When you have the wind at your back, it can be easy to sail toward your destination. But faced with a headwind, you may resort to tacking—moving at angles across the wind to achieve grinding progress. For a few years, investors often enjoyed the benefits of idyllic conditions: tax cuts, economic growth, earnings gains. The squall of the pandemic initially seemed catastrophic, but massive fiscal and monetary stimulus helped propel many portfolios higher, and nearer long-term financial goals. This year, the barometer has swung wildly again, with high inflation and new hawkishness from central banks contributing to the worst first half for financial markets in decades, and many forecasting that we are not yet done with this particular storm. Navigating what comes next may include a combination of “battening down the hatches” and tacking to move forward where you can.

At this point, the problems facing the economy are well known, but their durability and severity—along with the needed policy reaction and its impact—are helping to drive uncertainty. Annual consumer inflation hit a new 40-year high of 9.1% in June, with energy accounting for much of the increase, but gains showing up across many sectors, boosted by higher wages, shelter costs, supply chain sluggishness and other factors. Core inflation, which excludes energy and food, logged a 5.9% advance, or well above the Federal Reserve’s 2% target.

Despite its slow start, the Fed now seems committed to aggressively raising interest rates to gain control of prices, even if it means cutting into near-full employment. Recent readings on consumer confidence, easier hiring conditions and changing buying habits provide modestly encouraging signs, but more tightening is likely needed to truly make progress.

As it stands, we believe that inflation may increase somewhat more from here. Looking at the core Consumer Price Index, goods inflation has dropped sharply but services remain elevated, with housing showing strength. This could translate into core inflation of about 6% at year-end, followed by some easing into 2023. (“Headline” inflation, which adds in food and energy, could peak at around 10% before declining.) Such a trend would assume continued growth-curbing monetary tightening, with the fed funds rate likely reaching an eventual peak of around 3.25% – 3.75% (or higher if inflation is worse than expected) before beginning to recede.

Goods Inflation Has Declined, but Services Could Prove More Stubborn

Core Consumer Price Inflation

Source: Bloomberg, Neuberger Berman forecast. Shelter is a component of services inflation. Actual through June 2022. Forecast calculated using MoM seasonally adjusted data and converting to YoY% without adjusting for seasonal effects. Weights are also held constant at May 2022 levels without dynamically changing them. Forecasts done at summary product level and rolled up. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

Bond markets have already done much of the work for the Fed. A fundamental idea in monetary tightening is that, to bring down inflation, “real rates,” or interest rates above inflation, need to rise enough to have a constricting (rather than easing) impact on the economy. The increase in market rates across multiple sectors has achieved this to some degree (based on Treasury Inflation-Protected Securities yields). Assuming a reasonably benign outcome, U.S. economic growth could slow from 5.7% in 2021 to the Internal Monetary Fund’s projected 2.9% for this year and 1.7% for next. Even if we don’t enter a technical recession, the degree of the economic decline will likely make it feel like one.

Moreover, whether the Fed goes too far—or not far enough—remains a question, of which energy prices are a key element. With OPEC near full capacity, restrictions on Russian exports and discipline on the part of U.S. producers (see “Tight Oil”), oil prices could remain elevated and even accelerate should China’s efforts at recovery take hold. Although the Fed typically ignores energy in setting policy, there’s no denying its impact on inflation in areas that rely on fuel in production and distribution of their products, and its motivating influence for workers seeking wage increases.

Unfortunately, central bank policy can have only limited influence on supply-side issues—whether oil prices, supply chain capacity or disruption of food exports from Ukraine. As such, the Fed could pursue further tightening and still be faced with inflation that would be unacceptable in relation to its long-term target. At that point, we believe that officials would acknowledge their limitations and avoid going too far; but, if not, we could see further tightening that heightens impacts on the economy and markets.

Stresses on Stocks

After a 20% first-half decline in the S&P 500, and worse setbacks in growth and (particularly) speculative stocks, it may be hard to fathom that things could get worse from here—however, that’s something to be prepared for.

