The last three months of 2021 were a mixed bag for equities. At the beginning of the quarter, major equity markets rallied, largely driven by the consensus that the newly identified Omicron variant was less severe than previous strains of Covid. However, as the end of the year drew closer, both value stocks and cyclical sectors started to come back into favour. For example, the banking sector performed well towards the end of the year due to the prospect of rising interest rates in 2022.
We have seen a continuation of this trend throughout January. Growth sectors, such as technology, have seen significant pull backs and in turn this has caused wider movements leading to incredibly choppy markets. The Nasdaq index (US tech) entered correction territory this week (down -9.9% month-to-date), but unfortunately it hasn’t just been technology that has suffered. Growth stocks that have benefited from significant price increases through the pandemic have also seen prices pull back.
Why have markets behaved this way?
A more hawkish attitude from the US Federal Reserve (Fed) has been a major factor. Announcements from the Fed indicating plans to reduce their balance sheet and tighten monetary policy have caused short term market disruption. Also in play is UK and US inflation – both jumped to their highest annual rate for 30 and 40 years respectively. With inflation at its highest level in decades, interest rate hikes are now being priced into markets, with expectations that the Fed will raise rates as early as March.
Such high levels of inflation tend to impact valuations of growing businesses. Currently, investors are weighing the longer-term impact of higher borrowing costs, and higher prices in general, on the earnings potential of growth-based businesses. Therefore, tech and growth stocks usually suffer disproportionate setbacks. The opposite is true for value stocks – they will typically outperform when inflation is high and interest rates are increasing. As such value stocks such as banks and energy firms have performed well over the first few weeks of the new year.
The above graph demonstrates what a tough start to the year it has been for world equity markets. On the other hand, the UK market has moved higher. Largely speaking, this is due to the UK market’s value bias vs a growth bias for global equities.
Finally, weighing further on returns has been a strengthening pound. Whilst those that have manged to travel abroad in the first few weeks of the year will have benefited from British pounds buying a bit more, when sterling strengthens it essentially causes assets held in a foreign currency to be worth less when priced back into GBP, and therefore can weigh on sterling denominated returns (a portfolio based in pounds). The below chart shows the appreciation of GBP vs USD since late December.
World equity markets are lower today than they were at the beginning of November 2021 and whilst the near future is likely to remain volatile, as the outlook for inflation, interest rates and indeed COVID becomes clearer, markets should benefit from more stable and, in turn, more favourable conditions. We have a positive outlook for the year, especially within the equity space, which is reflected in portfolio positioning.
Source: Refinitiv – Market returns as at 20/01/2022