Coming into 2022, there was a lot to feel positive about. We thought that as COVID-19 abated, inflation would slow down. The Federal Reserve seemed to think inflation was transitory too, and it looked like they would take a measured approach to raising rates. Meanwhile, stocks had been on a tear with the S&P 500 up 100% in three years. As a result, valuations were rich and the market was likely to be volatile through the year, but we still expected stocks to yield positive returns and prove to be a better investment than bonds or cash. However, between Russia's invasion of Ukraine, China's COVID-19 lockdowns and a 40-year high in domestic inflation, the first half of the year was full of surprises.
As a result of these surprises, the global supply chain has not fully recovered and inflation has remained high. Consequently, the Fed is raising the federal funds rate more aggressively than anyone expected this year, which is impacting all asset classes. Bond markets have had the worst opening to a year in more than four decades, with major bond indices down significantly in the first four months of 2022. Equities also sold off in the first several months of the year and are likely to remain volatile through the rest of the year. All in all, financial markets are dealing with a lot of uncertainty right now. And when investors see uncertainty, they tend to sell riskier assets.
Stocks to remain a volatile, but attractive, investment
Even so, unless the economy falls into recession, we still believe that equities will remain an attractive investment through the end of 2022. Equity valuations have come down as a result of the sell-off, which means there's more potential room for investors to profit from identifying stocks that are priced lower than their intrinsic value. Bonds, meanwhile, tend to be sensitive to interest rate changes, and investors already demanding a higher return from high-yield bonds. Of course, there is also likely more volatility ahead as the equity market adjusts to the Fed's continued efforts to combat the worst inflation in nearly 40 years.
It's also important to keep in mind that many of the factors driving market volatility are outside the Fed's control. The biggest is the conflict between Russia and Ukraine, which is impacting food and energy prices. Depending on how long the conflict continues, it could even lead to potential food shortages and political unrest in some countries. The second-largest factor is China's continued COVID-19 lockdowns, which many thought would end following the Winter Olympics. Although some restrictions now are lifting, the continuation of the zero-COVID policy overall means that the global supply chain will remain disrupted. Meanwhile, central banks around the world are also tightening financial conditions by raising interest rates and either allowing their balance sheets to decline at bond maturity, as the Fed is, or actually selling bonds. This tightening undoubtedly will impact markets globally, which is creating some uncertainty.
Some of these factors will likely resolve before the end of the year, but for others, such as the Russia-Ukraine conflict, the end is uncertain. Meanwhile in China, the 20th National Congress of the Chinese Communist Party will be in the fall and one of the major questions will be whether they will relent on their zero-COVID policy further. Meanwhile, domestically, the midterm elections this November will allay some uncertainty. The equity market has historically performed best when the government is split—in other words, when one political party does not control both branches of Congress. With President Biden's approval ratings hovering around 40%, it is likely that the Republicans will win the House of Representatives, which would result in a split government.
Patience will be key
With all this in mind, my top piece of advice for investors for the remainder of 2022 is to stay patient. Sell-offs happen, but over time, equity markets generate positive returns. After every recession—every sell-off—equity markets have recovered to a new high.
Moreover, as we approach this fall, we should have a better feel for how the endgame for COVID will play out in China, what Russia's intentions are in Eastern Europe, and how markets are reacting to quantitative tightening and interest rate increases. As these concerns are resolved, then perhaps equity markets can begin to find their footing and recover.
. © 2023 BOKF, NA.