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New Year’s Revolutions

by Andrew Hardy, CFA

2022 has started with a bang! Barring a recovery today January will close out as being the weakest start to a year for global equities – down 7.0% in US dollar terms – since 2009, when markets were still spiralling through the financial crisis. While that’s enough to warrant attention, some of the underlying trends in markets have been considerably more abrupt. Nonetheless, rather than being cause for panic, we believe this is a healthy correction, led by parts of markets where the most excess had built up, and that the conditions for further medium-term progress in equity markets remain in place.

The vast majority of equity market falls have been driven by highly valued growth stocks, with the MSCI World Growth index down 12% in US dollar terms on a year-to-date basis. The ARK Innovation ETF, a widely held aggressive growth portfolio and poster-child for the dominance of growth stocks in the last few years, has fallen 27% over that period and has nearly halved from its high in June last year. From Zoom to Coinbase, Peloton to RobinHood Markets, highly valued growth stocks, many of which were direct beneficiaries of lockdowns, have rapidly moved out of favour and seen their valuations plunge, often with share price falls of over 60%. Larger index constituents are increasingly feeling the pain too; despite delivering quarterly earnings well ahead of expectations, Netflix and Tesla saw their share prices immediately slump over 20% and 10% respectively on the back of their latest results being reported.

It’s no coincidence that real yields in bond markets (the difference between the nominal government bond yield and the market’s expected rate of inflation) have been climbing rapidly since the falls in growth stocks began to broaden out. In the US, 5-year real yields touched multi-decade lows of nearly -2% p.a. in mid-November and have since climbed to nearly -1%. Real yields are still deeply negative and far below the normal historical range, so discount rates may yet need to move considerably higher before financial conditions materially tighten. Valuations for growth stocks are generally more sensitive to interest rates because they earn proportionately more of their earnings in the distant future, and the present value of those earnings is reduced more if discount rates rise, than for ‘value’ stocks.

Portfolios of value stocks have generally proved highly resilient over this period. The MSCI World Value index has only dipped 2% this year, supported by higher weightings in the outperforming financials sector, where many companies are benefiting from the rise in real yields and the energy sector, supported by a resurgent oil price. ‘Value’ stocks also tend to be more economically sensitive and should benefit most from the continued rebound in economic growth that is expected this year. Barring an extreme reversal later today, this month will see global value outperform the growth index by the most since MSCI records began in 1974. The fact that headline index returns are set to be so poor highlights how dominant expensive growth stocks have become in market indices, a risk we have long been alive to and mitigated in our portfolios.

The monetary tightening underway is set to be far more rapid than in previous cycles, clearly underlined by Fed chairman Powell’s comments following the latest FOMC meeting last week. Markets are now pricing in around five 25 basis point rate hikes from the Fed this year, along with a start to quantitative tightening (the opposite of QE). The liquidity withdrawal that this is driving is rapidly unwinding other excesses that had built up: that includes sky high valuations on speculative growth stocks, but arguably extends much further; a basket of crypto currencies*, heralded by many to be an effective hedge against inflation, is down 48% from it’s high (so far…).

We’re witnessing a material shift in monetary policy, which is likely to be mirrored across many other major economies and will continue to have significant implications for investors. Markets were remarkably benign last year, but a continuation of the elevated volatility we have seen so far this year should be expected as we adjust to this next and more difficult phase of the cycle, especially while supply chain issues persist, and inflation remains so high. Geopolitical risks, most notably around the ambitions of Russia and China, contribute further to uncertainty, for investors but also central bankers; the risk of a policy error at this point is high.

However, as things stand, we do not believe the conditions are in place for a sustained fall in broader markets. Although growth will clearly be slower than last year, recently downgraded global GDP estimates for this year from the IMF still stand at 4.4%, well above historical trend, and corporate earnings will, broadly speaking, continue to follow suit. But with such a significant shift in the monetary policy landscape coming into view, we expect the best returns are likely to come from a very different cohort of stocks than that which led returns over the past decade. As well as maintaining broad diversification, we believe it is more important than ever to include a significant allocation to value stocks in portfolios, across a broad range of industries and geographies. New Year’s resolutions rarely last beyond the end of January, but the revolution unravelling in markets may well prove more enduring.

For a more detailed outlook of the year ahead, see our latest Viewpoint article here.

Source for all data Bloomberg Finance L.P.

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