Equity markets had a bumpy start to the year even before Russia’s invasion of Ukraine last month. Profit reports remain strong, but the unmistakable signs of higher interest rates ahead are putting pressure on valuations, especially for the highest and most optimistically priced companies. The speculative mood that peaked a year ago is shifting quickly. As always, we focus on understanding and forecasting long-term profitability as the way to estimate equity returns. 

During this first quarter, we have witnessed a profound shift in monetary policy and a horrifying development in geopolitics, both of which have lasting implications for asset allocation. Unsurprisingly, asset markets are taking some time to recalibrate, and we should probably expect volatility to persist for a while. Yet despite the threat of significant monetary tightening, the distressing images from Russia’s invasion of Ukraine and the ongoing disruption to commodity markets, we do not forecast a global recession. And while we are proceeding with caution, we do see scope for improving returns over the middle part of the year.

As the impact of the COVID-19 pandemic begins to fade, we see increasing signs of normalization in our outlook for corporate profits around the world, although the pace of recovery continues to vary. Economic growth remains above trend in the U.S., and Europe was catching up but the burden of higher energy prices will hit Europe especially hard.

To be sure, recession risks have risen, but our base case remains that strong balance sheets, resilient margins and earnings—notably in the U.S.—and the release of post-pandemic pent-up demand will support global growth. There are regional variations: We see the potential for European growth to be roughly flat in Q2 and Q3 as supply constraints and a rising cost of living weigh on consumption. In the U.S., the rise in energy costs may be a headwind for growth, at the margin, but it is unlikely to cause a slump in activity now that the U.S. is largely energy independent. In sum, the pace of growth may be slower, but we expect it will remain positive and around trend. 

Inflation, however, is proving to be more persistent than expected, and the impact of the war in Ukraine on commodities presents an upside risk to prices across the board in 2022. Again, we note regional variations. In the 2Q 2022 U.S., inflation is finding its way into rents and wages— causing the Federal Reserve (Fed) to pivot swiftly to a profoundly hawkish tone—but for now inflation in Europe is more at the headline level, while in China it remains generally muted. Nevertheless, higher inflation and tighter policy will likely characterize the remainder of this economic cycle. This will lead to a markedly different environment for asset allocation compared to the immediate aftermath of the pandemic outbreak, or the previous decade. 

The good news is that U.S. household finances are in excellent shape. The strong labor market has kept real incomes positive even as inflation has risen, and rising asset prices over the past few quarters have boosted net worth to previously unseen levels. Many households have also accumulated cash balances that are well above the long-term trend. That will allow them to smooth consumption even when confronted with the prospect of paying more at the pump. As a result, we expect a gradual deceleration rather than a sudden stop in activity. 

Nonetheless, rising inflation and slowing growth are an awkward and uncomfortable combination for policymakers. For the past few decades, central bankers have preferred to look through energy price shocks as likely temporary. However, with inflation starting at such an elevated level, that won’t be possible this time around. The risk of inflation expectations becoming unanchored is a clear and present danger for the Fed, so we expect it to raise rates aggressively while also starting balance-sheet reduction.

We are also closely tracking corporate costs to understand how much of the pressure on supply chains, input costs and wages was transitory (the result of the pandemic-driven surge in consumer demand) and how much will likely constitute a “new normal.” 

Here, the picture is complex, but broadly we expect that many input cost increases will fade, and supply chains will gradually normalize throughout 2022. (Admittedly, little has happened so far.) However, wage inflation is likely to be a more serious and persistent issue, especially in the U.S. 

Meanwhile, the pressure on commodity prices has of course intensified in the past few weeks. Overall, our near-term and long-term profit expectations are stabilizing after big gains in 2021. We see a much more typical path ahead, with steady but slower growth, fewer positive surprises and more disappointments than we experienced during last year’s profit boom. After all, that’s what normalization looks like. 

Slowing growth (but no recession) and higher inflation (with the implication of tighter policy) create a recipe for volatility as asset prices adjust to the new environment. As a result, we have lightened up on risk for now. Technically, equities are oversold, and valuations present less of a headwind. However, after a lackluster 4Q 2021 earnings season we doubt earnings revisions will be an upside catalyst for stocks, until after 1Q 2022 earnings season, at least—assuming corporate guidance improves from the cautious tone last time out. 

Rising inflation is also causing concerns about profit margins. This is an acute issue for commodity- and energy-intensive sectors and regions. But generally rising productivity would take some of the sting out of higher wage costs such that margins might prove surprisingly resilient in aggregate. In our view, Europe looks vulnerable to higher costs that challenge margins, while U.S. margins seem better protected. Thus, we move our U.S. equity view to overweight and Europe to a mild underweight. 

For the time being, we keep emerging market (EM) equity at neutral, but we are closely watching the trajectory in China of both COVID-19 and monetary policy for signs that the outlook for EM equity is improving. 

Overall, our allocation views acknowledge the reality of slower growth but stop well short of positioning for a recession. True, risks to growth have risen, and tighter financial conditions are a headwind. But we see global growth roughly at trend in 2022, which, as risks begin to recede, may well present some upside to risk assets as the year unfolds.