2022 Mid-Year Investment Outlook

Invesco’s Brian Levitt, Global Market Strategist, and Jodi Phillips, Director of Editorial and Social Media Content, sat down with Kristina Hooper, Chief Global Market Strategist, and Alessio de Longis, Global Head of Tactical Asset Allocation, to discuss the 2022 Mid-Year Investment Outlook.

Jodi Phillips:

Brian, so much has happened since we released our annual outlook at the end of last year. Everyone's asking how this is all going to play out.

Brian Levitt

I think the operative word there is “all.” How is this all going to play out? I thought maybe I would start with quoting Vladimir Lenin: "There are decades when nothing happens and there are weeks when decades happen." And it certainly feels like since the start of the year, there have been weeks where decades feel like they're happening.

Jodi Phillips

Absolutely. The question though is, which decade has been happening over the past several weeks? It feels a bit like the '70s — high inflation, high oil prices, waiting on the Fed to raise interest rates?

Brian Levitt

I think that's the challenge. As we say, inflation hastens tightening cycles and cycles are ultimately killed by the Fed.  We spelled this out in the 2022 Investment Outlook. Of course, it wasn't the base case, but certainly highlighted as one of the main risks.

Jodi Phillips

That's right. We called that risk “persistent inflation.” It's hard to believe when that was written, the two-year rate was at 20 basis points, and the Fed was preparing the market for one or two rate hikes this year.

Brian Levitt

One or two rate hikes this year would've been nice. So, there's challenges to the cycle. Let's not sugar coat it. However, there's a potential path out of it as well. Can the Fed quell inflation without killing growth? I think if you answer that question correctly, all else should be able to take care of itself. Although certainly not an easy question to answer.

Jodi Phillips

No, no, it's not. And speaking of difficult questions to answer, the outlook also addresses what may come next with Russia. On one hand, how does it impact our outlook if hostilities with Russia deescalate? But on the other hand, what if Europe is cut off from Russian energy, either by embargo or by boycott?

Brian Levitt

Let's bring on Kristina and Alessio to talk about their views on all of this — to talk about a base case, to talk about alternative scenarios, and most importantly, what are the asset class implications?

Kristina Hooper

Thanks for having us. Brian, I don't think that having you quote Lenin was on my bingo card for this week.

Jodi Phillips

We’re here to look ahead. But before we do, just for a few minutes, let's look back at the annual outlook that came out at the end of 2021. Like we said, a lot has happened since then, but how have the first six months or so of 2022 tracked against the base case and the alternate scenarios that Invesco's outlook posed for this year?

Kristina Hooper

Ah, great question, Jodi. When we released the outlook back in early December of 2021, the world was in a different place. Our base case for 2022 was an environment in which global growth normalized, remaining above its long-term trend, but decelerating to a more sustainable rate as fiscal stimulus was gradually removed.

We anticipated inflation peaking by the middle of 2022, but of course, at a lower level than anywhere near where we've seen it go. And then, inflation would start to slowly moderate, backing down towards target rates by the end of 2023, as supply chain issues were resolved, vaccination levels increased, and more employees returned to the workforce.

We expected the Fed to actually remain patiently accommodative. Do you even remember that term? It was bandied about for a long time. I haven't heard it in about six months. We anticipated the Fed rate lift off, if you can believe this, in the back half of 2022, although we thought the central banks of other developed countries might act more quickly.

We anticipated volatility would increase, as markets digested that transition to slower growth and that gradual tightening in monetary policy. There's another word that we haven't heard much of recently, which is “gradual.”

Now the good news is we also, as usual, contemplated two alternate tail risk scenarios. One was what I would call the more positive scenario. We titled it “transitory inflation” risk, where we saw current inflation fears proving to be overblown.

Then there was that persistent inflationary scenario. And dare I say, we got a lot closer to that scenario than the base case. In that scenario, we thought developed central banks’ messaging would fail to convince markets that inflation was transitory, and that we'd see further elevated prints throughout 2022.

Of course, the difference is that it wasn't that I think there was a loss in confidence in central banks, so much that this unforeseen event occurred, which is Russia's invasion of Ukraine. That really altered the entire macroeconomic environment for 2022. But in that persistent inflationary risk scenario, we anticipated inflation expectations to become unanchored. And I don't think they have over the longer term.

Brian Levitt

Alessio, when we talk about inflation and policy tightening, it tends to speed things up in the cycle. It also tends to create, as Kristina said, volatility. How surprised are you by what transpired in markets over the first five months of this year? And what worked? How would you categorize market leadership?

