- Investment Insight
- 5 minute read
The start of the New Year has coincided with a very rocky period for global financial markets. Global equities were down over 5% in local currency terms over the course of January, while UK government bonds fell almost 4% in sympathy with global fixed income markets. Elsewhere, infrastructure, precious metals and global property were also challenged, while the more volatile and speculative areas of the market like cryptocurrencies saw even greater falls, with Bitcoin down over 16%. The VIX index, a measure of stock market volatility in the US, surged by 44% in January.
Economic growth not currently a major concern
What is behind this increase in volatility? While economists’ forecasts of GDP growth in 2022 have cooled somewhat, they remain above trend and the global healthcare situation shows signs of improving. This suggests the market rout has not been driven by concerns about global economic growth. Moreover, the US yield curve is sloping upward, suggesting market participants do not anticipate a recession (historically an inverted yield curve has been a good indicator of looming recessions).
Interest rate expectations driving market sentiment
The decline in both bond and equity markets points to interest rates as the key driver of the pull-back. Since November last year, we have seen a significant increase in the amount of monetary tightening anticipated by markets in 2022 and beyond. At the start of November, derivatives markets indicated that market participants expected the US Federal Reserve (Fed) to raise interest rates in the US fewer than three times, leaving rates well below 1% at the end of 2022. By the end of January, markets were pointing to over five hikes, with rates approaching 1.4%.
What's fuelled the rates rocket?
Why have interest rate expectations risen so fast? Given the important role the US dollar plays within the global economy, let us focus on the Fed. Firstly, it has been partly due to the improvement in the outlook for global growth as Covid-era restrictions on activity abate. The fact that countries, including the US, were able to weather a high number of Covid-19 cases and hospitalisations in the Autumn without reintroducing the most significant and disruptive social restrictions removes an important source of downside risk to economic growth in 2022. Secondly, the US labour market recovery continues, with unemployment falling. This is creating a tight labour market with signs of rapid wage growth. Mindful of the role of wage growth in supporting persistent inflation, the Fed have felt the need to begin tightening monetary policy in response.
This rise in interest rate expectations has weighed heavily on bonds, and some equities, though the impact has not been even. Equity sectors trading on higher price-to-earnings (P/E) multiples have suffered the most. The P/E multiple compares the current share price of a company with its expected future earnings. A high multiple infers that a company’s share price is high relative to its earnings, and perhaps indicates that investors are anticipating high levels of future earnings growth. However, share prices which are pricing in strong future growth have a greater sensitivity to interest rates, as they are a key component in the valuation models used to discount future potential growth to a present day value. Conversely, companies with lower growth expectations, but strong present cash flows are likely to be somewhat less sensitive to interest rate movements. The top three sectors ranked by long-term earnings growth returned -8.57% in January, while the bottom three averaged +0.37%. The best performing sector was energy, which delivered +13.74%, despite the fact that analysts expect this sector to experience negative long-term earnings growth.
What is the outlook for the rest of 2022? We do expect interest rates to rise and monetary policy to tighten in coming months, and this may continue to rattle markets. However, in our view, interest rate expectations are now looking somewhat demanding, and we think it is possible that markets may now be anticipating more monetary tightening than central bankers will implement. Volatility is certainly likely in the months ahead, as investors await to see how much of the forecasted tightening comes to pass. However, given the generally positive outlook for growth, and the fact that much of the change in interest rates is now priced in, we also see reasons for optimism.
Exiting the pandemic should also support companies with structural growth advantages. We continue to believe that a number of structural changes are in play within the global economy, and that businesses exposed to these themes can make attractive investments. Moments of market turbulence, when stocks in these often richly valued sectors are repriced lower, may present buying opportunities. As ever, our research teams are constantly seeking to identify attractive long term opportunities and advantageous entry points. While 2022 may be a bumpy year, a multi-asset portfolio can offer diversification benefits in times of volatility.
The information contained in this article is believed to be correct but cannot be guaranteed. Past performance is not a reliable indicator of future results. The value of investments and the income from them may fall as well as rise and is not guaranteed. An investor may not get back the original amount invested. Opinions constitute our judgment as at the date shown and are subject to change without notice. This article is not intended as an offer or solicitation to buy or sell securities, nor does it constitute a personal recommendation. Where links to third party websites are provided, Close Brothers Asset Management accepts no responsibility for the content of such websites nor the services, products or items offered through such websites.