Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. The Federal Reserve has started to raise interest rates. Inflation is still running hot, and some market watchers are talking about a recession. Joining me today to share Morningstar's take on the markets is Dave Sekera. Dave is chief U.S. market strategist in Morningstar's Equity Research Group.

Dave, let's pivot and talk a little bit about the inflation expectations that the group has. Earlier this year, we said that we expected inflation to start to subside in the second half of 2022. Are we still thinking that?

David Sekera: According to our US head of economics, we do still expect inflation will start to subside in the second half of this year. A lot of the inflation that we have had has been due to a number of one-time factors. Think about some of the supply bottlenecks, some of the disruptions that we've had, some of the shortages that have been caused by the pandemic--those we do expect to start easing in the second half of this year. Now, we did slightly bump up our inflation expectation for this year at the beginning of April. So, we're looking at 4.5% this year. But really, more importantly to me, is that we're still looking for below 2% for the two years thereafter, which are actually both well below the consensus estimates by the Street.

Dziubinski: Dave, let's talk about the stock and bond markets specifically. What are your expectations there for this year?

Sekera: In the equity markets, we do this bottom-up composite where we take the fair values as assigned by all of our equity analysts for the stocks that trade in U.S. Right now, after the selloff we've had this year, we're looking at the market trading at a 6% discount to our fair value estimates.

Now, when I start breaking that down into different categories, if you remember, at the beginning of the year, we had noted that we thought that value stocks were undervalued and there were good tailwinds. Value stocks have actually performed OK this year. I think that our index is up a little bit over 3%. Really, it's the core and the growth stocks that have really taken the brunt of the selloff. Both areas that we had noted, according to our analysts, were overvalued. I think the core stocks are down over 7%, and the growth stocks are actually down over 17% year-to-date. Now, with core stocks down as much as they are, they're actually now getting to the point where they're looking relatively undervalued on whole, trading at about a 7% discount to our fair values. So, while I still like value stocks and I still think there's good tailwinds, on a valuation basis, I think now is a good time to be moving into the growth category as well.

The other thing I would note that in the small-cap space is probably where we see some of the most attractive valuations today. Now, getting back to what we were talking about earlier with our outlook for inflation and for GDP growth, I think small-cap stocks are pretty well-positioned to outperform going forward from here. 

Now, turning over here to the fixed-income markets, again, coming into the year, we did expect the interest rates were going to rise. We've certainly seen that. I think the 10-year Treasury bond is up 1.4% or 1.5% since the end of last year. So, a lot of the main rise that we were expecting we've already probably seen year-to-date. Now, having said that, I do still expect that we'll see interest rates continue to rise, albeit at probably a slower rate over the rest of the year. I think the 10-year Treasury should probably get over 3% before people start reevaluating where that next level might be there.

In that kind of environment with interest rates, especially long rates, still rising, I think probably that three- to five-year duration place is still where investors get that best risk/reward trade-off for the amount of yield pickup that you get versus the amount of duration risk that you take. And specifically, I still also like the corporate bond market here. So, again, while spreads are on the tighter side, when you look at a long-term historical basis, when I think about our robust economic outlook and think about inflation starting to moderate, that actually bodes pretty well for the corporate bond market. That's going to help keep default rates relatively low. That's going to minimize the number of downgrades that we would expect to see. Plus, it would also help in getting more upgrades from the rating agencies over the next 12 to 18 months.

Dziubinski: There are a handful of factors that could jeopardize the expectations that you have for stocks and bonds for this year. The first is, of course, slowing economic growth. Talk a little bit about that.

Sekera: Yeah. We did actually ratchet our economic growth rate down a little bit for this year and for next. And a good amount of that was really just recalibrating because of this spike that we've seen thus far this year in interest rates. And of course, as interest rates go up, things like mortgages and other consumer borrowing get to be more expensive. So, that will put a little bit of a damper on consumer spending. Now, having said that, we still expect that consumer spending will do pretty well this year. Albeit I do expect to see a shift as people start moving away from the good spending that we've seen over the past two years during the pandemic back into a lot of those services areas. Plus, we should see good production levels this year as those supply bottlenecks and some of those shortages ease up.