Alessio de Longis

Yeah, it was, the world really turned upside down. We went from thinking about raising interest rates, to a race to the top. There was a competition about who would have the craziest call: 50 basis points. How many 50 basis point hikes? And 75 basis points.

Brian Levitt

I remember our friend Matt Brill said, "If you want to get on TV often, just say there's going to be 25 interest rate hikes this year."

Alessio de Longis

Exactly. So, what worked and what didn't? We had modeled more for a loss of confidence in central banks and unanchored inflation expectations. That certainly didn't happen, right? The 10-year, the 3-year break-evens widened somewhat. But it certainly wasn't out of the ordinary. The way that markets priced this inflation shock was not 1970s style but was rather a really serious cyclical inflation overshoot. But ultimately we do have central banks that will come in. That's why 30-year inflation expectations stayed below 3%. And the stress was really in the front end.

What happened to our asset class predictions based on this difference? In that scenario, we advised investors to reduce portfolio risk well below benchmark. I think that definitely played out. I think we argued for a short duration stance. I think that certainly played out. What we saw, in my opinion was, a fascinating shift higher across global discount curves everywhere around the world.

But when you look at the performance of risky assets — equities, cyclical sectors relative to defensive sectors, equities versus fixed income, high duration equities versus low duration equities — we did not really see a pricing in of a substantial growth deterioration. The bulk of the impact was a resetting of the duration effect on asset prices.

We argued that fixed income would outperform equities. Did that really happen? If you look under the hood, I don't think that that happened. Long-term, long duration bonds, or long duration investment grade credit underperformed equities. Defensive equities underperformed cyclical equities. Value, which is cyclical, underperformed quality.

So, we got a few things wrong because our assumption was that this monetary shock, this inflation shock, would have also included meaningful pessimism around growth. And I think that didn’t really happen, which brings in interesting dimensions, I think, for the outlook going forward.

Jodi Phillips

Brian, you picked the right quote to start off the podcast because it certainly feels like there's been decades that have passed since the last outlook.

Now, I want to look ahead to what the Mid-Year Outlook is calling for the next six months and beyond. We took the same path this time of articulating a base case and then exploring two alternate scenarios that could potentially happen and could potentially have an impact on how this all plays out.

Kristina, could you start out with that base case? Where is the base case now, looking ahead through the end of the year and into 2023?

Kristina Hooper

Think of us as having returned somewhat to our outlook at the start of 2022, with some alterations of course. Our expectation in our base case is that hostilities continue, but without escalation, or any kind of significant escalation, that might cause an abrupt disruption to Russian energy supplies to Europe.

With uninterrupted energy supplies, but still high energy prices, Europe would face high inflation and slowing growth through 2022 and into 2023. And that would limit the number of European Central Bank rate hikes we'd see in 2022.

Now, it's a different story in the U.S., where we would expect continued momentum from the post-Omicron reopening that could help sustain growth, despite the Fed's aims to achieve a neutral policy rate as quickly as possible during 2022, in addition to really zealously shrinking its balance sheet.

It's also a different story in China. In contrast with major developed Western economies, China continues to be in a substantially different cyclical position, driven by continuing challenges resulting from the pandemic. That zero COVID policy is a difficult one in a world in which the Omicron variant is spreading really rapidly. Having said that though, we expect a re-acceleration of Chinese growth in the back half of 2022, largely driven by policy support. We think volatility is likely to remain higher than it was in 2021, as markets digest tighter monetary conditions.

Jodi Phillips

Alessio, from your perspective, looking at the base case that's laid out, what are the asset class implications if that base case comes to pass? What would be the impact for investors and what should they be watching out for?

Alessio de Longis

From a high-level standpoint, especially given the current market narrative that is very prevalent, we think it's way too early to position your portfolio for a recession risk — way, way too early. And we know that positioning for recessions can be very costly in terms of the missed opportunity. Being a year too early can really cost much in investor target objectives. We think, nonetheless, that the cycle is maturing, growth is slowing and it’s slowing to trend rates. We think 2023 is likely to be a more challenging year from an economic standpoint than 2022.

But, going back to what we said earlier about the interpretation of what happened in the prior six months, I think we have all learned, and so has monetary policy, that the economy is way more resilient than we assumed. There is a reason why we are now assuming eight to nine rate hikes, which were unconceivable six to seven months ago. The labour market situation, and the strength, the tailwinds, among consumers are meaningful. That's what inflation is telling us.

So, it's important to factor that in our asset allocation. We think it's appropriate to reduce portfolio risk to about a neutral stance relative to benchmark, and that running an outsized, overweight risk posture at this point is not as appropriate as it was a year ago. At the same time, the question is where? Where do you go to reduce risk?

