After blistering gains in 2021 global equity markets have had a shaky start to 2022. Global equities have dropped 4% so far this year, with technology stocks, one of the big drivers of rising equity markets, underperforming. So far this is a pin prick in what has been a stellar run for equities; US equities are still just 7% below the all-time peak reached on 3 January.
Low interest rates and quantitative easing fuelled the equity rally, but the revival of inflation has raised concerns that the era of easy money may be coming to an end. Higher interest rates depress the current value of future dividend income and equity prices. Higher rates also dampen growth, and future profits, creating an additional headwind for equities.
Interest rates, and interest rates expectations, are crucial for the equity market. The mantra in financial markets for the last 40 or so years has been “don’t fight the Fed” - since the Fed can print money without limit, and collapse interest rates, it controls asset prices. Woe betide the investor who seeks to stand in its way. That process was at work in the financial crisis and the pandemic. Huge rate cuts, and quantitative easing, helped reverse equity sell-offs even though the economy was in intensive care. Investors believed the Fed would prevail and started buying equities well before recovery was entrenched.
That view, also encapsulated in the notion that investors should ‘buy the dip’ in equity markets (the Fed will support equities come what may) has taken a knock in recent months. Now investors are worrying about the prospect of the Fed raising interest rates more rapidly, and with less regard to the consequences for equities.
A previous chairman of the Fed, in the 1950s and 1960s, William McChesney Martin, once remarked it is the job of central bankers to "take away the punch bowl just when the party gets going". In the US today, with equity markets not far off all-time highs, inflation at 7.0% and the job market running hot, the party is in full swing. I cannot think of a time when the case for raising interest rates was stronger than it is today.
The current Fed chair, Jay Powell, clearly feels the time for action has come. His comments at the press conference following the recent meeting of the Fed’s rate setting committee were more hawkish than markets had expected. In the wake of Mr Powell’s press conference financial markets have priced in five 25bps (quarter of a percent) rate rises this year, taking US rates from 0.25% to around 1.5%. Much of the softening in equity markets this year reflects an adjustment to the prospect of higher rates in the US, and elsewhere.
The Bank of England wrong-footed markets by raising UK rates by 15bps just before Christmas, at a time when the full effects of the Omicron wave of COVID-19 were unknown. Six weeks later, last Thursday, the Bank raised rates by 25bps, to 0.5%. Markets now see UK rates ending this year around the 1.25% mark. The euro area, which has exhibited more deflationary tendencies than the US and UK over recent years, is on a much slower track. The European Central Bank insists it will freeze rates at the current -0.5% through this year. However, markets have become less convinced that the ECB will be able to hold out from the global trend and are now pricing in a 25bps hike in the course of this year.
This is a more challenging world for equities, but different markets and industries have performed differently this year. A number of long running trends have, at least in recent weeks, reversed.
Investors have been rotating out of some of the best performing sectors into those that have trailed. Technology stocks have underperformed while so-called value stocks, those offering relatively high dividends, which have long been out of favour, have outperformed. The heavy weighting of technology in the US equity market, which has been such a factor in its strong growth for more than 12 years, has been a drag in the last month or so. The appeal of unprofitable companies, some in tech, has been especially hard hit because their value rests so heavily on future profits discounted at today’s interest rates.
UK equities have been a long-term laggard among developed economies, but this year they have done slightly better than most. In the last few weeks, the UK’s low weighting in technology stocks, long seen as the Achilles heel of the market, has been something of a blessing. Within the UK market the faster growing smaller and medium-sized businesses which have been the darlings of investors for years have been outperformed by the largest companies.
Commodity stocks everywhere, especially oil and gas companies, have done well, as have the equity markets of commodity-dependent countries including Brazil, South Africa and Saudi Arabia. The exception is the Russian equity market that has fallen since December on geopolitical fears and concerns about Western sanctions. At the global level an impressive ten-year rally in shares in renewables companies has gone into reverse in the last year, with a global index of renewables dropping 40% while oil and gas stocks rose by just over 40%.
It is too early to call time on the equity market rally. The last 12 years has been punctuated by equity sell-offs that reverse. An optimist would argue that in the last year markets have had to adjust to the prospect of much higher US interest rates, yet US equities are 10% higher than a year ago. Besides, what’s to fear from a peak in US interest rates of 2.0% priced into markets, far lower than the post-war norm? With the bad news on higher interest rates already priced into markets, inflation likely to moderate later this year and good growth in prospect, why shouldn’t equities make further gains?
The simple answer is that inflation, and interest rates, could rise further than is currently expected. That view was voiced last week by one of the world’s most influential investors, Nicolai Tangen, chief executive of Norway’s $1.3tn oil fund. In an interview with the Financial Times, he said that in the debate about whether inflation was temporary or here to stay, he is “the team leader for team permanent… We will have much tougher times ahead… we could see a long period of time with low returns [on equities and bonds]”. To equity bears the combination of high US equity valuations, a record share of US GDP going to profits and rising interest rates spells trouble.
The debate between equity bulls and bears ultimately hinges on inflation. If, as central banks expect, inflation softens through the second half of this year, rates will probably not need to rise much further than is already expected. But were inflation forecasts to prove as wrong in the next year as they have been in the last, we could be in for much more disruptive rate hikes. We’re with the central banks on this one – but are closely, and nervously, watching commodity, wage and supply chain data for clues as to whether they, and we, have got it wrong.
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