After almost two years of virtually unbroken gains from the pandemic lows, investors were optimistic 2022 could bring more of the same.
Far from the case, it has turned out to be one of the weakest starts to the year on record across many asset classes in the face of intense uncertainties about inflation, growth and the unfolding impact of the war in Ukraine.
While the events in eastern Europe were not foreseeable, investors may have already positioned portfolios for the scenario of higher inflation and more challenging growth – versus the high embedded expectations going into 2022.
With the pendulum of market sentiment now swinging well into ‘fear’ territory, however, some perspective is called for.
Although the outlook remains very challenging, and volatility is likely to remain elevated, uncertainty cuts both ways and there are number of reasons to believe markets may stabilise before long.
* Although deteriorating, the global economy is still in reasonable health: Lead indicators such as purchasing managers indices are still indicating expansion ahead, the unemployment rate in the US is near a half-century low and, according to the latest World Bank forecast, global GDP is expected to grow by 2.9% this year.
* Policy conditions are still relatively loose by historical standards: For now, nominal interest rates around the world remain very low and are deeply negative in real terms, adjusting for current inflation. Fiscal policy remains supportive as well, with continued deficit spending and little sign of austerity ahead. While overall financial conditions may indeed have tightened, this has been from very loose levels.
* Tightening is being front-loaded and a lot has been discounted: Although policy rates are still low, forward guidance/jawboning from the US Federal Reserve, Bank of England and European Central Bank has led to an extremely sharp rise in rate expectations and bond yields- for example, the US two-year Treasury yield has gone from 0.3% to 3.4% over a year and the 10-year from 1.1% to 3.3%, both at decade-plus highs. It has been the weakest start to the year for investors in US Treasuries in more than 200 years and, although tightening has further to go, much of the rise in bond yields may be behind us, and longer-term yields in the US are now offering positive real returns.
* Inflation is likely to peak soon: This remains the biggest unknown but it looks likely that inflation will start to moderate soon and may come down faster than expected as pandemic-induced supply-chain problems ease, year on year effects subside, monetary tightening starts to bite and growth slows.
* Longer-term inflation expectations remain well anchored: Estimates of longer-term inflation have risen from pandemic lows but remain within the range of the past 20 years – the so called ‘5-year, 5-year’ inflation rate (the expected annualised rate of inflation for five years starting in five years’ time) stands at just 2.3%. The market expects inflation levels to revert, even if they are sticky for a year or two.
* China is increasingly in loosening mode and likely to start easing lockdowns: There are vastly different dynamics at play in China – the world’s second largest economy – which may emerge from lockdowns soon and where the People’s Bank of China is clearly focused on supporting the economy. Likely growth acceleration here will offset deceleration in developed markets.
* The consensus outlook has become almost universally gloomy: This is increasingly a positive from a contrarian point of view, creating more room for upside surprises.
* Equity valuations have improved substantially, even assuming a much tougher economic environment ahead: Global equities are into bear market territory, down 20% from the high at the beginning of the year – led by high growth stocks as the both the NYSE Fang+ and MSCI China indices are down by more than 40% from their 2021 highs.
* Parts of markets are less affected or even benefiting from the tough macroeconomic backdrop: Many businesses, particularly within the energy, materials and financials sectors, are benefiting from the commodity-price and interest-rate backdrop. Strategies with greater exposure in these areas – often those with a value-oriented investment style – have proved far more resilient than broader markets and, in some cases, have achieved outright gains this year.
* Good businesses endure and find a way: Equity markets have provided consistent and lucrative gains over the very long term and the chances of successfully timing when to sell out and when to buy back in are very slim. Periods of high inflation in past decades have been very challenging for equity markets but, ultimately, they created extraordinary buying opportunities, such as in the 1970s.
Andrew Hardy is a director and investment manager at Momentum Global Investment Management
