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How markets and the economy may respond to rising inflation

By Steve Lowe, CFA, Chief Investment Strategist | 05/10/2022


Rising interest rates, high inflation and concerns over slowing growth have roiled markets with global equity markets down. At the same time, fixed-income markets have produced the worst returns in decades, failing to counter-balance falling stock returns in mixed-asset portfolios.

Historically, high-quality fixed-income markets have often buffered negative equity returns as rates typically fall in volatile periods, producing positive U.S. Treasury returns. High inflation, however, has pushed up rates despite concerns over economic growth.

Volatility has been high, which often happens as the Federal Reserve (Fed) raises rates and markets adjust. The key issue has been inflation, fueled by strong demand for goods during the pandemic from consumers flush with cash. Inflation also has spread to the service sector as the economy has reopened amid a historically tight labor market, which is pressuring wages.

Higher rates have worked to push down equity valuations, as corporate earnings have risen, albeit at a slower pace, but valuation measures such as the price to earnings ratio (P/E) have fallen, especially in growth and speculative areas of the equity market that are more sensitive to rate increases.

Adding to the uncertainty has been the global landscape. The war in Ukraine has pushed up energy and other commodity prices with supply disruptions and sanctions on Russian energy and other exports. China’s strict zero-COVID policies have led to lockdowns in key cities, including Shanghai. This has further exacerbated supply chains already stretched by the pandemic and war.

On the positive side, there are signs that inflation may be peaking or close to doing so, with prices of some goods abating, such as used cars. Some key commodities, such as oil, have also declined off peak levels. 

In addition, month-over-month inflation has slowed. Supply chain issues and a tight labor market, however, continue to pressure inflation. We also expect commodity prices to remain volatile due to geopolitical risks.

Markets already have priced in substantial Fed rate increases that are expected to be above 3% by early 2023. The Fed funds rate at that level should work to slow demand, which in turn should work to slow inflation.  

Longer-term interest rates also have risen sharply. While rates still could increase, markets already have discounted substantial inflation risks. Market inflation expectations, for example, have moved modestly lower from peak levels. One exacerbating problem, however, is that inflation triggered by supply issues is less sensitive to rate increases. Importantly, we do not expect the Fed to slow rate increases until there are clear signs inflation is sustainably decreasing. That will require slowing demand.

Markets are increasingly focused on slowing economic growth globally. China’s lockdowns have materially dented growth, while Europe appears headed toward recession with much higher inflation and disruptions from the Ukraine war. The U.S. economy has slowed from high stimulus-fueled growth, but is supported by low consumer debt, high consumer savings, a strong investment cycle, and healthy corporate balance sheets. 

The risk of a recession has increased, however, as the Fed continues to raise interest rates to slow inflation. Historically, recessions have occurred about three years, on average, after the Fed started hiking rates, but the time has varied significantly. This cycle is likely to be more compressed, but we do not expect a recession in the near term. However, we expect the Fed’s rate hikes to slow the economy, resulting in higher recession risks into 2023 and beyond.

We remain roughly neutral in our allocation to equities versus fixed income. Within equities we are positioned defensively with an overweight to domestic equities. We expect growth stocks to outperform once there are signs of enduring rate stabilization. We are underweight international stocks, including Europe and China, as both face worsening growth outlooks.

Within fixed income, we continue to favor less rate sensitive segments such as high-yield and leveraged loans, as corporate balance sheets remain solid. Overall, we remain close to neutral on credit risk. While interest rates could rise further with stubborn inflation, markets already have priced in large Fed rate increases, and slowing growth likely will pressure rates lower over time. 

Investors should expect continued volatility as markets factor in multiple risks – inflation, higher rates, slowing growth, and global supply chain issues. It’s important to note that in periods of volatility, markets can move up or down quickly. For example, investor sentiment is very negative currently, which is often a contrary sign that markets are poised for a rally, as positioning is too one-sided. A quick move to the upside could happen with a trigger, such as lower than expected inflation data.

The key to markets stabilizing and finding an enduring bottom will be signs of an enduring peak in rates combined with slowing inflation. Lower rates would support equity valuations, especially segments sensitive to interest rates such as growth stocks. Also, we would like to see underperforming segments, such as small capitalization stocks, stabilize before adding meaningful equity risk.

As always, investors should have a long-term horizon and work in consultation with one’s financial professional, especially in periods of high market volatility.

Steve Lowe, CFA
Chief Investment Strategist

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All information and representations herein are as of 05/10/2022, unless otherwise noted.

The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Thrivent Asset Management, LLC associates. Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon, and risk tolerance.

Any indexes shown are unmanaged and do not reflect the typical costs of investing. Investors cannot invest directly in an index.

Past performance is not necessarily indicative of future results.

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