Looking ahead: Volatility, Fed actions, recession

Chief investment officers and strategists at the largest asset management firms mostly agree that investors are in for a bumpy ride in the second half of 2022.

Most expect markets will remain volatile while inflation persists against the backdrop of falling stock and bond prices, the ongoing war in Ukraine and the COVID-19 pandemic. The Federal Reserve is in a delicate position, managers said, as it raises interest rates at the fastest pace in decades to combat inflation without causing a recession.

U.S. inflation was 9.1% year-over-year in June, the Labor Department said July 13, the highest in more than 40 years.

Gregory Peters, Newark, N.J.-based managing director and co-CIO of PGIM Fixed Income, which manages $890 billion, said the company was already cautious at the start of the year. It felt valuations were high and global central bank tightening would ultimately lead to a recession.

The previous six months have played out in a "much more volatile and quicker fashion than I think we envisioned," said Mr. Peters, who remains cautious and expects the second half of the year to be like the first.

In a July 11 report, the BlackRock Investment Institute, a research arm of BlackRock Inc., the world's largest money manager with $8.48 trillion in assets under management, acknowledged the same themes and said it was "bracing for volatility." The institute's analysts believe central banks will keep raising rates until inflation curbs. In the meantime, markets will fluctuate in a way not see since the 1980s, according to the institute.

Before June's inflation data were released, Kristina Hooper, chief global market strategist at Invesco Ltd., said in an email that aggressive tightening by central banks was bruising markets. "If Western central banks can slow tightening later this year (they likely feel some pressure to keep up with the Fed), it would help the asset price environment. A long-awaited moderating in inflation should also help," she said. Invesco manages $1.39 trillion in assets.

But if inflation persists at high levels and the Fed keeps aggressively raising interest rates in the coming months, volatility will continue, according to Ms. Hooper and others.

In a July 13 note about June's inflation data, Vanguard Group Inc. analysts said they expect the Fed to make the equivalent of 12 to 14 rate hikes of 25 basis points for the full year, with the target federal funds rates landing in between 3.25% and 3.75% before the end of the year and a terminal rate of at least 4% in 2023, much higher than what they consider to be a neutral rate of 2.5%.

"So much of the volatility right now is because of elevated inflation and the Fed's response to inflation,'' said Daniel J. Brady, chief investment strategist for PNC Asset Management Group's investment office, which manages $167 billion. "And because we're nowhere near to saying the Fed can pause additional rate hikes, we expect further volatility to play out."

Antony P. Ressler, Los Angeles-based co-founder and executive chairman of the $325 billion alternative investments manager Ares Management Corp., said it will be a "more difficult economic period" for private credit and his firm is telling its roughly 700 private borrowers to proceed with caution.

"We have had … 10 or 12 years of incredibly low interest rates that leads to high asset prices," Mr. Ressler said at the board meeting of the $441.7 billion California Public Employees' Retirement System, Sacramento, on July 11."So when you do see a repricing going on in the marketplace, which we are at this moment, your focus hopefully and your managers hopefully are focused much more on quality."

Heightened equity and interest rate volatility are here to stay in 2022, Josh Emanuel, chief investment officer at Wilshire Advisors LLC, which manages $93 billion, said by email before the June inflation data were released. At the time, he said the stock and bond markets had "significantly" priced in the economic and earnings risks associated with a mild recession.

Priced in or not, most asset managers don't think the U.S. economy is already in a recession. Although the same group seems to think there is danger of one occurring.

Jim McDonald, chief investment strategist at Northern Trust Corp. in Chicago, puts the odds of a recession at 50-50. The Fed is "in a difficult spot," balancing rate hikes to lower the prices of goods and services while not causing a recession, he said.

The chance of a recession occurring over the coming 12 to 18 months is relatively high; "it's a coin toss," said Jason Vaillancourt, Boston-based global macro strategist at Putnam Investments, with $167 billion in AUM.

If a recession happens, Mr. McDonald and other managers expect it to be a cyclical one, rather than a dramatic, event-driven slowdown such as the one that followed the start of the COVID-19 pandemic, or one caused by a structural collapse, like the financial crisis in 2008.

"The good news is that an upcoming U.S. recession may be relatively shallow, as corporate and consumer leverage and default rates are starting from a good place. This potentially offers something of a buffer until inflation begins to recede," said Alex Veroude, New York-based chief investment officer of fixed income at Insight Investment, a £817.1 billion ($1.07 trillion) asset manager that is part of BNY Mellon Investment Management.

Even if inflation slowed in June, Mr. Veroude said his firm anticipates inflation will remain above the Fed's 2% target until at least 2024. Some components of inflation are "sticky" or will take time to deflate. For example, rents have meaningfully accelerated in 2022 and will take months to come down, Mr. Veroude said.

Whether it is called a recession or not, Invesco's Ms. Hooper said the economy will "definitely have some kind of slowdown." The silver lining is that it will be relatively short-lived and markets — within months instead of years — could soon reflect a future recovery.

"We're telling clients not to panic because nothing seems to be broken in the market at this point," said Stephen L. Nesbitt, New York-based CEO of Cliffwater LLC, an alternative investment consulting firm, which manages $8 billion in discretionary assets and advisory assets of $99 billion. "The economy has already baked in the problems. We can't predict the direction of the market, and we are urging clients not to try to time the market."

Arleen Jacobius, Christine Williamson, Hazel Bradford and Brian Croce contributed to this article.