With 2022 now well underway it seems clear there will be no escape from inflation or higher borrowing costs when it comes to the two major challenges financial markets will be faced with this year. After a decade and a half of ultra-lax monetary policies, supply chain disruption as we emerge from the ravages of the COVID pandemic and a healthy slug of geopolitical posturing, this combination of factors stands to generate as many opportunities as it does threats on the investment landscape.
After years of stubbornly low inflation, major Central Banks simply haven’t been blessed with the necessary headroom to tighten monetary policy through raising interest rates. This is after all a valuable weapon in their arsenal, as the subsequent reduction of borrowing costs provides a great tool for stimulating economic activity at a later date. With inflation running strong and the employment market in many countries faring well, we should expect many policymakers to be latching onto the opportunities this holds. The US Federal Reserve is now widely expected to make at least four rate hikes during the year and the Bank of England won’t be far behind, although any similar action from the ECB or SNB is likely to take somewhat longer to materialise. Even where the blunt tool of raising base rates can’t be justified, the reigning in of other stimulus measures such as asset purchase schemes is likely to proliferate as borrowing costs start to rise globally and demands increase to ensure associated costs are kept in check.
So, are rising rates always bad for equities?
There’s a well-worn, albeit rather simplistic, piece of financial doctrine that says when interest rates rise, the temptation to save (rather than spend) kicks in amongst businesses and consumers alike, pushing fixed interest products into favour at the expense of stocks. However, a quick look at stock market performance between 2004 and 2007 – when the Federal Reserve’s target fund rate moved from below 1% to in excess of 5% – showed solid gains across all major US indices with the S&P500 increasing by 34% during this time. The last time the Fed raised interest rates occurred in 2015 – 2019 which simultaneously had an increase in the S&P500 of 45%. This was on the back of a 150% gain in the index following the credit crunch of 2008.
As has been said before, history doesn’t repeat itself, but it often rhymes.
What’s more, by digging a little deeper we can see that in those rising rate environments, one of the factors investors have historically looked for is quality. In turn that highlights the benefit of hunting out those stocks with more defensive attributes such as lower earnings multiples and steady dividend histories. Then there’s also the idea – especially amongst North American stocks right now – that hype and being on-trend matter as much as the fundamentals when forming valuations, a principle which remains largely in-tact even if some of those newer technology firms have been left struggling as lockdowns come to an end. Couple this with the sheer surplus of uninvested cash and it really does add to the idea that it’s going to take markets a fair while to normalise. Indeed, polling conducted at the end of last year amongst many of the biggest banks suggested the S&P 500 would finish this year between 4600 – 5330, implying an upside from current levels of 2% -17% (at the time of writing).
Rising commodity prices – some cause for cheer?
In short, quite possibly. Part of this is driving inflation, but a general supply/demand imbalance as markets leave the worst effects of the pandemic behind is keeping prices buoyant in everything from raw materials to finished goods. This has an obvious trickle-down effect which ought to help bolster revenues across the board, although if companies start to absorb some of the input costs themselves, then margins – and potentially headline profitability – will suffer, too. And again, looking to offset any financial myths, there’s a frequently cited belief that high energy prices act as a drag on US equity valuations, but to offer an example here, an IMF study from 2008 showed that there was no meaningful correlation between the two. Clearly, there’s the potential for short-term price shocks to rattle sentiment, but over a longer-term horizon there’s less cause for concern.
Where do the risks lie?
The COVID pandemic was first recognised as a potential issue by the markets in early 2020 but despite the best endeavours of scientists – and rousing claims from many a politician – the constant mutation of the virus has served to ensure the global health crisis isn’t going anywhere fast. However, the Omicron variant does appear to be a distinctly milder form of the disease so this, combined with rising immunisation rates, maybe start to deliver that holy grail of herd immunity. But could a future, more aggressive variant be detected, and what of the risk posed by those countries pursuing zero-COVID strategies? Do they now risk becoming breeding grounds themselves for more dangerous strains of the virus?
Geopolitical risks can’t go unmentioned, either, with a growing list of potential flashpoints being seen across the globe. Russian troops amassing on the border with Ukraine is raising concern over what this might mean for European energy prices if gas pipelines are cut as a result. Whilst global wheat markets are also seen as being at risk of any production disruption which could manifest itself across the Eurasian Steppe. China continues to make no secret of its offshore ambitions into the South China Sea, either.
Then heading back to financial market mechanics, it’s also worth noting that there’s significant downside potential associated with long-dated, low-yielding fixed income securities, but that on its own is no reason to justify writing off debt as an investment tool. Shorter-dated paper coming to the market right now has the scope to deliver a meaningful premium.
Will 2022 be a turbulent year for the financial markets?
There can be little doubt of that, but given the resilient performance of markets over the last decade which hasn’t been without its shortage of adversity, now is a time to ensure your assets are working for you. Negative interest rates in Switzerland are likely to persist for a while yet, but with inflationary pressures set to grow, it’s more important than ever that clients remain invested in the market. Prudent portfolio selection will be key, but with so much uninvested institutional capital still on the sidelines, corrections should be seen as buying opportunities, not a catalyst for running to the hills.
In conclusion, we are advising our clients to hold their investments. As the saying goes, “it’s not timing the market, but time in the market”. The greater part of wealth accumulation over time has to do with sticking to your investment goals.
Should you wish to have a conversation about your finances in 2022, please don’t hesitate to get in touch with us for a quick chat or a full financial review.