Key Takeaways
Uncertainty about inflation, the Fed and the war in Ukraine has triggered volatility that’s battered the stock and bond markets in 2022.
Seeking answers to the questions hanging over the markets, investors are reacting to each piece of new information.
Although uncertainty is high in the near term, we think impulsiveness, impatience and failing to account for downside risk are the biggest long-term risks to investors.
The Market Doesn’t Like Uncertainty
If today’s investment backdrop were a puzzle, we’d discover a lot of missing pieces. We face unanswered questions about the course of inflation, the Federal Reserve’s (Fed’s) ability to bring it under control without triggering a recession and the resolution of Russia’s war on Ukraine, to name a few.
While we continue to receive positive news about corporate earnings and low unemployment, fears of sustained high inflation, Fed policy mistakes and escalating geopolitical tensions have muddied the picture. With this level of uncertainty, it’s natural that financial markets are enduring bouts of volatility.
In the absence of a clear outlook, investors looking for answers tend to overreact to pieces of new information — positive and negative.
When Will Inflation Return to Normal?
The lack of a definitive timeline for inflation to ease is a crucial source of volatility. We expect it to start moderating later this year, but we can’t predict when or if inflation will return to pre-pandemic levels.
This uncertainty has left many investors searching for clues. It also helps explain why you might see a sharp negative reaction to higher-than-expected inflation data or news that a COVID lockdown threatens to further disrupt supply chains. On the other side of the coin, we recently saw the market react positively to news that higher prices haven’t dampened consumer spending.
Will the Fed Cause a Recession?
After what we consider a late start, the Fed has accelerated its inflation fight. But, even with inflation soaring to a 40-year high, the central bank must walk a fine line. It must apply appropriate and timely interest rates to reduce market liquidity without tipping the economy into recession.
History is not on the Fed’s side. My colleagues John Lovito and Charles Tan doubt the central bank’s ability to engineer a soft landing for the economy in a recent article. They cite a long history of rate-hike campaigns followed by periods of recession.
How Will the War in Ukraine End?
The humanitarian crisis from Russia’s invasion of Ukraine continues to unfold. The war remains a significant source of financial and geopolitical uncertainty.
The West has been united in imposing harsh sanctions that have isolated Russia financially and profoundly impacted its economy. However, those same sanctions have delivered another shock to already stressed global supply chains.
Before the war, Russia was the world’s second-largest oil crude oil exporter and provided one-third of Europe’s energy needs. Russia and Ukraine are also significant sources of natural resources used in industry.
3 Risks to Watch
These open questions weigh heavily on many investors’ minds. And indeed, the answers could cause large market swings in the near term. Still, we think there are three more significant risks for individual investors over the long term.
Risk #1: Impulsiveness
When the market is volatile, you may be tempted to abandon your long-term investment strategy and sit on the sidelines until things calm down. Investing is a long-term commitment that entails risk along the way, and each of us has a unique risk tolerance. If you’re uncomfortable with how recent market action has affected your portfolio, you should discuss your strategy with your advisor.
Risk #2: Impatience
Like constructing a puzzle, it will take time to piece together enough data to build conviction about the future of inflation, impact of higher interest rates and outcome of the war. We expect uncertainty to dissipate over time as investors build better foundations for making informed decisions. In the meantime, you should avoid getting caught up in the daily news flow and resist making snap judgments about your portfolio.
Risk #3: Failure to Account for Downside Risk
A diversified investment strategy can help position your portfolio for periods of volatility. For example, including inflation-protected strategies in your bond allocation can help combat rising prices. A blend of growth, value and income-generating strategies in your stock allocation may be beneficial as economic conditions shift and investment styles rotate in and out of favor. In addition, maintaining your geographic diversification may help compensate for potential volatility in a single economic region.
Author
Diversification does not assure a profit nor does it protect against loss of principal.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.