Brian Levitt

Before you get there, can I ask a follow-up question on that? Put on the mindset of a lay investor, or any of us, having this conversation. At one point a few weeks ago, the S&P 500 was down about 20%, right? How would you categorize that? You're sitting here saying "it's too early to position for a recession," but if I just lost a fifth of the value of my portfolio, do I care whether we're technically in a recession as defined by the National Bureau of Economic Research? Why does that matter to me? Was that just a valuation adjustment based on rates? And if there is a recession forthcoming, how much worse would it have to get than that?

Alessio de Longis

Brian, excellent question, and I think you're hitting the nail on the head. In my opinion, the narrative has started with an inflation scare, then moved to a growth scare, and it's still largely there. But in my opinion, we have gone from an inflation scare to a de-rating of U.S. growth tech stocks, especially the growthier parts of the market, which are not necessarily the mega caps that we all think of.

When we look under the hood at the relative performance between sectors, between asset classes, within credit sectors, it really comes down to that duration play. And the de-rating that was caused by that increase in global bond yields — it was the de-rating of valuations that are sensitive to that duration, to that interest rate move.

When you look at the outperformance of value, when you look at the outperformance of the most cyclical parts, what do we mean by cyclical? We mean the parts of the economy that have more operating leverage to the cycle from an economic standpoint, not just judging the top-level performance of asset classes. The outperformance of value over growth, and the outperformance of small and mid-caps over large caps over the last six to 12 months speaks for that lack of contagion effect and lack of panic.

A recession risk implies dislocations, freezing in markets, freezing in trading and the less liquid parts of the market that literally have gap risk. I don't think we've seen that in the typical way that we’ve seen that in other recessionary environments.

Six months ago, we talked about reduction in portfolio risk in the base case. We are maintaining that stance today. A neutral exposure in total risk to benchmark. And how do you accomplish that? We think an investor can still be overweight equities over fixed income. So that risk reduction, in our opinion, should come by being overweight the more defensive assets in the portfolio.

It's sort of a rinse and repeat of what we said six months ago for the base case. The difference now is that the valuations and the pricing of that scenario is much, much more favourable. If this time we can get our policy call a little bit more in line with our expectations, we think that the argument for a defensive tilt in sectors, in styles, can help maintain a lower risk profile.

Now the question is, how do I build in more defensiveness in case we do get more of a recessionary type of risk, rather than just a mild slowdown?

Brian Levitt

Right, does that extend to government-related bonds, given that people have gotten hit pretty hard in long duration bonds and munis? Are you suggesting that when everyone's trying to flee anything long duration, that they may be doing so at an inopportune time?

Alessio de Longis

I think that investor behaviour can go through excesses to the downside and the upside, whether it's in equities or government bonds, right? We never associate government bonds to greed and panic like we do for equities, but I think there can certainly be an element of that there. To be frank, none of us has ever experienced the bond market like the one that we are seeing. That has to play a role in investor psychology as well. So, I think the price now is a little bit more appropriate for picking up again some yield in credit and in government bonds.

If we are right that we are approaching the end of the cycle, and the monetary conditions will tie them with the risk to go slightly into restrictive territory, a way to prepare for that and to place defensiveness in the portfolio is to underweight risky parts of the credit markets.

Ultimately your typical recession risk tends to manifest itself first in the weaker, less liquid parts of credit markets before it shows up in equities. And that's another example to your point, Brian. It's not what we saw in the last six months, right? Equities, high duration, high quality equity markets actually led the way, rather than risky credits, such as high yield or bank loans, or even emerging debt for that matter.

Brian Levitt

Kristina, so much of this seems to be grounded in this idea that inflation will peak, or it may even already be peaking and moderating, so that the Fed can ultimately back off some of this tightening stance and not take the (federal) funds rate to what some people suggested 4%, 5%, and instead more along the lines of a 3% neutral rate. What gives you some confidence to suggest that inflation may now be peaking? And what do you need to see as the year progresses?

Kristina Hooper

That's a great question, and there are so many factors. One is that more people are entering the labour market, and so that should take some pressure off wage growth. In addition, if we start to see layoffs because the Fed is actually tightening monetary policy conditions, that could also play a role in helping to tamp down wage growth. So, that is one way.

Another way, is in general, we have very high comparables at this point. So, we should see some level of improvement from here. There are some issues that are being worked through with supply chains, but there are also some issues that are going to continue to be problems. The Russia-Ukraine crisis is clearly going to create pricing pressures and that will continue to be an issue. But if, for example, we see China continue to roll back stringency — which I think is going to be the case as we've already gotten some positive signs already — that can alleviate pressures as well.

