Volatility is rattling markets, but could there be opportunities in the near future?
Volatility is rattling markets as we write, with concerns about inflation, interest rates and economic growth. Although it is impossible to forecast short-term movements in risk assets, it is possible already to see how there might be opportunities to take investment risks in the near future.
What is the US Federal Reserve aiming to do?
The market movements this year have been remarkable by their speed. The US Federal Reserve (Fed) has announced its planned interest rate hikes in full, and markets have reacted very quickly to its statements. Clearly, the Fed has been as surprised as investors by the acceleration and broadening of price rises. The Fed’s primary objective has switched very fast from achieving full employment to controlling inflation at any cost, and it has realised that the current level of employment in the US needs to be curtailed in order to bring inflation down to its 2% target. There are currently 1.7 job openings per jobseeker in the US. All the Fed is trying to do is to level that playing field so that wages don’t feed into price rises. This means slowing the US economy by reducing consumer demand, which it has suggested could be achieved without a recession, i.e. with a simple slowdown.
How have markets reacted?
Government bond yields have soared this year, triggering the worst losses to bondholders in living history. This year alone, US 10-year treasury yields have more than doubled from 1.50% to 3.30%, UK gilts from 0.96% to 2.46%, and German bonds from a negative -0.19% to +1.63%. The magnitude and speed of these movements has caused equity markets to correct sharply. The US officially entered a bear market yesterday (defined as markets falling 20% from their peak).
How are equities performing?
Within equities, however, there has been more discrimination than within bonds. The FTSE All-Share has been one of the most defensive markets in the world, due to its high energy and commodity components. European equities, though, have fared worse than the US. The main differences in performance, however, are seen not so much between countries but between sectors. The energy sector is up 40% this year whereas information technology is down 30%. This is where the crux of the problem lies: the world has piled up on tech stocks whose future has changed very rapidly as interest rates have surged, whereas energy shares have been forgotten for decades. In simple terms, higher rates reward companies with steady earnings and dividends as opposed to those with faster growth but profits further out. The biggest losers in markets have therefore understandably been ‘profitless tech’: companies with a great investment thesis and a bright future but no immediate prospects of breaking even. Even the largest US tech firms such as Facebook (Meta), Amazon, Apple, Netflix and Google (Alphabet) (known previously as the ‘FAANGs’) – have succumbed to higher rates.
What is the likelihood of a market rebound?
The speed of movements in one direction usually foreshadows a similar speed in the other direction. What is currently missing is the catalyst for a move up. Such catalysts can be of two kinds – technical or fundamental. Technically, an oversold market tends to rebound sharply. Fundamentally, the Fed can take markets out of their misery by changing its rhetoric. If the Fed raises rates sufficiently enough to see inflation pointing durably downwards, it will then have no reason to keep a hawkish stance and will be mindful of the cost to the economy of keeping rates too high for too long.
When could a recovery start to happen?
We don’t know at this stage, but right now, we are probably at the peak of investor gloom and a technical recovery is likely to happen in the next few weeks. The more fundamental rally could come when inflation figures start to moderate in a consistent fashion. Although forecasting that point is beyond analysis, the likelihood is that the point will come sooner than people expect. Unlike the 1970s, the current inflationary surge has not been fed by a weak US dollar, deficient technology, abysmal productivity and cost-of-living adjustments in union contracts. The spike in inflation has indeed broadened within the consumer basket, but wages have lagged prices massively, which should help inflation return to a lower level faster than during other inflationary periods in history.
It is important to note that a high percentage of the excesses accumulated in the long cycle since the 2008 financial crisis are now being unwound very quickly: crypto-currencies, SPACs (special purpose acquisition companies), concept stocks¹, etc. This should help cleanse markets of their froth much faster than in previous bear markets.
Are there any bright spots in equities currently?
It is interesting that in the middle of the carnage of some equity markets, many areas have remained resilient: Japanese and Asian equities, energy and materials sectors, value shares² compared to growth shares³. All it would take for other sectors to join them would be a halt to the relentless pace of rising interest rates. We could well see this happen in the next few months and it would be a shame for any investor to miss this recovery.
It is unusual for equity and bond markets to fall so sharply at the same time. It means that both markets could recover simultaneously, with not only shares but also government bonds, corporate bonds and various other credit markets providing upside to investors.
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Investment involves risk. The value of investments and the income from them can go down as well as up and you may not get back the amount originally invested. Past performance is not a reliable indicator of future performance.
This is not a recommendation to invest or disinvest in any of the themes or sectors mentioned. They are included for illustrative purposes only.
The information provided is not to be treated as specific advice. It has no regard for the specific investment objectives, financial situation or needs of any specific person or entity.
The information contained herein is based on materials and sources that we believe to be reliable, however, Adam & Company makes no representation or warranty, either expressed or implied, in relation to the accuracy, completeness or reliability of the information contained herein. All opinions and estimates included in this document are subject to change without notice and Adam & Company is under no obligation to update the information contained herein.
¹Concept stocks Generally defined as stocks with extremely high market to sales ratios. The term ‘concept’ relates to the suggestion that investors need to buy into the concept or idea of a company to understand what would otherwise appear to be a high valuation.
²Value stocks Investors looking for ‘value’ seek out stocks which they believe have been undervalued by the market and are trading for less than their intrinsic worth. They are viewed as trading at a lower price than justified when measured against metrics such as earnings, profit margins or sales.
³Growth stocks A company that is expected to deliver better than average organic revenue and earnings growth over the medium term.
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Investment involves risk and you may not get back what you invest. It’s not suitable for everyone.
Investment involves risk and is not suitable for everyone.