Investment Outlook

Coming to Grips With the Shifting Economic and Geopolitical Backdrop

Global financial markets are experiencing a return of volatility in the opening months of 2022. After an extended period of relative calm, the uncertainty of new market dynamics is making investors anxious. While dealing with uncertainty comes with the turf, we think some of the worries underlying this volatility are well-founded. 

Inflation, the Fed and Russia Top the List of Concerns

Inflation is clocking in at rates we haven’t seen in 40 years, and it appears more sustainable than many predicted. Typically associated with an overheated economy, persistently high inflation harms consumers and dampens economic activity. 

To protect the economy’s long-term health, the Federal Reserve (Fed) has become more determined to raise interest rates to fight against higher prices. The Fed’s aggressive tone caught some investors off guard and renewed worries that central bankers won’t be able to tame inflation without choking off economic growth. 

The humanitarian crisis of invasion of Ukraine is still unfolding as we write this quarterly update in early March. While inflation and the Fed are primary sources of economic uncertainty, the war is a significant source of financial and geopolitical instability. 

Russia is the world’s second largest crude oil exporter and supplies one-third of Europe’s energy needs. The war has spurred a significant rise in energy prices, stoking inflationary pressure for the rest of the world.

The war’s longer-term economic impact could depend on how much the West ratchets up sanctions. The Fed’s decision-making process could become more complex if the conflict and economic sanctions cause a significant slowdown in global growth. For now, we believe the Fed will implement a series of measured rate hikes followed by balance sheet management to help rein in inflation.

Stagflation Is a Risk

The war also raises the economic specter of stagflation. A period of high inflation combined with stagnating economic growth, stagflation is a challenge for central banks because the usual monetary tools are not effective.

We are particularly wary of this scenario in Europe, where sharply rising energy prices are reducing expectations for economic growth while pushing inflation higher. 

COVID and Supply Chain Disruptions Continue

Not that long ago, it would have seemed unthinkable that the pandemic would slip down our list of worries. Cases are declining worldwide, but news of a more contagious version of omicron is a reminder of COVID’s tenacity. It is an economic headwind contributing to labor shortages rippling through already strained global supply chains.

We expect the war to exacerbate supply chain problems. In addition to oil and grain, Russia and Ukraine are major exporters of natural resources used in industry, including neon gas, palladium, titanium, platinum and aluminum. 

A tighter supply of these materials could curb output globally in the automotive, aerospace and semiconductor industries, among others. 

The recently completed earnings season confirmed there’s still a long way to go in restoring the world’s distribution networks. It remains a top concern for corporate management teams, and some are meeting the challenge more effectively than others. We found many cases of head-to-head competitors reporting divergent results because one was more adept at managing its supply chain and passing through higher costs to its customers.

No Resting on Your 2021 Laurels

With all these issues in mind, I met with some of my fellow American Century chief investment officers and a group of our clients in February to discuss approaches to this unsettled environment. A clear takeaway was that strategies that flourished in 2021 might not be as effective this year. 

We believe financial markets are adjusting to the reality that the low inflation regime of the past 40 years is over for now. We’re entering a period of structurally higher inflation. 

Investors also are adapting to higher interest rates, which have edged up ahead of Fed policy tightening. Rising rates bring higher borrowing costs, which threaten corporate profits and slow consumer and business spending.

During our discussion, we highlighted these implications of the shifting investment regime:

Check your style allocations. There’s been a strong reversion from growth to value, and we prefer a balance between these asset classes while emphasizing quality within the value allocation.

Reduce interest rate risk and maintain inflation protection. It may be appropriate to consider deploying inflation-protected fixed income and short duration multisector fixed-income strategies.

Stay Active

We expect the uncertainty that’s rattled investors and the markets in the opening months of 2022 to remain with us until we know the details of the Fed’s plans to combat inflation.

We believe this environment lends itself to active management. In our view, it’s beneficial to evaluate individual securities and judge their near- and long-term prospects as conditions evolve. 

Thank you for entrusting us with your capital.