Markets remain volatile. Global equities started last week on a firm note but ended some 0.5% lower and are down 2% this morning. These declines take them back down to around their low-point in late January.
The cause for today’s fall is clear, namely recent warnings by a number of countries that a Russian invasion of the Ukraine is imminent. If this does transpire, to state the blindingly obvious, markets could well fall further.
However, some kind of Russian intervention is now priced in and the market reaction will depend on the extent of the move and the impact on energy supplies. Oil is already discounting this threat, at least to some extent, with the Brent price up to $95/bbl, the highest level since 2014.
It is far from clear how long any Ukraine-related market decline will last. Certainly, the experience of most geo-political conflicts in the past, as long as they have been relatively contained, is that losses have not been that great or sustained for that long. That said, there is clearly a tail-risk that any such event spirals into a wider confrontation, inflicting more material and long-lasting damage on markets.
Moving onto matters we feel rather more qualified to comment on, the other major market focus remains policy tightening. The big question is how much central banks will raise rates, now they have belatedly woken up to the fact that they woefully under-estimated the surge in inflation.
The January US consumer price numbers made unwelcome reading. Headline and core inflation (which excludes food and energy prices) both rose more than expected, hitting new 40-year highs of 7.5% and 6.0% respectively.
Expectations of how large a rise in interest rates we will see in the US and UK over the coming year have increased dramatically over the last few months. Even so, they increased still further last week.
The market is now pricing in as many as seven 0.25% rate hikes in the US over the coming year (one for each Fed meeting), which would take rates up to 1.5-1.75%. Recent hawkish rhetoric from the Fed suggests this is quite probable and there is a fair chance that rates will be hiked 0.5%, rather than just 0.25%, at the next meeting in mid-March.
As for the UK, the market now expects rates to rise from 0.5% currently to 2.0% by early next year. Two more 0.25% rate hikes in March and May do look very likely but thereafter the pace of tightening should slow significantly. 2.0% seems an increase or two too far. Certainly, it is inconsistent with current MPC guidance although, as we learnt late last year, the latter is often little guide to anything.
Bond yields have continued to climb, although more so at shorter rather than longer maturities, leading to a flattening of the yield curve. 10-year US Treasury yields tested 2.0% last week while 10-year UK gilts are back yielding 1.55%, having yielded close to zero at their low point in August 2020.
The upward climb in yields has put global equity valuations under some pressure as was to be expected. The forward-looking price-earnings ratio is back down to 17x from a high of over 20x in 2020. This remains a little above the long-term average but seems warranted given bond yields still remain very low by historical standards.
The start of Fed tightening has in the past usually been associated with some turbulence and setbacks for equities and this time appears no different. However, just as with most geo-political conflicts, markets have generally regained any such losses within a few months.
We believe equities will in time see renewed gains and outperform bonds over the coming year. Our intention therefore remains to ride the current volatility in equities and where possible take advantage of it.
Chief Investment Officer