INVESTMENT UPDATE

Looking beyond the market downturn

  • Shunil Roy-Chaudhuri
  • 09 February 2022
  • 7 mins

Financial markets have had a nervy start to 2022, with declines in many different types of assets. This reflects market concerns about inflation, possible interest rate rises and tensions over Ukraine. But it is worth remembering that such declines are not unusual in financial markets and that investing for the long term can potentially help ride out such turbulence. Moreover, we can take steps to try to limit such declines within a portfolio.

Almost all equity (share) markets are down so far this year. The US has led the way in declines, with the MSCI North America index falling by 9.6%. But Asia Pacific equities (as captured by the MSCI AC Asia Pacific ex Japan index) are down by 5.1%; the MSCI Europe ex UK index has fallen by 4.9%; and, in emerging market equities, the MSCI EM index is down 3.2%.*

Modest bond declines

Global fixed income (or bond) markets have also fallen, although not as much as equities, since the start of the year. Global corporate bonds (as captured by the Bloomberg Global Aggregate Corporate index) have declined by 2.7%. And global government bonds (as reflected in the Bloomberg Global Aggregate Government Treasuries index) have dropped by just 1.4%.* This has largely been driven by two factors. First, concerns over high levels of inflation, with US inflation, for example, hitting a 40-year high of 7.0% in December 2021. Second, by anticipated swift rises in interest rates.

Holders of bonds generally receive fixed interest payments from the companies or governments issuing the bonds. High inflation can make these fixed interest yields look less attractive, so bond prices can fall as a result, thereby making the yield larger (bond yields go up when bond prices fall).

The yield on a bond is the annual fixed interest payment divided by the bond’s price. So a bond with a price of £100,000 that pays £5,000 a year in fixed income, would have a yield of 5%.

Higher interest rates can also make bonds look less attractive, as they enable investors to potentially get larger interest payments from bank accounts or newly issued government bonds. So, when interest rates rise, they can make corporate bonds and existing government bonds with lower rates look less attractive, and their prices also usually fall as a result.

Central banks worldwide have kept interest rates low to support their economies during the pandemic. But the effectiveness of vaccines and the lower threat of the Omicron variant of COVID-19 (as compared with the threat of the Delta variant) reduce the need for lower interest rate policies.

Rate rises expected from the Federal Reserve

Furthermore, interest rates are a tool used by central banks to manage inflation, with interest rates typically raised in an effort to bring inflation down. Against today’s inflationary backdrop it is perhaps unsurprising that the US central bank, the Federal Reserve (Fed), has made comments about raising interest rates. In addition, the Fed has also commented about curbing its bond-buying programme. This could reduce demand for bonds and so lead to falls in bond prices and rises in the interest they pay.

When interest rates rise, or when they are expected to rise, share prices can typically fall as the higher returns equities can potentially offer now look less attractive. And this seems reflected in the declines of equity markets since the start of the year.

Ukraine uncertainty

But tensions between Russia and the West over Ukraine have added to the nervousness of financial markets. In particular, any conflict or ongoing lack of cooperation between Russia and the West could be seen as detrimental to the supply of oil and gas. And this is perceived as likely to lead to renewed rises in energy costs and inflation.

Markets are keenly sensitive to potential upward spikes in the price of oil, which bring to mind the heady oil price rises of the 1970s. These helped create an unstable combination of stagnant economic growth and high inflation, otherwise known as ‘stagflation’. As a result, we have seen the VIX index, which attempts to measure market sentiment, rise to 30. VIX typically varies between 10 and 20, but nearly hit 80 during the Great Financial Crisis of 2008 and rose above 60 at the start of the pandemic.

Growth companies versus value companies

Growth stocks have been particularly vulnerable to this poorer sentiment. Growth companies are those whose share price is driven by their future earnings prospects rather than their current level of earnings. They include technology companies, such the giant Facebook-owner Meta and Google-owner Alphabet. The shares of growth companies have the potential to do well against a backdrop of economic expansion, when the growth prospects of the economy look solid. Equally, though, growth stocks can be seen as higher risk, due to the possibility that these future earnings won’t materialise. And, when the prospects for the economy look weaker, then the outlook for the earnings prospects of growth companies also looks weaker, which can lead to share price declines. This is what we have seen so far in 2022, with the MSCI ACWI Growth Index, which comprises global growth companies, down by 13.2%.*

In contrast, so-called value companies, whose share price depends more on current levels of earnings than on future earnings prospects, can hold up more strongly when the economic outlook weakens. This seems reflected in the performance of the MSCI ACWI Value Index, which has declined by just 3.2% so far this year.*

Falls in US and European equities and in government bonds and corporate bonds have impacted the returns of our funds, as they invest in these assets. For example, 31% of our SPW Balanced Portfolio is currently invested in overseas stock markets and 35.5% is invested in fixed income markets. The Balanced portfolio has just 15.2% invested in the UK stock market, reflecting the UK market’s relatively small size from a global perspective.

UK equity market in positive territory

The UK market, which has risen slightly so far in 2022, has high exposure to financials and energy companies, whose share price prospects can be less impacted by inflationary concerns. It also benefited from more positive market sentiment, as the UK has been quicker to deal with Omicron than other larger developed economies.

As the markets have come to expect more interest rate rises from central banks, they have also brought down their expectations for growth companies and fixed interest investments. This has impacted government bond, corporate bond and growth equity markets.

However, our view is UK inflation, although currently high, should be largely transitory. For the US, our view is recent high inflation reflects the peak of price rises following the reopening the global economy in the wake of COVID. As such we do not think central banks will have to rapidly raise interest rates any further in 2022 than markets already anticipate.

Protective measures

In light of our outlook, we have in our funds sought to limit exposure to fixed income investments with relatively high sensitivity to interest rate changes. In contrast, we have increased our exposure to those corporate bonds and higher yielding bonds that could offer some protection against longer term interest rate moves.

In recent months we have also been reducing our exposure to equities, given the economic outlook. And, during November, we also increased our holdings in commodities. As the rise in commodity prices has been a key driver of inflation, owning commodities could offer some investment shelter against inflationary pressures.

Benefits of long-term investing

We believe that these investment decisions could provide a measure of protection against current market conditions. But we contend that the best response to market declines is to invest for the long term. Between 31 December 1999 and 31 December 2021, UK equities rose by 165%* (based on the total returns of the MSCI UK IMI index). And that was despite the dotcom bust, the September 11th attacks, the Great Financial Crisis and COVID-19. We cannot say with certainty if these returns would be replicated in the future, but, in our view, they do indicate the benefit of staying invested for the long term.

*Source: FactSet, 28 January 2022

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