Correction Time

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Equity markets resumed their decline last week following a pause the previous week. Global equities fell a not insignificant 4% in local currency terms and 3.2% in sterling terms and are down again today.

As of Friday’s close, global markets had lost around 6% from their high on 4 January. There have been no major new developments to trigger the latest fall. Rather, it is mainly just a continuation of the same worries bugging markets since the start of the year, namely the surge in inflation and the policy tightening now planned to bring it back under control.

Expectations on this front have changed markedly over the last three months. The market is now pricing in four 0.25% rate hikes this year in the US and also a similar number in the UK, on top of the 0.15% move in December. This would leave interest rates at around 1.2% in both countries by year-end.

Equity corrections are far from unusual at the start of Fed tightening cycles and have in fact been the norm in the past. Sharp jumps in bond yields, as we have seen in recent weeks, are also prone to trigger market falls. The important point, however, is that these declines have tended to be temporary and followed by renewed gains.

We expect the same to be true this time. Bond yields remain relatively low and are not back up to levels which leave equities looking relatively expensive and vulnerable to a marked de-rating. The absence still of any real alternative to equities for investors looking for a half decent return should remain a significant support and trigger some ‘buying the dip’.

As for the Fed, while it has turned considerably more hawkish, we don’t expect it to push the economy into recession, which would undoubtedly pose a major problem for markets. Monetary tightening takes at least twelve months to slow activity and growth still looks set to remain quite strong over the coming year.

None of this is to say that the decline in equities could not have further to run as it is so far nothing out of the ordinary. Since the global financial crisis, there have on average each year been two corrections totalling at least 5% with one of these amounting to as much as 10%.

There is also no obvious immediate catalyst to trigger an easing of concerns and a market rebound. A marked fall in inflation would clearly be very helpful but no relief on this front is likely for a few months yet.

Indeed, the threat of a Russian invasion of the Ukraine heightens near term concerns by putting renewed upward pressure on energy prices. Oil prices have recently hit US$88 per barrel, their highest level since 2014.

In the UK, inflation also came in stronger than expected in December, hitting a 30-year high of 5.4%. Depending on the size of the hike in the energy price cap, inflation now looks set to peak in April at as much as 6-7%.

The fall in markets has been part and parcel of a sizeable rotation by investors out of expensive growth stocks into cheaper value stocks. This in turn has meant some areas of the market have fallen much harder than others. At one extreme, the high-flying darlings of the pandemic, such as Peloton and Zoom, are now down as much as 70-80% from their highs last year.

Netflix has not had quite such a rude awakening but disappointing subscriber numbers still managed to trigger a 20% decline last week. The tech sector overall is now down around 10% since the market peak and the US, with its high tech weighting, has suffered disproportionately, falling close to 9%.

By contrast, the cheaper markets have held up very well. As of Friday, UK equities were down only 1.3% since 4 January while emerging markets were actually up 1.9%. We expect value markets such as these to outperform further as so far they have only reversed a relatively small part of their previous underperformance.

Most likely of all, market volatility should remain on the high side. Concerns about inflation, policy tightening and geo-political tensions are set to remain elevated for a while yet.

Rupert Thompson

Chief Investment Officer