Midyear Investment Outlook: Three Actors to Watch in 2022’s Inflation Special

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Thomas Lee, CFA

Chief Investment Officer

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As investors wait for inflation to settle down, diversification and rebalancing provide better protection than market timing. We explore the economic threats that make this protection necessary. 



Following the financial markets during 2022 has felt a lot like watching one of those cliffhanger movie endings that keep viewers on the edge of their seats until the credits roll. Will the forces of good defeat the evil inflation without subjecting the economy to a painful recession? The next six months will likely tell us how the tale ends.  


The three main characters in our saga are Federal Reserve chair Jerome Powell, Russian president Vladimir Putin, and Chinese president Xi Jinping. Other characters contribute to the storyline, but these three have driven the inflation narrative in 2022. That trend is expected to continue, if not accelerate, in the second half of the year. Let’s look at each of them individually to see where the story may take us.



Will Powell save the US economy from the worst?


Inflation became a problem in the second half of 2021 as COVID-19 restrictions started to loosen and the US economy opened. Personal Consumption Expenditures (PCE), the Fed’s preferred measure of inflation, was approaching 6% by December, nearly four percentage points over the Fed’s stated target of 2%. Powell signaled then that the Fed would start to tighten monetary policy aggressively. At the time the target range for the federal funds rate was 0.0% to 0.25%. 


Our 2021 year-end outlook predicted that Fed actions would dominate headlines in 2022. Unfortunately, that prediction has turned out to be accurate so far. The market currently estimates that the federal funds target has a 75% chance of falling between 3.25% and 3.75% after the December 14 Federal Open Market Committee (FOMC) meeting, the last of the calendar year. That target implies a minimum 3.25% rate increase in one calendar year. The last time the US economy experienced a rate increase that large in a 12-month period, Paul Volcker chaired the Fed, leg warmers were in style, and “Endless Love” topped the charts.


Keep in mind that at the same time the Fed is aggressively increasing interest rates, it’s also shrinking its balance sheet—known as quantitative tightening—initially by $47.5 billion per month. That number is expected to increase to $95 billion per month, starting in September. Powell has put price stability at the top of the Fed’s agenda, and he’s working to achieve it. But what does that imply for the future?



Inflation as measured by Personal Consumption Expenditures (PCE), 2013–2022
Inflation as measured by Personal Consumption Expenditures (PCE), 2013-2022

Source: Federal Reserve Bank of St. Louis, 3/1/2022. For illustrative purposes only.


As the impact of higher interest rates and quantitative tightening works its way through the US economy, we’ll likely see reduced demand and slowing growth. The sell-off in the equity market, which has now reached bear-market territory, is pricing in this economic slowdown. The Fed is hoping for a soft landing, with only a modest uptick in unemployment. A soft landing would mean the economy remains resilient in the face of more restrictive monetary policy, unemployment ticks up but generally remains low, and inflation reverts to the 2% level as supply and demand achieve an equilibrium. In this scenario, the yield curve steepens, and equities begin to recover. 


The alternative to a soft landing is, of course, a hard landing. In this scenario, inflation remains more entrenched in the economy, forcing the Fed to tighten even more aggressively as we enter 2023. The result is the US economy falling into a recession and unemployment rising sharply. The transition to a restrictive monetary policy puts pressure on financial and housing assets that impact consumers’ balance sheets, causing a further reduction in spending. The yield curve continues to flatten, possibly inverting, while equities remain under pressure.


Obviously, many scenarios lie in between a soft and hard landing. As the leader of the Fed, Powell will be the central figure in the battle with inflation. Can he thread the needle and rein in inflation without seeing the US pushed into a recession? That outcome will in part depend on others. 


Boost diversification and fight inflation

Will Putin take his boot off commodity supply?

Few people at the beginning of 2022 predicted a war for control of Ukraine. Russian troops were beginning to mass on the Ukrainian border, but most thought Putin would avoid a full-scale conflict and ultimately seek to negotiate favorable terms that would increase his influence over the country. It now looks like the war in Ukraine will continue for the foreseeable future, or at least until one side fully expends its military resources.  


Putin’s decision to invade Ukraine and start the first war in Europe in over 70 years was a major contributor to inflation. Russian aggression has disrupted the production and flow of oil and gas, causing energy prices to spike. Both now trade at near their 10-year highs. Food staples like wheat and corn, both primary exports of Ukraine, have also experienced sharp price increases.  


West Texas Intermediate (WTI) crude oil prices, 2012–2022
Global West Texas Intermediate (WTI) crude oil prices, 2012-2022

Source: Bloomberg, 5/1/2022. For illustrative purposes only.


Natural gas prices, 2012–2022
Global natural gas prices, 2012-2022

Source: Bloomberg, 5/1/2022. For illustrative purposes only.


Corn and wheat prices, 2012–2022
Global corn and wheat prices, 2012-2022

Source: Bloomberg, 5/1/2022. For illustrative purposes only.


At a minimum, an end to the conflict in Ukraine would be a welcome first step toward tackling inflationary pressures on food and energy, which could make the jobs of central bank leaders like Powell a bit easier. Just as few believed Putin would start a war with Ukraine at the beginning of the year, few now expect him to end the conflict any time soon. If that’s the case, prices in these key areas will remain volatile with upside risk. Of course, we may end up seeing an early end to the war, followed by a rebound in energy production and an end to flow disruption, which would reduce price pressures. Putin is the only one who can end hostilities in Ukraine and begin the return to normalcy. 



Will Xi give global manufacturing its comeback?
China’s role in the inflation saga is more nuanced than Russia’s, but it’s equally important. China is the world’s top manufacturing hub, producing 28.7% of global manufacturing output. The US is a distant second at 16.8%. For the global supply of goods to meet demand, China must remain open and functioning. That’s why Xi’s decision to pursue a zero-COVID policy is so critical. The world got a glimpse of what this might look like in April, when an estimated 355 million Chinese citizens went into full or partial lockdown. Industrial production plummeted, causing a shortage in the global supply of appliances, consumer electronics, and automotive parts, which added more global inflationary pressure.

For now, Xi is doubling down on the zero-COVID policy by building permanent testing and quarantine facilities. Most experts don’t believe China will win the race against nature and will instead experience partial or full lockdowns in the future. Lockdowns in China mean continued shortages of manufactured goods in the rest of the world. In the near term, supply-chain restoration would reduce inflationary pressure and make the Fed’s job easier. In the longer term, if a zero-COVID policy remains in place, more companies will seek to diversify their manufacturing operations outside of China. Xi will ultimately determine how aggressively China pursues a zero-COVID policy and makes widespread lockdowns and subsequent supply disruptions a thing of the past. 



The bottom line
Powell has committed the Fed to reining in inflation, and its actions in the first six months of the year are worth taking seriously. Continued geopolitical turmoil may force the Fed to tighten aggressively enough to put the US economy in a recession, making Putin's and Xi’s actions critical. Given this level of uncertainty, investors should resist the urge to time the market. Instead, they should hold a diversified portfolio and rebalance when their allocations drift too far from their targets. That approach will give them the best opportunity to end this market cycle’s story on a happier note.

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