The combined effects of higher interest rates, inflation and a slowdown in the economy will result in the markets being weaker during the second of 2022, investment managers are warning.
Geopolitical issues such as Russia's war on Ukraine, the lockdowns in China due to covid and monetary tightening by central banks will result in more volatility and a softening of the global economy. Russia's ongoing war against Ukraine will impact the global commodity markets by pushing both energy and food prices higher.
The stock and bond markets are pricing in an “impending recession,” said Darrell Cronk, chief investment officer for wealth and investment management at Wells Fargo. The repricing began with the higher persistent inflation rates and the reset of interest rates by the Federal Reserve.
The U.S. will “likely enter a recession late this year or early next year,” he said.
This recession is likely to emerge as a “mild or short one” with a recovery occurring during the second half of 2023, Cronk said. A recession is typically defined as two consecutive quarters of GDP contraction.
The global and U.S. economies are fragile as growth has declined across several industries. In the U.S., GDP dipped by 1.5% in the first quarter and remains under 1% for the second quarter.
Central banks globally will have to “go further” in their tightening policies, Cronk said. “They really have no choice.”
The economic conditions for the second half of the year are more challenging even if peak inflation has occurred, he said.
Mortgage Applications are Falling
Consumer confidence has also fallen, which has been demonstrated in declining mortgage applications, fewer auto sales and credit card debt surging along with dips in employment in sectors such as technology, Cronk added.
The economy shows signs of resilience with a strong labor market as the unemployment rate in May held at 3.6% with the addition of 390,000 jobs.
“The consumer so far has spent well and is resilient,” he said. “The real challenge is whether the Federal Reserve can soft land the economy.”
Investors should expect a second consecutive quarter of both negative equity and bond returns, Cronk said. During the past four times it occurred, there were three instances that coincided with a recession.
Markets Could Rebound
The S&P 500 is anticipated to rebound to 4,200 to 4,400 by the end of 2022 with the recovery beginning in 2023, Wells Fargo estimates.
The bear market should reach the 3,500 level for the S&P 500 late in the third quarter of this year because of lower earnings per share growth estimates, said Sam Stovall, chief investment strategist of NY-based CFRA Research.
The S&P 500, a benchmark for the markets, could reach 4,200 by the end of the year, he added.
The market will rebound by early next year.
"Encouragingly, history reminds us that new bull markets (as defined by a 20% price advance off of the bear market bottom) typically started three months after the end of the bear," Stovall said. "What’s more, based on the average 40% price jump in the 12 months after bear bottoms since WWII, look for the S&P 500 to trade around the 4,675 level by this time next year."
Investors should expect volatility to be elevated during the second half of the year, Shawn Cruz, director of trading strategy at TD Ameritrade, told TheStreet.
The Fed has been part of the “liquidity puzzle” and now has stepped back as the primary buyer in the Treasury markets which anchor almost all financial systems, including equities and bonds, he said.
Large cap stocks of well-established companies such as JPMorgan Chase ((JPM)) and Apple ((AAPL)) will likely be the ones to stage a strong recovery first.
“Once you see these types of core companies rebound, that might be a sign you can look outside the U.S. for a turnaround in equity prices,” Cruz said.
Investors could allocate smaller amounts of capital to stocks as signs of inflation reaching a peak occur, such as housing prices and new vehicle sales falling, he said.
Diversify Your Portfolio
Maintaining a diversified portfolio is key, Cruz said.
“Rotate into sound companies that have been beaten up and dragged down that still have buy ratings from analysts like Meta ((MVRS)), Amazon ((AMZN)), Microsoft ((MSFT)), Apple and JPMorgan Chase,” he said. “These are good, well known companies that have around and expect to be around.”
Stock valuations were punished by increasing interest rates during the first half of 2022.
Investors are facing a different set of factors and their expectations for inflation, interest rates, earnings growth and volatility need to be adjusted, said Sébastien Page, head of global multi-asset and chief investment officer at T. Rowe Price in a note.
While investors have believed in the past that the Fed or other central banks can increase liquidity into the markets if the decline in prices for assets are too fast or too far, the central bankers are taking a different strategy now.
Three Big Challenges Ahead
An inflation-wary Fed could decide to respond by hiking interest rates even more aggressively if any risky assets rally too soon during the second half of the year, cutting off the chances of a rebound, Page said.
“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,” he said.
Inflation remains a large factor in the valuations of companies.
“Although investors must contend with various headwinds, inflation is the risk that channels those pressures into financial asset prices,” Page said. “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.”
