Coming out of the depths of the pandemic, US equity and fixed income markets are facing new challenges this year amidst a rising interest rate environment and deceleration in growth. With this changing backdrop, Franklin Templeton Investment Solutions’ Ed Perks shares his latest outlook and the investment opportunities he sees across asset classes.

Key Points:

• The US equity and fixed income markets are facing challenges due to a slowing US economy along with a significant pivot in monetary policy towards a more hawkish stance.
• Combating inflation has become a priority, and investor focus has shifted towards the uncertain impact of rising interest rates on the economy and markets.
• Despite challenges, US corporations are faring well so far in 2022, and the strength of the US labour market could delay or prevent a US recession.

Equity and Fixed Income Markets Facing Challenges

Looking back to the latter part of 2021, the US market environment was robust for equities, with strong economic growth that led to stock valuations that appeared appropriate to us. At the same time, the US Federal Reserve’s (Fed’s) accommodative environment—put in place during the pandemic—impacted fixed income markets.

So far this year, market performance has been challenging across a broad range of asset classes. US equities, as measured by the S&P 500 Index, are down 14.04% through 6 May 2022. Growth-oriented stocks, as measured by the NASDAQ Composite, declined even more than the S&P 500. The broader bond markets, as measured by the Bloomberg U.S. Aggregate Bond Index, have also declined this year. Investment-grade and noninvestment-grade bonds within the aggregate index have also fallen, reflecting the broader rise in yields and some weakness in corporate credit spreads.

Entering 2022 Investors expected that US gross domestic product growth would decelerate, but we still believe growth is likely to be above long-term trends. In our opinion, it was inevitable that US year-over-year growth would slow following robust growth in 2021 as economies reopened. Also, the fading monetary and fiscal stimulus contributed to the US economy slowing. Economies worldwide are also moderating, with Canada doing better than other places due to the commodity-oriented nature of its economy.

Inflation Concerns Have Become Top Priority

While economic activity in the United States has been normalising as it gets past the pandemic, a lot of inflationary pressures have been more pronounced and are rotating through different parts of the economy. This scenario is what is leading the Fed to raise the federal funds rate, and the market has baked in more frequent rate hikes for this year. These likely increases have rippled across the Treasury yield curve in general, which is what we believe is driving the challenging performance in fixed income markets. Thus, the backdrop remains highly uncertain in terms of the kind of tightening that is possible as the economy decelerates. In addition, there are other risks for investors—mainly geopolitical risks. These include of course the Russian-Ukraine war, which could further dampen economic activity in certain regions, particularly in the eurozone.

Consequently, rising inflation and its impact on the economy has become the primary focus. One of the bigger questions the market has right now is whether or not the Fed can successfully engineer a soft landing, or if a hard landing is more likely, given the pace of rate hikes and quantitative tightening starting up in June. With the Fed starting to make aggressive rate hikes and reducing its balance sheet, it is a dynamic time for the markets. Challenges are likely to stick around for quite some time. Thus, we believe that being nimble in finding opportunities will be critical.

Previous US rate hike cycles, specifically the last time the Fed raised rates in 2015–2018, played out over a long period of time as the economy generally slowed without elevating inflation. This time, it is radically different, with inflation at a very high level at the same time economic growth is decelerating. The United States has not experienced this type of inflation outlook in more than four decades, leading to newer challenges and uncertainties impacting current market performance.

Corporations Starting 2022 on a Positive Note

Historically, earnings expectations for companies tend to start the year on an optimistic note, and then decline over the course of the year. An exception was 2021, which started with a high degree of uncertainty around the level of earnings coming out of corporate America, but then surprised on the upside as companies managed supply challenges and other logistical issues.

As for the outlook for 2022, companies are generally performing well in terms of meeting first-quarter expectations. For the remainder of 2022, expectations are starting to come down as companies will likely vary in how they navigate the changing macroeconomic environment. Demand is still very strong, and challenges with logistics still exist; COVID-19 lockdowns are still occurring in China and may ripple through the United States and the world.

Meanwhile, the US labour market is nearing record low levels of unemployment, with elevated numbers of job openings. Employee sentiment is still high, and while tempered by market declines and higher inflation, household wealth and wages remain robust. The challenge for consumers is how to maintain purchasing power. In our analysis, the resilience of the US labour market—as well as how monetary policy transitions impact the economic outlook—could delay or prevent a US recession.

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