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Recession Risk Is Real; Long-Term Market Shift Likely: T. Rowe Price

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What You Need to Know

  • Value may outperform growth as pressure on the tech sector continues, according to T. Rowe Price's investment team.
  • The era of ample liquidity, low inflation and low interest rates in global markets has come to an end.
  • The key question is whether these risks will push economies into recession, hitting corporate earnings.

The economic and market environment may indicate a shift more favorable to value over growth investing, T. Rowe Price’s investment team said Wednesday, citing the heavy weight of technology stocks in the growth universe and various pressures on that sector.

Skilled worker shortages and salary inflation are hampering the tech sector, and consumer-focused technology platforms could be exposed to a cyclical slowdown in spending, the firm noted in its midyear outlookThese factors suggest that the investing style rotations seen since the pandemic recovery have tipped in favor of value.

“A shift in market leadership appears to be underway,” Justin Thomson, head of International Equity and chief investment officer, said. “As we’ve seen from history, these cycles have tended to last a long time.” 

The new environment could bring opportunities for investors, he said, adding, “In volatile markets, active management can be your friend.”

The firm suggested the “new era” is likely to be marked by less liquidity, higher inflation and higher interest rates, with investors possibly needing to rethink expectations that the Federal Reserve will pump liquidity into the market to prop up falling asset prices.

In fact, the Fed could hike interest rates more aggressively and cut off a second-half rebound “if risky assets rally too exuberantly,” T. Rowe said.

Real Risk of Recession

T. Rowe’s analysis came the same day that Federal Reserve officials raised benchmark interest rates by three-quarters of a percentage point — the biggest hike since 1994 — lowered their outlook for gross domestic product growth and signaled they will continue to aggressively raise rates by another 175 basis points in 2022 to reach 3.4% by year-end.

Arif Husain, T. Rowe’s head of International Fixed Income and CIO, said the recession threat is real.

He suggested that the era of ample liquidity, low inflation and low interest rates in global markets has come to an end. 

“With inflation pressures coming from both supply and demand, and driven by cyclical and structural factors, the forecast is exceptionally cloudy,” Husain said. “I think that means that the Fed is going to keep raising rates. There will come a point where they’ll want to pause and see what effect they are having. But my view is that we should be prepared for much higher rates going forward over the next few months.

“Over the medium term, I think there will be a level of yields that will make clients happy with the income they’re getting from their bond portfolios,” he added.

U.S. Treasurys and other developed nations’ bonds “did an exceptionally poor job of offsetting equity volatility in the first half. This suggests that investors may need to expand their search for diversification across fixed income sectors and geographic regions,” according to the outlook.

Sébastien Page, head of Global Multi‑Asset and CIO, said he thinks Treasurys “still have a role to play in portfolio allocations — especially if the next leg of the crisis is a recession. But I also think investors are going to want to consider other approaches to downside risk mitigation.” 

High Yields Make Bonds Attractive

Given high yields, Husain said T. Rowe considers this “the most attractive point to buy bonds that we’ve seen for several years. We think that over the next several quarters investors may want to consider adding duration.” (Higher duration bond prices fall as interest rates rise.)

However, he added, with the Fed expected to keep raising rates this year, the firm didn’t think bonds had reached peak yields yet in early June.

It’s unclear whether the spike in stock/bond correlations seen in early 2022 was temporary or will persist, Page said. In the latter case, he said, alternatives to the traditional 60/40 stock/bond allocation that include dynamic hedging and other defensive strategies could offer advantages to investors. 

Second-Half Earnings Risks

High inflation and rising interest rates remain the biggest threats to global financial markets in the second half of 2022, with elevated food and energy prices and supply chain disruptions arising from Russia’s war in Ukraine compounding those risks, according to the firm.

Rising interest rates slammed equity valuations in the first half, and growing economic concerns could slow corporate earnings and further pressure stock prices in the year’s second half, the firm noted.

“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.”

The key question is whether these risks will push economies into recession, hitting corporate earnings, he warned. “Now, with growth concerns rising, the focus is shifting to the ‘E’ side of the P/E ratio,” Page said. “This could be the next shoe to drop in a challenging market.”

While poor earnings environments historically tend to favor growth investing, this time could be different, the firm said, citing the tech sector issues.

Russia’s war in Ukraine, China’s lengthy COVID-19 lockdowns, and central bank monetary tightening are likely to keep the investing environment difficult, according to the firm. It added that, in the near term, food and gas prices are likely to stay elevated as a result of the war, which could speed the transition to renewable energy longer term.

While an easing of supply chain bottlenecks might be able to help ease inflation, it also could cause problems, potentially limiting pricing power and eating into profits, the investment team noted.

Chinese equity valuations appear potentially attractive, with the regulatory climate possibly easing and turning more market friendly later this year, according to the firm.

An inflationary “shock on shock” from rising interest rates and high inflation is pressuring the Federal Reserve and other central banks to tame inflation by tightening monetary policy without squashing economic growth, Page noted.

The inflation outcome is key for global equity markets, Thomson said.

“If inflation settles around 3%, that could be a reasonable backdrop for equities. If it’s between 3% and 4%, things could get a bit more difficult. But if it’s over 4% it could be [Paul] Volcker time, which is to say interest rates could go much higher in order to break an inflationary spiral,” Thomson said.

“I’m reluctant to predict a leadership shift to non-U.S. equities in the second half, given the U.S. market’s extended outperformance over the past decade,” he added. “However, if the U.S. dollar appreciation seen in the first half subsides, and the technology sector continues to struggle, the relative performance of non-U.S. equity markets should at least improve.”

Disappointing oil and gas sector financial performance led many equity investors to underweight energy stocks heading into 2022, but “the Russian invasion was a wake-up call,” Thomson said. “It’s as if the market suddenly realized that energy is a strategically important sector, and that it probably has been undervalued. A lot of portfolios are feeling the consequences.”

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