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2022 Midyear Market Outlook: Finding Clarity Amid Complexity

After three consecutive calendar years of above average performance, global risk assets finally stumbled in the first half of 2022. Tightening monetary policy, fading fiscal stimulus, China’s zero-COVID strategy and the Russia-Ukraine conflict, combined with rapidly rising interest rates and surging inflation, roiled markets and rattled investor sentiment. The growing threat of a global recession has raised serious concerns about the future sustainability of corporate profits.

60/40 Portfolios Disappoint

The expected diversification benefits from combining stocks and bonds in portfolios has failed investors miserably throughout the first five months of the year. According to Strategas Research Partners, US stocks are off to their fourth-worst start to a year (January 1 – May 15) in the past 90 years.1 And, more specifically, the S&P 500 Index is off to its worst midterm election year start in history.2 Meanwhile, 98% of all fixed income funds are trading at a year-to-date loss, with an average return of -8%.3

For investors desperately searching for silver linings, stocks typically recover soundly for the remainder of the year (May 16 – December 31) after suffering such a poor start.4 And the Bloomberg US Aggregate Bond Index has never produced back-to-back calendar years of negative returns.5

Fed Focuses on Taming Inflation

Perhaps the single biggest question in the second half of 2022 is whether the Federal Reserve (Fed) can successfully engineer a softish landing. Continued global shocks from the pandemic, the Russia-Ukraine conflict and China’s zero-COVID strategy have made balancing supply and demand very difficult this year. The result has been rampant global inflation. Despite economic data indicating a potential cyclical slowdown, the Fed and other global central banks are likely to keep raising interest rates until they are confident that longer-term inflation expectations are stable.

Monetary policy tightening is seeking to cool economic growth just enough to address supply-demand imbalances and tame inflation. But the risks remain skewed to the downside. The US economy recorded a surprise negative GDP in the first quarter of 2022. Inflation has remained high for so long that it risks becoming entrenched. The Fed may need to tighten further and faster than expected as inflation data remains red hot. If the Fed wants to aggressively defeat inflation, short-term interest rates have to move above the inflation rate. Given today’s lofty inflation figures, that’s a scary proposition for investors and suggests that the Fed has a long way to go in raising rates.

In addition, global supply shocks show little signs of abating. Regrettably, if supply cannot rise to meet demand, then demand has to fall. As a result, corporate profits are likely to come under additional downward pressure.

Three Strategies for Current Challenges

Today’s investment environment is more complex than it has been in recent years. But despite the challenges, all is not lost for investors. A lot of bad news is already reflected in the first half performance of global risks assets. Unexpected good news from the Fed, China or the Russia-Ukraine conflict — or data that suggests inflation has peaked — could spark a relief rally in risk assets later in the year.

Consider these three strategies when constructing portfolios for the second half of 2022:‬‬‬

  1. Emphasize high-quality value in the core
  2. Limit duration in pursuit of real income
  3. Consider inflation-sensitive alternatives