Dziubinski: Another risk to the forecast could be tightening monetary policy. Talk about that one.

Sekera: Sure. I do think the Fed probably did get behind itself a little bit and they now have to play catch-up here with inflation running as hot as it is. So, there's really two parts to monetary policy. First is managing the federal-funds rate. So, the Fed most traditionally is managing its monetary policy in the short-term part. So, we are looking for increases in the federal-funds rate this year. No surprise. Everybody is expecting that. Now, based on some of the language that we've heard from chair Powell and some of the other Fed board members, it appears that we might be looking at some 50-basis-point increases over the next couple of meetings.

The other part that we're watching for is more clarity as far as quantitative tightening. As you remember, during the pandemic, the Fed went through a quantitative-easing program, making monthly purchases in the bond markets for both Treasuries and mortgage-backed securities in order to be able to provide liquidity to the markets during all that time of disruption. So, now, we're going through the opposite, where they're going to start letting their balance sheet start to roll off. I think that they're probably going to let about $95 billion worth of bonds roll off per month, which, to put that in context, that's over $1 trillion of liquidity that will be taken out of the markets on an annualized basis. So, we're watching those. We're watching to see how that's going to work through the markets. At this point, we don't think that's something that's really going to impact our economic outlook from here. But it is certainly something that we're monitoring.

Dziubinski: Dave, you touched on rising interest rates as a possible risk to the outlook. But let's talk a little bit more about what impact rising interest rates could have on that outlook.

Sekera: Sure. So, there's really two areas when I'm thinking about rising interest rates and how they might impact the markets. First, from just a pure economic point of view, as those interest rates are going, it increases the borrowing costs. When I think about things like mortgages, that could put a damper in the housing market. As other consumer borrowing costs go up, you could see less consumer spending. Of course, that all could impact corporate earnings going forward.

The other part that I would be concerned about is--if interest rates spike too far, too fast from here--is that from a financial point of view when people are valuing stocks, they look for specific required rate of return or internal rate of return when they're doing their discounted cash flow analysis. With interest rates rising as much as they have, I actually don't think they've really impacted those required rates of return yet because I don't think most investors really brought their required rates down nearly as much as like the 10-year Treasury had fallen during the pandemic. Now that we're getting back up toward 3% and start going over 3%, I could start seeing some investors that have brought those required rates of return down starting to lift those back up again. And of course, as they start increasing the required rates of return, that decreases the price that they're willing to pay for that stock today.

Dziubinski: And then, lastly, there's of course, geopolitical risk that's going on in the world right now. Talk a little bit about how that risk in particular might pose a threat to your outlook.

Sekera: Yeah. And geopolitical risk is really, from my point of view, probably one of the hardest risks really to analyze and especially hard for investors really to manage that risk in their portfolios. So, really, that gets back to making sure that you have the right risk allocation in your portfolios based on your own individual needs. And the problem with the geopolitical risk is that they're usually low probability but can be high severity risks. At this point, we did have our webinar about a month ago talking about Ukraine specifically and why we didn't think that the Russian invasion would have an impact on the U.S. markets. Now, having said that, as the conflict is still ongoing, there is risk that that conflict could widen or that there's a possibility for other unforeseen events to occur surrounding that.

The thing I would probably watch for there for investors is: Make sure you're dialed into what that right allocation is for you, and as we're watching at that event specifically, or other geopolitical events in general, as they heat up, that might be times that you do look to reduce some of your risk assets, and then, when there is that market pullback, make sure you have the intestinal fortitude to be able to put that money back into the market after you do see those dips.

Dziubinski: Well, Dave, thank you so much for your time, sharing your market outlook and for these risk factors that you're keeping an eye on today. We appreciate it.

Sekera: Well, thank you, Susan.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.