And, Brian, I didn't even talk about perhaps the most important reason why, and that's because inflation has a funny way of solving for itself, right? We're seeing consumers not as interested in buying goods. You've been really great about citing University of Michigan consumer survey questions like ‘is it a good time to purchase a car?’ Or a big-ticket item. And what we're hearing from consumers is that it's not a good time to be purchasing these things. I think unlike the 1970s, when there was an assumption that next month prices are going to be higher so we need to buy today, that's not the way consumers seem to be operating right now. And longer-term inflation expectations seem to support that.

Jodi Phillips

So now we move on to the alternate scenarios. I want to start off with the option that I definitely hope we see, which is the alternate scenario of de-escalation between Russia and Ukraine. A reduction of hostilities. How does that scenario play out in your outlook?

Kristina Hooper

That would reduce geopolitical risk. We'd likely see key commodity prices go down, and this would likely result in improved growth. I don't think we'd get back to estimates for 2022 that were laid out before Russia invaded Ukraine, but certainly we'd see some improvement in economic growth. And it would enable most Western developed central banks to have more flexibility in terms of raising rates, if they chose to do it, because their respective economies wouldn't be as fragile. So, that would likely be the best case scenario for us.

Alessio de Longis

I would agree. I think there is so much risk premium that has been built in factoring the end of the cycle as imminent. In my entire career, I’ve never been in a situation where there's been such a rush to join the consensus that a recession was imminent and that it was unavoidable. In every other cycle prior to this one, there was always this reluctancy to ever embrace the worst case scenario. And that doesn't mean that it's not going to occur, but I think it certainly speaks to how much the worst case is priced in.

In other words, I think the scenario that Kristina lays out of a reduction in geopolitical tensions creating somewhat of a more benevolent inflationary boom —that type of market scenario may play out.

There is a decent probability that scenario also plays out under the “no new is good news” scenario. As the market becomes accustomed to the fact that there is a war in Europe and we have to live with uncertainty, without new fuel to the fire, valuations and risk premium may actually give a boost to market confidence. We saw a bit of an appetizer of that in the last couple of weeks, right? So, market sentiment can change on a dime, even just because of the lack of further bad news.

Jodi Phillips

I want to mention the final alternate scenario in the outlook so that we can bring it to a full circle. And that's the alternate scenario about a cutoff of Russian energy supplies to Europe — whether that's from Russia cutting off supplies or Europe boycotting supplies. Can you step us quickly through that alternate scenario and what you would see in that instance?

Kristina Hooper

Well, this would be an energy shock, right? Created by a Russian embargo or European boycott of energy that would result in significantly higher inflation, especially in Europe. We think that would lead to a stagflationary environment in Europe and really have reverberations throughout the globe, biting into real incomes, and resulting in lower overall global growth. It's certainly not an ideal scenario by any stretch of the imagination. I think it drives up recession risks everywhere.

Brian Levitt

Alessio, as we come towards the end of this conversation, how do you view what we've just lived through in the last two years? We went from a pandemic to inflation to a growth scare in a very short period of time. Is this just a unique pandemic cycle and then things get back to normal? Or has something meaningful changed in the global economy? And if the answer to that is yes, then is there something different that we need to do to our portfolios than we did in the 2010s?

Alessio de Longis

On the secular side, there are many challenges. I would say there has never been a better labour market environment to really bring back the hidden labour force. This is the time where everybody can probably find a much higher propensity to return to the labour force, so that argues favourably in terms of long-term growth potential/growth rates. Those are not conversations we hear much about. The conversations around higher productivity rates due to technological innovations, I think those have not changed. These are all factors that arguably create a very favourable potential backdrop for long-term trend growth rates.

The bar for central banks to quickly go back to unconventional easing tools and bring policy rates back to zero is going to be extremely high. We have played successfully with those tools for a very long time, but now we are confronted with the fact that eventually they can be difficult to unwind, especially given the interaction with fiscal policy. I think that's a structural change. For asset allocation that means the assumptions on discounting cash flows — the assumptions of the present value of long-term cash flows — should be very different going forward.

Brian Levitt

Well, my big takeaway is that the cycle likely has room to run. The fundamentals of this economy are stronger than many people suspect. The risks are elevated, but a lot of those risks appear to have been priced into the market.

Kristina Hooper

I think that's a great summary, Brian, and I would add that we still anticipate inflation peaking. I think it's either happened or will be happening very soon, and there are a lot of reasons for that. I should also include in there that the big drop off in fiscal stimulus in the U.S. and other Western developed countries will help with that effort.

Brian Levitt

We're all looking forward to that declining rate of inflation. And we're looking forward to monitoring it with both of you, as the weeks and months progress.