The flow of funds into equities was extraordinary over the past two years, and likely the result of massive liquidity infusions—which are now being withdrawn. As of June 30, 2022, the S&P 500 was still roughly 13% above levels seen right before the pandemic declines, when many investors were already concerned about valuations. Those who’ve held onto stocks for the past 10 years have enjoyed a healthy return of about 13% on an annualized basis, versus the 11% average since 1957.

Second, there’s reason to believe that, despite recent price declines, a slowing economy is likely to further affect the stock market. We believe the first leg of the market decline was largely a repricing based on interest rate levels. Valuations have come down from extremes, while the variation of valuations among individual names has compressed, suggesting that no particular group is very expensive relative to others.

However, this assumes that earnings remain static, and there’s reason to believe that they could deteriorate. Higher costs may become harder to pass on to stressed consumers, cutting into profits, while a reduction in economic growth of two to three percentage points could translate into a 15- to 20-percentage-point decline in earnings, with an actual recession implying more. As a result, it’s possible we could see a second leg to the sell-off, this time associated with earnings weakness, which in our view could last into the first half of 2023, or later—not news that anyone but a short-seller likely wants to hear.

That said, a look at market performance around historical recessions may offer context. Although in recent instances the S&P 500 saw severe downturns, at other times the impact has been more modest—and less than we have already experienced in the current cycle. Should a recession occur, we believe it will be focused largely on the consumer, as corporate balance sheets and the financial system remain strong—likely translating into a relatively shallow downturn and less painful path to recovery.

Peak-to-Trough S&P 500 Index Declines Around Recessions

Source: Goldman Sachs, Deutsche Bank and Neuberger Berman. As of December 31, 2021. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

Adjusting as Winds Persist

In our view, prospects for continued volatility lend themselves to a continuation of what we’ve been saying to clients: seek to maintain an asset allocation that provides proper diversification across equities, fixed income and (where appropriate) alternatives, and is well suited to your personal goals. For those who are able to make tactical tilts in portfolios, you may want to consider leaning into exposures that are more defensive—less to the broad market, but more to value shares and equity income—which can potentially draw on dividend income to help ballast price weakness.

Dividend Growth Has Kept Up With Inflation

Source: Absolute Strategy Research, as December 2021. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

Although fixed income didn’t provide much relief in the first half, we see more reason for optimism moving forward. In our view, many investment grade corporate bonds are providing attractive risk-adjusted yields, while the high yield market’s yield advantage (or spread) over Treasuries recently hit about 5% (for total yields of about 8%). Top-quality municipals now trade with healthy yields and only a small discount to Treasuries, which is typically larger given their tax advantages (see “Yield and Volatility”). More broadly, we believe active, go-anywhere fixed income investment strategies may have the potential to capitalize on current opportunities across fixed income sectors.

In this environment, real and alternative assets can also help to provide diversification and manage potential risk. Real estate, whether public or private, has tended to provide insulation from inflation.  Although they could potentially be affected by a downturn, oil and other commodities have structural limits to supply, including chronic underinvestment, disruptions from the Ukraine conflict and climate-driven policies, which could keep prices elevated.

Private equity may also be worth considering, given the ability of managers and companies to weather economic turbulence without the short-term pressures of public ownership. New commitments to vintages raised early in economic and market downturns have often benefited from their investments being made while public equity valuations have declined.

Finally, I would mention the benefit of cash as potential “dry powder” for further investment. Current headwinds may persist for months, but increasingly managers will look for ways to put money to work—in fixed income currently, but with equities likely to follow.

Sailing Ahead

We believe it’s important not to minimize the turbulence in the economy and financial markets over the past six months. Inflation is imposing real hardships, and many investors have seen portfolios—representing personal goals and aspirations—contract in alarming fashion. What seems to lie ahead may be less than reassuring; however, perspective matters. For those who are investing over the long haul, recent paper losses may represent a temporary setback; for those who rely on investment income, declines in bond valuation may offer offsetting yield opportunities. Importantly, no one is helpless in the face of market turbulence. We believe it’s crucial to stress-test your portfolio, make adjustments where feasible, and stay focused—because an eventual break in current headwinds could allow you to straighten course and resume progress on your investment journey.