Investor Insight February 2022, February 2022

The first month of 2022 has seen market volatility, especially in US equity markets.

The selloff has been led by the NASDAQ, or technology related index, which is down –8.98 per cent for the month and has had an impact on both the Dow Jones down –3.32 per cent and the broader S&P 500 down -5.26 per cent.

Australia has not been immune, disappointingly falling -6.35 per cent, whilst European markets held up with the UK’s FTSE +1.08 per cent, Germany’s DAX -2.60 per cent and Frances’s CAC -2.15 per cent.

Market watchers are asking whether equity markets are overvalued, and is this the next big correction, OR are we once again in the ‘roaring twenties,’ with plenty of upside still to come.

We have stated many times that we do not think returns from financial assets in 2022 will match those of 2021, as we expect a sell off globally in government bonds which reflects the outlook for monetary policy and, whilst we see equities rewarding investors, this will come with volatility and at moderate levels.

The NASDAQ is technically in a correction. Over 50 per cent of the component stocks in the NASDAQ index have fallen over 50 per cent, therefore many of the component stocks are in bear market territory.

We think it is important to point this out as globally we are experiencing a sector specific sell off or correction and it could overall become a bear market for the NASDAQ. This is not a negative, as it is taking the air out of what was an overvalued part of the equity markets.

Whilst technology stocks have in general fallen and, in some cases, sharply, further declines do appear ahead of us in this sector of the market, on the back of a broader deterioration in appetite for risk and the mood for tech heavy parts of equity markets.

What is concerning is the contagion effect this is having across equity markets more broadly.
US earnings season has seen over 70 per cent of major companies exceed expectations, yet guidance has been below expectations. Those that have missed expectations have dominated headlines and have been sold down aggressively.

Whatever an investor’s view; it is vital to be aware of the implications of tightening financial
conditions. The Reserve Bank of Australia has repeatedly stated we will not see rate increases yet bond markets have priced in four rate hikes for 2022, and it appears the Federal Reserve in the US is well set to tighten as early as March, This will have implications for risk assets.

Currently, we are mid cycle with growth decelerating therefore we have moved from recovery to
steady growth. The question is, when will we see monetary policy tightening?

Ahead of the Global Financial Crisis there were 17 interest rate hikes made by the US Federal Reserve (Fed) before this trend caught the attention of investors! Yes, that was certainly a different environment compared to now, with sub-prime loans weakening the market, but as we have always said, the main story to watch is about interest rates.

RISKS

At HWP we are always conscious of the risks. What we look at is what can be considered but it is what is unknown that is difficult to balance.

Balancing risk also means you need to be an optimist, as it is always easy to overdo the gloom which at the end of the day will cost you performance through cash drag. Upside risk needs to be factored in as well.

Inflation is a rising issue for markets. Australia’s inflation figure last month highlighted this. Capital Economics in London “forecast that inflation will fall this year, but at a slower pace than most currently expect. If supply constraints in both product and labour markets were to ease more quickly than we anticipate, then it is possible that inflation will fall more quickly too.”

How do you monitor for wage price inflation? Watch services closely to ensure inflation does not roll over from goods inflation to services inflation.

Capital Economics also see China as a risk factor. They have “assumed that policy support will help shore up property sales and put a floor under the construction slowdown around the middle of the year.” It is important to monitor not just future home sales but also confidence as “if sales continue to weaken, many more developers will be in deep trouble, along with their creditors in the bond market and among China’s banks.”

Risks are not just economic in nature but can also be geopolitical. Geo-political risks are risks you need to be aware of but positioning portfolios for these risks can be dangerous, as it is often white noise.

Therefore, whilst elections are due in France in April, Australia in May and later in the year in Brazil the noise can cause very short-term movements but in the scheme of things will have no impact on our asset allocation.

COVID 19 also cannot be discounted. Omicron has had a negative effect on short term growth and
has exacerbated supply constraints however, it has also held central banks back from reacting quickly and in the US maintaining their hawkish positioning.

ARE WE IN A BEAR MARKET?

Apart from 1987, bear markets are usually caused by recessions. As we have discussed we are mid
cycles economically.

We do not see the Fed raising interest rates to the extent of creating a credit crunch, likewise, increasing rates to counter run-away inflation that creates a recession we do not believe is probable.

The technology sector is going through a downside rerating and the companies that are leading this are those with no earnings. There was hype and excess and as we mentioned the air coming out of this part of the market is a positive.

We believe we will see a bear market in the technology sector but not more broadly at this stage.

INTEREST RATES HIGHER

Interest rates will trend higher but again at a manageable level, and well below trend on a long-term basis, therefore continuing the “lower for longer” theme. What will spook markets is if we see an acceleration in the pace of interest rate rises or if they rise in an unorderly fashion, different from what markets currently predict. Be aware of this but also note that volatility can provide great buying opportunities as well.

Both inflation and interest rate expectations must be watched carefully as they will indicate if we are to see rougher water ahead. At the same time, the headline watchers will take risk off the table at the slightest market move which is why we are expecting higher volatility.

The historically low levels of interest rates today inevitably imply lower returns going forward but interest rates at historical lows have also exacerbated total equity returns in the short term.

We see both interest rates and inflation trending higher but at manageable levels. Expect volatility as these movements occur. Inflation expectations are baked in, and markets are expecting for this to trend up. Inflation may well moderate, which will provide less pressure on interest rates, but also possibly increase market volatility.

Our asset allocation consultants Heuristic Investment Services point out that central banks will “not want to risk their growth/employment achievements by tightening too quickly or too far. On the other hand, central banks cannot risk inflation becoming unanchored. Four tightening’s (total 100 basis points) in the US in 2022 and another three in 2023 can be digested by markets”.

On inflation, Heuristic like Capital Economics see inflation coming off its recent highs, but as Heuristic point out “markets are pricing 3 per cent inflation over the next 2 years, 2.8 per cent over five years and 2.5 per cent over 10 years in the US. In other words, markets are suggesting inflation eases back towards but still above the Fed’s 2% target. For equity markets, as long as medium-term inflation expectations remain below 3 per cent current valuations may not prove too challenging”.

We should see risk assets rewarded medium term over defensive, but that is through a conservative lens as opposed to high beta exposure.

Successful investors never forget risk as a key component of strategy and so, facing into the new year, we strongly emphasise the need for prudent risk management.