What do investors need to know about current market volatility?

2022 has started with significant market volatility, affecting equities and bonds, and seen most obviously in the US equity markets.

Our Chief Investment Officer, Michel Perera, discusses the key questions investors may have about the current market disruption and share price falls.

What are the reasons for the current market volatility?

Market volatility is not unusual - and we should bear in mind that in 95% of calendar years, there is at least a 5% downward move in shares; and in 63% of the years, there is a more than 10% market correction. But what we are seeing now is a reaction to a very strong 2021, in particular for US indices, which went up 26% last year and have indeed fallen more than other markets.

In addition to the technical correction, there is a fundamental reason for market volatility. The US Federal Reserve (Fed) made very clear at its January meeting that it is focusing on inflation above anything else and is willing to use all the tools at its disposal to stamp it out. Giving the strongest hint yet that the Fed Funds rate* would rise at the meeting in March, concomitant with the end of asset purchases (quantitative easing – QE), Fed Chair Powell also talked about reversing the QE process, i.e. selling assets at some point this year. The combination of these policies was probably more than many market participants had been expecting and caused significant moves in the US equity markets, mirrored in many other markets globally.

Which sectors have been most affected?

Some sectors have benefited from the recent market moves (such as energy, but also financials to an extent, known as ‘value’ stocks as they tend to be undervalued by the market and trade for less than their intrinsic worth) but most have suffered (such as technology, communications, consumer discretionary and healthcare, known as ‘growth’ stocks as they tend to be ‘over-valued’ but are expected to grow faster than either the overall economy, other industry segments or their competitors).

‘Long duration’ within growth stocks are companies with a high rating which do not return high dividends. These have been particularly affected, such as small technology shares and the ‘ARK companies’ (stocks owned by the famous ARK innovation ETF, a fund run by Cathie Wood).

Overall, small capitalisation shares have been the most affected by market moves since last quarter, while firms with strong cash flows paying high dividends have been less damaged.

How are interest rates impacting market moves?

The reason behind these moves is that the standard valuation of equities is based on a calculation of a company’s future earnings and the discount rate (the rate at which a central bank charges interest on short-term loans to financial institutions). If discount rates go up, mathematically, equity prices should go down. Of course, the discount rate is not the overnight Fed Funds rate, but a longer-term bond yield, which has risen this year but is not expected to rise as much as the Fed Funds rate.

The current fixed income market pricing is calling for four Fed rate hikes this year and the same next year, moving the Fed Funds rate from 0% now to 2% at the end of 2023. Long-term bond yields are not expected to rise by the same percentage, so the equity repricing may not be that violent. Historically, equities tend to perform well during a rate-rising cycle if economic growth is also strong, which is the case now.

It is well known that some sectors benefit from a rate-rising cycle. Chief among those are banks, but also commodity-related sectors such as energy and materials. In addition, many companies are in a position to pass on additional costs to their customers through higher prices. As we have said in our thematic views for this year, inflation is a cost to the consumer but, for the investor, there are ways to deal with inflation by selecting shares of companies that can maintain their margins when costs are going up.

What is happening across global equity markets?

There is also a shift going on in markets this year, which may or may not continue later on. After many years of the US market beating all other world equities, it seems that the rest of the world is waking up. Indeed, the UK, Hong Kong, China and, to a lesser extent Europe and Japan, have been faring much better than the US in 2022 to date, which could be an indication of things to come.

How could liquidity and corporate earnings impact market volatility?

The current volatility has to be seen in the context of the massive liquidity available to markets. We have US consumers sitting on US$5trn of cash, money supply all over the world much more supportive than during most periods, credit being widely available and in general, financial conditions being the most benign in recent history.

The other important backdrop factor is corporate earnings, which have been very strong over the last two years and show no sign of exhausting themselves. The risk of a recession, which is what normally hits earnings and triggers bear markets, is low. This is because the growth momentum coming out of post-COVID-19 fiscal and monetary stimulus is still strong. Interest rates after inflation, known as real rates, are sitting at an historically negative level, whereas restrictive real rates (higher than inflation) are generally required to halt economic growth and cause a recession.

What next for investors?

At this stage, we would suggest that the worst asset class to sit on is cash, whereas equities, which have been widely sold off, are likely to provide the long-term returns expected of them, although volatility is part of that return. 2021 was exceptional by having very little market volatility. This year seems to be back to normal, but that phenomenon should not detract from the ultimate return.

* The Fed Funds rate is the rate at which US deposit-taking institutions lend money to each other overnight on an uncollateralised basis).

This article was written by Michel Perera, Chief Investment Officer, on 2 February 2022.

In case you missed it:

• Why investing to beat inflation will be a key theme in 2022
• A guide to equities & inflation

If you would like to speak to a professional wealth manager to discuss your personal circumstances, please get in touch.

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, Canaccord Genuity Wealth Management 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 Canaccord Genuity Wealth Management is under no obligation to update the information contained herein.