We had been expecting volatility for over a year and it finally arrived in the first quarter. While we didn’t predict a war in Ukraine, we thought valuations in both bonds and stocks were relatively high and the U.S. Federal Reserve (Fed) could potentially raise interest rates and stop its bond-buying program faster than investors expected. The war in Ukraine has possibly delayed the Fed’s actions and maybe even softened them, but a hawkish Fed remains a risk to markets. Overall, the impact of the war on financial markets will be tied to higher commodity prices caused by sanctions. Russia and Ukraine are a small part of the global economy but export a lot of oil, gas and wheat.
The global economy will normalize this year after a bumpy couple of years, crashing in 2020 and rebounding in 2021. We think economic growth expectations for the United States could come in below forecasts due to Omicron overhangs, lingering supply-side disruptions, inflation and maybe even a hawkish Fed later in the year. However, we do not anticipate a recession, or two quarters of negative GDP growth.
We expect inflation to moderate in the second half of 2022 but remain above trend. Labor inflation may be less transitory than many believe. On the bright side, the equity and bond valuations we just mentioned are improving and there are potentially many more opportunities in both securities. While large cap U.S. equity valuations remain elevated relative to historical standards—they are lower than last year—smaller companies have valuations far below their recent past and international stocks are below their 15-year averages.
Bond yields have risen sharply in some cases, reducing the interest rate risks many were worried about to an extent. Rising rates are still a risk in our view. Credit spreads have widened, offering more yield for investment-grade corporate bonds and high-yield corporate bonds. A modest amount of inflation can be healthy for corporate issuers and default rates are projected to be very low this year.
We want to reiterate our recommendation to diversify across asset classes, sectors and countries, while adhering to long-term risk and return objectives.