A Look at Global Financial Markets 4.02.22
This Investment Strategy update aims to provide clients with a comprehensive picture of the global economy and regular updates on current stock market and fixed income trends, in order to assist investors in making informed investment decisions. It is headed by Tom Elliott, deVere's International Investment Strategist, who produces regular updates on a wide range of topical investment issues. Please find below the update from 4th February 2022.
Market sentiment: Global stock markets are volatile, investors are nervous. The two most common explanations are tensions over Russia’s designs on Ukraine, and the US Fed’s surprisingly aggressive statement, following its policy meeting in late January, in response to 7% December inflation. The market has gone from pricing in one rate hike in the US in 2022, at the start of the year, to pricing in five -with the first now expected in March.
Rising inflation and interest rates are occurring while economic and corporate earnings growth decelerate, after the strong bounce-back of 2021. As we described in the last Investment Outlook, this is a classic inflection point in the economic cycle, current market volatility -and the pain going through tech stocks at the moment- can be ascribed to mid-cycle blues. Financial history suggests that long term investors with a balanced, multi-asset portfolio, are best placed to ride out such periods of market nervousness as the macro-economic conditions alter.
Tech stocks: After outperforming during most of the pandemic period, tech is now fading as a favoured investment theme. Sharp falls for Netflix, Meta (parent company of Facebook), and some other NASDAQ giants have contributed to the tech-heavy index falling by around a fifth from its November all-time high. The decline of US tech has also pulled down the S&P500, leading to relative outperformance in recent months from value-heavy stock market indices, such as the FTSE100.
The reason is that rising inflation and interest rates have increased the opportunity cost, to investors, of making ‘jam tomorrow’ bets. Companies that rely on the promise of growth always do badly in such an environment, as investors want to see their investment deliver returns sooner. The first tech stocks to suffer were those that didn’t make a profit, the ones for which there was no certainty of investors even getting their money back. As interest rate expectations have increased, investor nervousness has extended to profitable tech companies that have complex stories of weak growth in existing services, but promises of as yet untested technologies that require millions of dollars of further investment that may, or may not, deliver profits (eg, Meta reporting its first decline in daily active users on Facebook, while maintaining heavy investment spending in developing ‘metaverse’ technology).
The rotation we are seeing, from growth into value stocks, may have further to go. However, after the falls that we have seen, investors should be cautious about trying to ‘time the market’. Too often a recovery rally can kick in just when despair is being felt most acutely by an investor. Meanwhile, in a balanced multi-asset portfolio, value stock markets and sectors will have gone some way to make up for the decline of tech holdings. For example, materials, energy, financials, industrials are ‘jam today’ sectors that offer investors some protection from inflation through their pricing power and relatively generous dividend payments.
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The Bank of England leads the way: This week the Bank of England raised interest rates, again by 25bps, taking the main lending rate to 0.5%. It says it expects inflation to reach 7.25% in April, the highest in 30 years. The Bank also announced it would reduce its balance sheet, by selling off corporate bonds acquired during earlier quantitative easing programs. It will also stop reinvesting the money it receives as bonds mature. It is showing a determination to bear down on inflation that was missing during the summer and autumn of last year, but the question remains how effective tighter monetary policy can be when the prime driver of global inflation at the moment is a series of supply side shocks.
Higher borrowing costs will not ease labour shortages (primarily caused through EU workers leaving the EU, elderly workers leaving the workforce and Covid-related disruptions). Neither will they affect demand for more-costly energy, food or other essentials. As we have argued before, central bank policy today -whether in the US, UK, or eurozone- is about managing inflation expectations in order to head-off wage inflation. Most central bankers still believe inflation will roll over in the spring and summer, of its own accord, and the biggest risk is that wage growth creeps in before then, creating an embedded wages/ prices spiral.
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The debate on quantitative easing continues: Anyone who was watched the recent BBC two-part documentary ‘The decade the rich won’, might have been surprised to learn of the scepticism being directed at the Bank of England, and other central banks, over their asset purchase programs, of which QE is the best known type. Even Mervyn King, who as Governor of the Bank of England during the global financial crisis introduced the policy to the UK, appeared to harbour doubts over its worth. This is after almost $32 trillion has been spent by central banks on such programs since 2000 (to put that into perspective, it equates to around 15 times the size of the UK economy).
The House of Lords wrote a scathing report on the UK’s experience of quantitative easing last summer, accusing the Bank of England of -in essence- woolly thinking. It notes that asset prices rose, as the Bank of England bought bonds and risk-free rates fell. This was predictable, and part of the plan. But what did not happen was an increase in bank lending to stimulate growth. Neither did it happen after the 2016 bout of QE that followed the Brexit referendum. The banks that sold the bonds to central banks were expected to use their increased reserves to lend to businesses and households. Instead, they built up their reserves to repair their balance sheets. A similar story can be found in the euro zone and, though to a lesser extent, in the US.
Furthermore, and this persists to today, the very low interest rates that central banks had engineered to stimulate demand for loans deterred banks from lending – because the profit margins became so slim. Why take on the risk of lending if the profit margin has been shrunk so much? (Being the difference between the cost of funding, and the interest rate charged on loans to customers).
The Covid-19 related asset purchase programs again helped lift asset prices, as the risk free rate fell. But, again, they have not contributed notably to a sustained increase in credit growth and spending. Instead, where we are seeing evidence of demand-led inflation it tends to be attributed to fiscal policy not because of an increase in bank lending (eg, bursts of US consumer spending following receipt of emergency stimulus cheques during the pandemic).
Critics maintain that QE has simply made those with assets richer, so increasing wealth inequality. Meanwhile central banks will struggle to ween governments and economies off the drug of cheap money that they policies have created.
But defenders of QE point to the urgent need in 2008 and early 2009 to avoid global recessions. The time lag between interest rate cuts and their effect on the economy, the argument goes, is simply too long to avert catastrophe. Something more radical was needed, and QE did the job. When the pandemic started, with global interest rates already at near-zero, or below, an additional argument for QE was that interest rate cuts would be ineffective, and QE was the only tool left in the tool box.
Crucially, by avoiding a prolonged recession -possibly a globally depression- in both cases, unemployment was kept to relatively low levels compared to previous downturns. And this is the key argument: previous recessions have left a legacy of long-term unemployment, that carries with it a broad range of social and economic problems. QE helped minimise unemployment, and so has reduced the long-term scar on the economy of the two crisis.
Stay well!
deVere's International Investment Strategist