A painful start to 2022

Some of the world’s biggest stock markets, notably the US S&P 500, had their worst start to the year since the financial crisis amid growing investor concerns about more interest rate rises than they’d expected, the squeeze on consumer incomes from inflation and the geopolitical risks posed by the Russia-Ukraine stand-off.

Going into February, stock markets had begun tentative, but short-lived, rallies. We’re braced for further volatility, but we think a market rebound is likely in the first half of this year.

As our co-chief investment officer Ed Smith explains in this video update, corrections of the magnitude we saw in January are normal. They occur in more years than they don’t, and rarely prevent equity markets from delivering positive calendar-year returns. Bear markets are rare without an economic recession, and there’s little risk of one this year.

A broad swathe of forward-looking economic indicators suggests that the US and global economies are still expanding solidly. Our analysis of some of our favoured survey-based indicators of business, construction and consumer confidence indicate there’s a less than 3% chance of the US falling into recession in the next three months. Looking at the world from the ‘bottom up’ – by way of company earnings – also suggests a recession looks unlikely. Company results for the fourth quarter earnings season are, so far, fairly upbeat (with some notable exceptions). Nearly half of S&P 500 companies have reported their fourth-quarter earnings and more than 75% have beaten consensus earnings expectations. In aggregate, these companies are reporting year-on-year earnings growth of above 25%.

With company earnings still rising, equity market declines have been driven by falling valuations, partly because investors are demanding more compensation for uncertainty around tomorrow’s earnings as they position themselves for a world in which some of the biggest central banks are hardening their efforts to combat inflation.  

The US Federal Reserve (Fed) has now opened the door to a rapid cycle of interest rate rises, while the Bank of England (BoE) has increased rates twice in successive months. This policy tightening is driving up government bond yields, and unnerving some stock investors as these yields are used to calculate the value of stocks’ earnings tomorrow in today’s prices. But rising bond yields are not ordinarily a headwind to stock markets overall, especially when this rise is due to a decent economic outlook, which is especially the case now that Omicron seems to be waning.

Inflation pressures have definitely broadened out in recent months. But we continue to expect global inflation to fade meaningfully from the spring as energy prices start to ease and spending patterns normalise. (You can find out more about our inflation outlook in our year-end InvestmentUpdate and related videos.)

Rotation in motion

It makes sense that markets are experiencing upheaval as they adjust to the prospect of tighter central bank monetary policy and higher borrowing costs. Companies that are focused on growing rapidly to create a large and (hopefully) profitable dominance many years into the future have been hit hardest. Many of these more speculative businesses have been fed with cheap money, so as the era of cheap money passes, they are likely to struggle. This has spilled over somewhat into other ‘growth’ companies that are profitable today, but have high prices relative to earnings, as investors have  been more interested in buying ‘value’ businesses that are priced more cheaply.. The leaders of this value  rally are banks, which can make more money from higher borrowing costs, and the energy companies that are enjoying a ramp-up in the price of what they sell. The rotation from growth and into value intensified sharply in January, leading to a year-to-date decline in the growth-heavy Nasdaq Composite index of about 10% at the time of writing.

We believe businesses that can reliably increase their profits faster than GDP growth should rebound well once the ‘cyclical’ gains of the pandemic reopening are behind us and investors once again crave quality, dependable earnings growth.

Meanwhile, we believe that companies whose earnings are driven partly by structural themes – such as cloud computing, green buildings and construction, or digital health and wellbeing – also warrant closer attention when easy cyclical gains are behind us. As innovations and disruption broaden out into other sectors from the giant technology platforms that have dominated returns over the last five years, we expect ‘micro’ themes to play a greater role in driving these returns. We will be talking to you about these themes more throughout the year.