Stock markets have experienced significant volatility so far this year, particularly in the US. Expectations that the US Federal Reserve will need to raise interest rates sooner than expected to tame inflation have combined with fears of Russia aggression against Ukraine to create a sudden change in attitude to risk. US equities have declined -8.2% in sterling terms since the start of the year to 25 January 2022 after returning a very impressive +29.3% in 2021. Of the 500 stocks in the S&P 500 Index, 137 have declined by more than 20% from recent highs, including high-profile companies such as Moderna, Peleton and Netflix.
The US NASDAQ Composite Index, dominated by large technology stocks such as Apple and Microsoft, declined by -13.1% to 25 January, meeting the definition of a ‘market correction’. While concerning, this type of market movement occurs more frequently than may be realised and follows a period of exceptional returns.
Another clear indicator of the increase in risk aversion has been the substantial fall in the value of more speculative assets, crypto currencies being a notable example with the best known, Bitcoin, falling to its lowest level in six months and by c. 50% from its November 2021 peak.
The US Federal Reserve is meeting on 25-26 January amid expectations of a first interest rate hike in March and more interest rate increases to come this year than previously anticipated, signalling a rise in bond yields. The tightening of monetary policy is generally seen to have negative implications for the valuations of highly rated growth stocks where consistent profitability and significant dividend payments are sometime in the future, the value of these earnings/payments is therefore discounted. Many stocks in the technology, healthcare and consumer discretionary sectors, which are a substantial element of the US market, have this profile and are sensitive to the expected change in monetary policy.
Conversely companies trading on lower valuations in more economically sensitive areas will often see improved performance in this environment, banks for example benefiting from higher profit margins as interest rates rise and the natural resources sector from higher demand and the ability to pass on inflationary price rises.
The risk of Russian military action against Ukraine has the potential to impact markets more broadly with disruptions to oil and gas supplies to Europe being a potentially damaging economic consequence. The change in investor sentiment against highly valued growth stocks in favour of lower rated value stocks, does mean that certain markets have fared better so far this year including Europe, Japan and notably the UK. With technology companies under represented and banks/financials, natural resources and industrial companies forming the majority of the UK market, this can be evidenced from comparative market returns to date this year:-
Market Performance – Year to Date
|S&P 500 Index||-8.2%|
|FTSE UK All Share Index||-1.6%|
Total returns in GBP to 25/01/2022
Although volatility in equity markets can be unnerving, some reverse after the impressive recovery from the lows of 2020 immediately after the onset of the pandemic is only to be expected as monetary policy begins to normalise and governments start to remove the costly levels of support they have provided. The global economy is expected to produce healthy growth once again in 2022 with the risks from the pandemic seemingly receding allowing supply chains, labour markets and demand for goods to adjust. Together with some tightening of interest rates these factors may contribute to inflation peaking and starting to move lower in the second half of the year.
High equity valuations in many sectors and the challenge of growing earnings from recent levels, may mean a period of lower market returns than the exceptional levels of recent years. For longer term investors though a diversified portfolio of UK and overseas equities should continue to provide good prospects for growth, with capital returns underpinned by healthy levels of dividend income in many areas including the UK. Fixed interest yields and interest rates are likely to move higher as monetary policy is tightened, returns from cash and bonds are set to remain low in nominal terms nevertheless, although still providing a defensive element to portfolios. The longer term benefits of maintaining a suitable allocation to equities across a range of sectors and geographical regions can be expected to outweigh the impact of shorter term adverse movements.
26 January 2022