Investing is a process of risk and reward. Typically, low-risk investments will yield modest returns while high-risk investments will generate higher returns. A balance between risk and return is essential to investing for the long term. This approach will keep your money safe while enabling long-term growth.
Interest rate hikes will degrade appetite for stocks
Investors have already begun pricing in higher rates and lower growth. The stock market has already begun adjusting to the reality that the Federal Reserve is unable to reverse its course quickly. Inflation has been more persistent and stickier than expected, and key areas of the economy have not cooled off quickly enough to counteract rising rates. Many economists predicted that the Fed would start reducing interest rates early in 2023, but the reality has been different.
In order to gauge whether the stock market is adjusting to these changes, investors can look at a historical interest rate chart. The chart below plots the Fed funds rate against the two-year forward return of the S&P 500. The earlier in a rate hike cycle, the more stocks performed well.
While there are several trends affecting global growth, there are several factors that will slow down growth: the war in Ukraine, rising commodity prices, inflation, declining consumer sentiment, the zero-Covid policy of the Chinese government, tighter global monetary policy, and reduced fiscal support. In addition, investors should take care to deploy their cash in an opportunistic manner. This includes deploying cash into investments that have a positive after-inflation cash flow and are priced fairly.
The Fed needs to address the domestic economy and curb the risk of inflation exceeding an unmanageable level. Inflation is the result of higher rates and tighter financial conditions. But many investors are still betting that interest rates will peak at 3%, which is unlikely to rein in underlying inflation. In fact, underlying inflation has already exceeded 5% on the Fed’s preferred measure.
Emerging markets assets will provide greater diversification
A more aggressive Fed outlook may lead to tighter financial conditions and a potential recession, but the underlying fundamentals of emerging markets assets are strong. The growth trajectory of many commodity-exporting nations is on a recovery path, and debt valuations have become much more attractive.
Despite the challenges facing emerging markets, these assets will continue to be attractive to investors in 2022. The global economy may slip into a recession by 2022, but emerging markets equity has held up better than the developed world. This could make them a good entry point for investors.
Several EM central banks have already begun raising interest rates ahead of the U.S. Federal Reserve, and may start hiking rates earlier than they have in past cycles. Rising commodity prices are also a tailwind for many EM exporters. Lastly, the growing trend of friendshoring could be a tailwind for EM exposures in Latin America and Southeast Asia.
Emerging markets assets are becoming a standard part of many long-term investment portfolios. Many low-cost index funds now invest in these assets. Emerging economies represent 39 percent of the world’s economy, and about a quarter of its stock markets are in emerging countries. According to Morgan Stanley, a 27 percent allocation of emerging markets assets to a diversified portfolio provides the best balance between risk and return.
But investors should be aware of some of the risks of investing heavily in emerging markets. Some of these countries have unstable governments and economic systems, which could lead to severe consequences. Additionally, these countries may be plagued by a shortage of labor and raw materials. In addition, currency risk can reduce investment gains.
Political battles over federal spending
Politicians are facing tough choices in the next budget debate. Both parties want to cut costs and increase government spending, but Republicans are resistant to such moves. The latest proposal is a budget that would raise the debt ceiling through March 2019 and increase discretionary spending caps by $296 billion over two years. But it’s unclear how the proposal will affect the federal budget’s deficit and inflation levels. The long budgetary process has been made more difficult by the Republican pushback. Congress has cemented the spending for the current fiscal year, but is likely to begin negotiating legislation for fiscal 2023.
The federal government is set to open for the new fiscal year on October 1, 2022, and lawmakers have yet to pass the 12 appropriations bills that set discretionary spending levels. But lawmakers still have time to pass legislation before the end of the month, or the government will shut down. If that happens, a continuing resolution would be passed to give Congress more time to finish its work on the spending bills.
In the next budget battle, lawmakers will face a series of pitched battles over their country’s financial and physical health. They will have to confirm the nominees to the Federal Reserve, finalize $10 billion in pandemic aid, and refashion the White House’s signature social spending initiative.