds. “In volatile markets, active management can be your friend.”
The Era of Tame Inflation and Ample Liquidity Appears To Be Over
(Fig. 1) U.S. inflation* and the yield on the U.S. two‑year Treasury note
Explore our four themes:
Navigating Challenging Currents
How can investors respond to the risks of recession in Europe and the US and a further growth slowdown in China?
With earnings growth likely to decelerate and interest rates rising, what opportunities do equity markets offer?
Flexible Fixed Income
Bonds struggled to diversify against equity risk in the first half of the year, so how should investors approach fixed income?
Managing Through Geopolitical Risks
Geopolitics will continue to be a key focus for investors in the second half, reinforcing the importance of diversification.
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, the T. Rowe Price CIOs say.
“We are in the midst of a paradigm shift here,” Thomson says. “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.”
Now, “the Fed put is either gone or deeply out of the money,” Page says. If anything, he argues, 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 more aggressively, choking off 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, Thomson says.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, Thomson observes. “The way central banks are dealing with inflation is more sophisticated this time. I think that will lead to better outcomes than we saw for the duration of the 1970s.”
But the new paradigm also will require investors to pay close attention to their time horizons and tolerance for risk.
“Risk tolerance doesn’t usually get tested in normal times,” Page cautions. “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,” Husain says.
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