A relaxed read on the issues of the day
It has been a rocky start to 2022 in financial markets as volatility spiked in both equities and bonds. Concerns about inflation, interest rates and a stand-off between Russia and NATO allies on the border with Ukraine all contributed to falls in markets during the month.
It’s often said that markets can only focus one thing at a time and in December that was Omicron, but as 2021 came to an end, Covid fears eased and it was the conclusion of the Federal Reserve’s December meeting that drove markets in January. With inflation proving stickier than the Fed had expected, the Fed had changed tack to rein in stimulus more quickly than investors had anticipated. Initially, the Fed will wind up its Quantitative Easing programme, with a series of interest rate hikes to follow.
With economic growth positive, albeit falling back from the high levels recorded immediately post lockdown, and with the US at full employment, the Fed believes stimulus is no longer warranted – particularly given the evidence of inflationary pressure building within the system and the potential for wage inflation in 2022. In 2021 energy and commodities were major contributors to inflation, but the Fed will have been concerned to see inflation increasing in sectors such as housing, where it has historically been more persistent and harder to tackle. Food costs have also been rising and, coupled with housing and energy prices running high, inflation is becoming visible to the consumer with a risk that behaviours may start to change. The Fed concluded that the risk to its credibility and to the economy of not acting was greater than the risk of pressing ahead, and recent data will have supported that decision.
Inflation presents challenges for equities markets, but the impact is profound for bond investors where rising inflation and interest rate expectations leads to falling bond prices. Bond markets have been adjusting to the prospect of higher rates although there may still be more pain ahead, particularly for holders of bonds that don’t mature for many years to come.
In equities, there have been falls across markets, with a sharp change in the type of businesses that have led markets. Companies with strong growth prospects over the long term had been in favour, but a higher inflation and interest rate environment has more recently favoured businesses with improving earnings prospects in the near term and low valuations. The UK stock market is naturally rich in the banks, mining and energy companies that have come into favour and consequently the UK did not suffer as much as other regions during the month. This was a reversal from 2020 and 2021 where the UK substantially lagged global equity markets. Emerging markets was another underperformer of 2021 that has done better this year, benefiting from China increasing stimulus to its economy in the wake of issues in its property sector.
Whilst headwinds persist for fixed income investors, as Omicron’s impact begins to wane, we expect economic growth to stabilise. In equities, the price investors are prepared to pay for businesses is recalibrating, but we expect pricing power and the ability to generate earnings growth to come to the fore as we move through the year.