This may not be the low point; markets are likely to remain volatile as politicians and central banks react to evolving events. Persistent inflation may cause markets to worry that central banks will raise rates and cause global growth to go into reverse. But it’s because the market is now discounting a recession, falling earnings, rampant inflation, and higher rates that this may be a good time to invest. We would favour equities over bonds and so advocate an allocation to funds that have a high equity content.
It’s been a bad start to the year
At almost every level 2022 has started poorly
- From the start of the Covid crisis. governments and central banks had taken unprecedented steps to protect the global economy from the effect of the lockdown. Rates were cut to zero or less and the balance sheet of the central banks exploded because of quantitative easing. As concerns over Covid eased, markets were already worrying about the effect on asset prices of unwinding these positions.
- The legacy of Covid meant that as economies restarted, there were supply-side bottlenecks that caused prices to rise sparking inflationary fears.
- The spike in inflation was initially dismissed as temporary, but increasingly markets started to worry that it was more permanent.
- The war in Ukraine is a disaster at many levels. The impact on markets has been to drive up the price of energy and agricultural prices, fuelling the inflationary spiral.
- With inflation approaching 10% across developed markets, there is an increasing risk that we will see another wage/price spiral as workers try to maintain real living standards.
- Central banks have been forced to act. They are now increasing rates rapidly, and faster than markets originally expected to maintain their inflation-fighting credibility even though the problem was originally a supply-side issue.
- The surge in energy and food prices sucked demand from other goods and services causing growth to slow. A recession in Europe is very likely and it's now probable that there will be a recession in the US as well
- Markets now worry that central banks will tolerate a recession to squash inflation
Markets have already responded. 2022 has been one of the worst ever years for mixed-asset portfolios with equities and bonds falling in tandem. The chart below shows the returns from global equities and bonds, and of a mix of 60% equity and 40% bonds.
The benefits of diversification are notably absent. The tech stocks that led the rally have crashed back to earth as we can see in the chart below that shows the performance of ARC Innovation Fund. The disastrous performance of this fund makes this quote from Warren Buffet seem very appropriate: It's only when the tide goes out that you discover who's been swimming naked
Inevitably the geopolitical and economic backdrop and poor returns have sparked a chorus of concern and worry from commentators and pundits keen to get a name for predicting financial Armageddon. But it’s probably worth dipping into the deep well of quotes from Peter Lynch:
Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves.
What do we know?
We think that attempting to predict markets in the short or medium term is a mug’s game. What we do know is that over the long-term markets rise as economic growth is reflected in the earnings of companies. But in the short-term markets rise and fall, and it is almost impossible to anticipate these moves.
It’s clear that economic growth is slowing and there may be a recession which could impact Europe more than the USA. Central banks will increase rates. However, there is some good news. Consumers, companies and banks have robust balance sheets and corporate earnings have been growing healthily. There is some cause to think that if there is a recession it will be shallower and milder than the last two downturns (Financial crisis and COVID).
To a large extent, markets have done a lot of the hard work required to bring down inflation. Interest rates have increased in anticipation of central banks’ rising rates. Supply-side issues have increased prices and so demand for other goods and services has already started to decline. Unless prices continue to rise, inflation will start to moderate. Markets react quickly and have already discounted the effect of higher rates and slower economic growth. The S&P 500 is now in bear market territory (a fall of 20% from the peak). Equity valuations have come back from the peak levels at the end of 2021 because asset values have declined, and earnings have increased. Bond prices have also dropped as yields increase.
The risk now is that a recession will cause real earnings to fall below current estimates. It’s probable that analysts’ estimates will start to be reduced as they discount the gloomy macro prognosis.
What should we do?
We would not want to be drawn into making predictions, but it is worth going back to some wisdom from Peter Lynch and Warren Buffett
Peter Lynch: People who succeed in the stock market also accept periodic losses, setbacks, and unexpected occurrences. Calamitous drops do not scare them out of the game
Warren Buffett: We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful
BlackRock has an interesting view. They think that central banks will be prepared to live with higher inflation and so will not raise rates as much as already been discounted. But they worry that inflation will be more persistent than expected and that this will cause markets to worry that rates will go higher. Anticipation of higher rates could then cause equity markets to fall.
Ultimately, BlackRock thinks that the Fed will blink and will not raise rates as much as is being forecast when they realise that this is tipping the economy into a recession.
Our perspective is that it is futile to try and catch the highs and lows in a game of bluff and double bluff with the market. This is a time for patience and to remain invested. We recognise that there are headwinds that may be significant, but these are broadly recognised. Aside from a pending recession, the material risks are a catastrophic escalation of hostility in Ukraine, as opposed to the grinding war of attrition, or deterioration of the situation around Taiwan. There are also risks of greater geopolitical tension globally as economies shrink and food becomes expensive, or even worse, scarce.
On balance risks like this are ever-present and the more likely path is that things become less bad. This may be a moderation of inflationary concerns or de-escalation of hostilities or a less oppressive response to Covid in China. However, the prospect for bonds and fixed income assets looks poor with rates set to rise further. For equities, profits may suffer if there is a recession and higher rates reduce the value today of future earnings, but in our view, this is now reflected in current prices.
It’s worth closing as we started: this may not be the low point; markets are likely to remain volatile as politicians and central banks react to evolving events. Persistent inflation may cause markets to worry about a policy error. But it’s because the decision to invest now is so difficult that this may be a good time to invest. We would favour equities over bonds and so advocate an allocation to funds that have a high equity content.