Three risks we're watching in the second half

How to manage what lies ahead: Don't panic.

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Key takeaways

  • The second half of 2022 will likely feature volatile markets and low returns on investments.
  • One of the biggest concerns for markets is how the Federal Reserve will manage inflation in the US.
  • China's zero-COVID policy and the war in Ukraine are also crucial concerns that could affect the US economy and markets.
  • Higher interest rates are unlikely to lead the US economy into recession in the near future.

The first half of 2022 has reminded investors, both professionals and do-it-yourselfers alike, that the predictable cycles of economic and business activity aren't the only things that can push financial markets up and down. As the sun rose on January 1, the future looked bright. Corporate earnings were strong, the economy was growing, stocks were near record highs, the COVID threat was shrinking, and the Federal Reserve was planning only a gradual rise in interest rates. But at mid-year that hopeful dawn has given way to a bear market in stocks, the biggest-ever drop in bond prices, the highest inflation in decades, the sharpest rise in interest rates in years, and the most destructive conflict in Europe since World War II.

Fidelity capital markets strategist Claus Te Wildt calls this the most complex market environment he's ever seen.

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"Inflation and what the Fed does about interest rates, the Ukraine conflict, and China's COVID policies will have the most material impact on investing in the second half of the year," says veteran Fidelity portfolio manager Ford O'Neil. "They're extraordinarily hard to predict, but you're going to see a lot of headlines about those things in the coming months."

The 3 big risks ahead

1. Fed tightening drives the US economy into recession

The Fed has escalated its war on inflation with a 0.75% increase in short-term interest rates, and plans for a series of further increases that could raise the rate that banks charge each other on short-term loans to at least 2.75% by the end of 2022, and potentially 3.3% by mid-2023. The Fed is also unwinding its "quantitative easing" program under which it had bought trillions of dollars' worth of government and mortgage-backed bonds since 2008. These moves reflect the Fed's increasing sense of urgency about trying to slow inflation, which threatens the financial wellbeing of investors and consumers alike. Fed leaders are concerned that prices are rising too rapidly and they hope that raising borrowing costs will slow spending and reduce inflation. They say they expect inflation to drop below 3% by the end of 2022 but have also expressed concern that with current inflation around 8.5%, companies might raise prices and wages, which could prolong higher inflation.

2. China's COVID crackdown fuels inflation

China is the world's second-largest economy and it makes many of the products that consumers and companies around the world rely on. It's also an important market for multi-national companies and a major consumer of commodities from other countries. Because of its importance to the global economy, what happens in China affects economies and investors around the world. Even as much of the rest of the world is seeking ways to balance controlling the COVID virus with the needs of people to work and live their lives, China's government remains committed to its "zero-COVID" policies of mass quarantines and shutdowns. Because China makes many of the products used around the world, these policies may cause shortages and higher prices for US consumers and companies as well as turmoil in financial markets.

3. Ukraine war drives up commodity prices, heightening recession risk in Europe

The war in Ukraine is an escalating human tragedy and also the focal point of what Fidelity geopolitical risk analyst David Bridges calls a new era of escalating struggle between democracies and autocracies for incremental advantage. Since the end of the cold war, both Russia and Ukraine have been important producers and exporters of energy and other vital commodities, especially to Europe. The longer the conflict continues, the greater the impact on supplies of important commodities such as oil, gas, and wheat and the greater the potential for economic harm to countries beyond Ukraine and Russia. Fidelity's Asset Allocation Research Team says that Europe's economy, which is bigger than that of the US, is moving closer to recession, partly because of the effects of the war on energy supplies. The imposition of economic sanctions against Russia is also reducing the earnings of multi-national companies who have stopped doing business there. A recession in Europe would further harm those companies, many of which are familiar names in US investors' portfolios.

How these risks may affect your money

While higher interest rates may benefit savers, borrowers will feel the pinch and stock market volatility is likely to continue to increase. As the Fed raises rates, it also raises the chance of inadvertently tipping the economy into recession, which could mean lost jobs as well as lower returns on investments.

Fidelity Managing Director of Research Lisa Emsbo-Mattingly says higher rates in the short term aren't likely to trigger a US recession, but that doesn't mean the path back to historically normal monetary policy will be smooth. "The Fed has raised rates before, most recently in 2018, without triggering a recession, but its job was easier then because inflation was low, and the stock market still reacted negatively to the rate hikes."

The most clear beneficiaries of higher rates may be those who invest in bonds primarily for income. Typically, when interest rates rise, newly issued bonds may pay higher yields while prices of bonds that are currently in the market decline. So far this year, prices of those existing bonds have fallen as investors have anticipated the impact of higher rates and sold many of their bonds. But Beau Coash, institutional portfolio manager with Fidelity's fixed income division, says that a lot of the anticipated rate hikes have already been priced into the structure of longer term rates.

While the Fed's policies have clear effects on your finances, the policies of the Chinese, EU, and Russian governments also have impacts on your financial health because of the global nature of the economy and financial markets. Even the familiar US-headquartered companies of the S&P 500® rely heavily on other countries for significant portions of their sales and profits as well as sources of raw materials used in their products and locations for low-cost manufacturing. Those companies and their stock prices prospered as international trade increased over the past 30 years but war, sanctions, and differing policies toward COVID among various countries are all presenting challenges that may force the global economy to become less global. That could mean higher costs for US consumers and lower returns for their investments.

Don't believe the hype

Individual investors can't do much to stop wars, control a virus, or bring down inflation, but they can overreact to bad news and make decisions that they may later regret. Financial markets contain an ever-present tension between investors' fear of loss and their desire to take risks in pursuit of gain. That means they can easily be thrown out of balance by overreactions to alarming headlines that are out of proportion to the risks these events present to most people's portfolios.

In a time full of bad news, individual investors can give themselves greater peace of mind by maintaining a long-term focus and by seeking the help of professional managers who understand how to find opportunities when others are reacting fearfully. "We believe in allocating investments across and within a broad spectrum of asset classes and investment management styles, rather than trying to time markets that may sharply change direction several times in the course of a single trading session," says Lars Schuster, institutional portfolio manager with Fidelity's Strategic Advisers LLC. "That doesn't mean we turn a blind eye to changing market conditions, we just keep them in a long-term perspective."

Keeping perspective

Higher rates, inflation, and fear-inducing headlines may all add to market anxiety, but they are not reasons for long-term investors to abandon well-diversified financial plans. Instead, they should maintain perspective on news events and the short term and focus on their longer-term goals. In an environment where higher volatility and lower returns may be expected, experienced, skilled management and careful security selection backed by rigorous research may help you stay on course to achieve your financial goals. Fidelity offers a variety of ways for you to benefit from our disciplined, unemotional approach to investing in fearful times. Professionally managed mutual funds and managed account programs offer a variety of options for investors who understand that seeking balance offers a better route to achieving their financial goals than reacting to fear does.

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