2022 Mid-Year Outlook: Global Stocks and Economy

• The war in Ukraine has shown no signs of ending, but also no signs that natural gas supplies from Russia to Europe will be cut off—an event that would likely lead to an economic recession. Economic data in Europe has remained resilient despite the conflict, perhaps due to pent-up savings from lingering COVID-induced restrictions on household spending over the past two years.
• Severe lockdowns in response to the latest COVID-19 outbreaks resulted in a sharp economic slowdown in China—the world's second largest economy—but as restrictions began to lift, economic data began to sharply rebound. As people were able to leave their homes in major cities and economic stimulus accumulated, the surprisingly big gains in China's May Purchasing Managers' Index suggest the worst of the economy's slump may be over.
• While supply chains remain stretched and delivery times are still lengthy, they have shown some signs of improvement. Inventories have been rebuilding, with some retailers such as Walmart, Kohl's, and Target reporting excess inventories in some products in May.
• Some central banks remain focused on reining in pandemic stimulus but clarified their intentions on the near-term path for rates: reducing the likelihood of 75-basis-point (bp) rate hikes from the U.S. Federal Reserve or a 50-bp hike from the European Central Bank.

While the modest easing in uncertainty was welcome news for investors in recent weeks, economic risks remain that may continue the above-average stock market volatility we had forecast for 2022.

• We noted the heightened risk of geopolitical conflict: "An invasion of Ukraine by Russia could prompt world powers to impose new sanctions which may elevate energy cost inflation."
• We also highlighted the risk of stagflation (a stagnant economy combined with high inflation), cautioning that: "with valuations above average in many countries, markets aren't priced for even a small risk of stagflation…leaving central banks with no good options for monetary stimulus and pushing markets into a downfall."

Concerns over a global economic recession have grown this year, due primarily to high inflation, further boosted by the war in Ukraine, and central bankers' efforts to tamp down inflation through tighter monetary policy. Economists' 2022 GDP forecasts have slumped in the first half of the year for most major countries with growth estimates cut by 1% or more, as you can see in the chart below. Canada is the exception, thanks to strong demand for its natural resources.

It is rare to see a divergence in the direction of the economic and earnings forecasts, so why now? It isn't that economists and analysts have different outlooks, it's that they have different tasks. For example, rising energy prices in the current environment may act as a drag on the economy but may boost earnings for the energy companies that make up the indexes. Also, the current rapid growth in business investment contributes more to corporate earnings than it does economic activity.

While investors have been focused on the slowdown in the economic outlook for much of the first half of the year, the direction of earnings may be more important to stock prices than GDP for the second half. If earnings remain solid, stocks may rebound. In fact, the price-to-earnings ratio (PE) for international stocks, represented by the MSCI EAFE Index, has rarely been lower than it is today outside of a recession (the history of analysts' estimates for the next 12 months of earnings begins in 1988, allowing us to look at nearly 35 years of the forward PE ratio), as you can see in the chart below. But should we begin to see the earnings outlook deteriorate, low valuations may not protect against further declines.

• Diversification - We have been recommending strategic weights across asset classes and sectors this year, not because we don't have any ideas but because diversification itself is an especially good idea right now in the current period of heightened volatility. The correlation across stock markets has fallen to among the lowest levels in 20 years and portfolios benefit from diversification as sectors and markets move more independently of each other.

• International - Historically, when long-term inflation expectations are rising, it has led international stocks to outperform U.S. stocks. International markets tend to be more inflation sensitive, with more companies that benefit from higher inflation than those that suffer. While there can be no guarantees, international stocks have been outperforming in recent months—just as the long-term relationship forecast that it would.

• Short duration stocks - Shorter duration stocks help manage the risk of rising rates. In other words, stocks with more immediate cash flows, rather than cash flows in the distant future, tended to outperform after rates bottomed in 2020, and are more dominant in international markets.

• Buybacks - As we forecast in our 2022 outlook, those companies around the world that are announcing new or increased stock buybacks seem to be benefitting from more price support than those that don't, as measured by the Solactive Buyback Indexes. These indexes track the performance of stocks whose management has announced plans to repurchase shares within the prior two months. In general, buybacks are seen by investors as a sign that a company has good cash flow and a strong balance sheet. These indicators are usually considered hallmarks of a high-quality company.

• Guard against gluts – Potential supply gluts could be forming. Shortages can cost companies growth opportunities, but gluts can negatively impact earnings expectations as demand and prices fall. Keeping an eye on inventories can be crucial to determining when and where gluts may form.

Economic uncertainty may have peaked in the first half of 2022, but it remains high. Having a well-balanced, diversified portfolio, with a risk profile consistent with your goals, and being prepared with a plan in the event of an unexpected outcome are keys to successful investing.

Michelle Gibley, CFA^®, Director of International Research, and Heather O'Leary, Senior Global Investment Research Analyst, contributed to this report.