It's the worst start in 20 years. Here's why investors should feel fine.
It’s the worst start in 20 years. Here’s why investors should feel fine.
Tue 25 Jan 2022
Entering their fourth week, financial markets have had the worst start in 20 years. A 50% Equity/ 50% Bond portfolio in the US, the world’s biggest market, has now lost nearly 5%, more even than it did during the 2008-2009 Global Financial Crisis.
A lot of analysts cite that the retrenchment is really a growth-to-value rotation. Tempting as it may sound blaming big tech valuations, the truth is slightly more complex. The S&P 500 has lost 7.7% since the end of 2021. Excluding the top seven big tech stocks (Apple, Microsoft, Amazon, Google, Meta, Tesla, Nvidia), the rest of the world’s leading index is still down 6.4% for the year, which would individually constitute the fifth-worst opening since 1971.
It’s the end of the world as we know it…
Ostensibly, the world has turned on its head. Global High Yield are outperforming US Treasuries during a sharp downturn and the FTSE 100 is outperforming all major global equities. What in fact is happening is a rotation out of some of the most overvalued securities, plus those who rallied near the end of last year, like Japan. This is a direct result of a more hawkish Fed, putting Quantitative Easing, the driving force behind asset prices for over a decade, into hiatus.
The ebb leaves those vessels forgotten by the rising tide unscathed, simply because investors have poured less fast money in them and don’t have as much to pull out. Thus, the FTSE 100 and Emerging Markets seem to be doing better than the rest of the equity world. Global High Yield have lost nearly as much as the US 10-year treasury, the bedrock asset of global allocators. Commodities also staying afloat are more a result of 40-year high inflation and rising geopolitical tensions.
The end of Quantitative Easing and the visible beginning of quantitative tightening, without the mitigating factor of a roaring economy are certainly enough to explain the ghastly experience investors have had since the beginning of the year.
…And I feel fine…
The fact that the state of the market can be fully explained, however, does not in itself give comfort. However, we believe long-term investors should not necessarily feel (too) anxious for two reasons: Ample liquidity and a receding pandemic.
We don’t really need the Fed
The Federal Reserve’s Quantitative Easing has served to heal collective trauma after the near-collapse of capitalism in 2008. When the ECB embraced the process, it managed to keep the Euro together after 2012. After more than a decade, however, investors noticed that the economic benefits, save from staving off financial collapse, have been minimal. If anything, persistent QE exacerbated global income and wealth inequalities to a political boiling point. From a financial asset standpoint, since 2008, major global central banks have added nearly $23tn in global financial markets. The number is formidable, but market capitalisation has increased by a lot more than that, nearly $43tn for equities and $73tn for bonds.
Residual liquidity is still plenty, and many are waiting to buy at better prices (and lower volatility). US corporates (ex-banks) have a record $3.3tn in their balance sheets to buy back their own shares. The top eight companies alone have more than half a trillion to spend. An expected 22% rise in earnings for Q4 should only be helpful. US households have a record 95% deposit- to-income ratio. They can afford to keep their pension accounts intact and add more at lower levels. Global Private Equity is sitting on nearly $2tn of dry powder. This unspent capital was not waiting for higher bank rates. It was waiting for more attractive valuations. And let us not forget the $1.6tn of just public money earmarked for ‘Green’ investments.
With inflation running above 5%, seasoned investors and corporates can ill-afford cash stockpiles. Simply put, there’s a lot of liquidity and powerful incentives for money to be put to work at lower prices. Central banks QE served as a reminder that powerful organisations will be buyers of the last resort, but institutional and individual investors have poured a lot more money into markets. And let us not forget that while central banks (ex-EU) are decidedly more hawkish, they do remain buyers of the last resort. Just not at the first sign of trouble. This is what letting the markets mature and overcome trauma would look like. The fact that central banks were forced to stop spoon-feeding markets due to inflation tells a story more about an overprotective parent than a needy child.
The pandemic may well be improving
Rising volatility has obscured the fact that, fundamentally, we are looking at the increasing possibility of pandemic economic disruptions ending sooner than anticipated. The Omicron variant peaked for a lot of the world almost simultaneously, which in and by itself should help re-harmonise some parts of the global value chain. The potential for the highly-transmissive but milder variant to remain dominant, coupled with higher vaccination rates and Covid-targeted medication in the pipeline, have left an increasing amount of analysts more optimistic that disruptive policy responses, like lockdowns, may become a thing of the past. Q1 economic performance may well be worst than originally expected, but the probability of a faster economic rebound thereafter is increasing. The problem for markets is that no one can be sure that we are indeed dealing with the final Covid-19 dominant variant. Therefore, an upside scenario hasn’t been priced in.
What it all means for investors
We believe that we are experiencing a Fed-driven asset rerating, not an existential threat to capitalism. If it holds true, then at the end of the process lie opportunities. With global stocks down 6% from their recent peak, we don’t have any evidence to say that we have seen the end of this correction. It could well last longer and go much deeper. Opportunistic retail buying has been rampant over the past two years and it looks like there is more to be shaken off. But we also see a lot of capital waiting for more attractive prices. More evidence that the pandemic may be near its end and an eventual plateauing of inflation pressures could be just the triggers global asset allocators are looking for to re-position at lower prices.
The outlier risk
We think that a key risk right now is geopolitical. The Crimean War (1853-1856) marked the rapid decline of the Ottoman and Russian empires, while consolidating Britain’s status as the global military superpower for decades. The same area is once again the focus of global powers. Tensions have been rising fast between the US, Russia and China. Further escalation could have unforeseen consequences for markets, especially commodities. Situations like this usually come down to last-minute decisions and/or deals, and there’s precious little investors can do, other than quickly recognise a change in the status quo when and if that happens.