It has been a difficult first 4 months of 2022 and while the UK market has held up relatively well, we have seen significant retrenchment across most other markets and asset classes.
In America, the S&P500 broad market has fallen by 13.5%, while the growth orientated NASDAQ has dropped by some 22%. In many respects this is a healthy re-rating of stocks whose valuations had become stretched, and it is important to note that US markets have only actually given up their gains from the second half of 2021 and remain very significantly higher than their pre-pandemic levels (see below).
By contrast, while the UK main market has achieved modest gains year to date, it remains slightly below its pre-pandemic levels and the positive price movements we have seen largely reflect the much lower relative valuations of UK stocks.
The critical question now is, are we still in the early stages of a more significant market correction or does the current pull back represent an opportunity to build positions in good quality assets at attractive prices?
To help answer this we need to understand key forces that are at play and explore how they might evolve in the second half of the year. So, what has changed so dramatically since December?
The short answer is inflation, but this has its roots in two very different problems.
The past decade has been characterised by what would previously have been considered an extreme monetary policy experiment, combining ultra-low interest rates with quantitative easing - the printing of enormous quantities of money.
In response to the COVID pandemic, the four major western central banks expanded their balance sheets by a staggering $11.3 trillion, bringing the total expansion since the 2008 financial crisis to circa $23 trillion dollars (see chart below). Ironically these novel policies became mainstream in response to the perceived deflationary threat posed by globalisation and have since been used liberally, and arguably successfully, to nurse the global economy through both financial crises and most recently the COVID pandemic.
Throughout the past decade the conundrum for many economists was to explain why all this money printing seemed to have so little impact on inflation. The answer, as is now becoming clear, is that QE was priming the inflationary pump but that alone was not sufficient. It required another trigger to enable inflation to take hold.
That trigger has been a supply side shock to global production.
The global response to the COVID pandemic was almost universally to lockdown. This precipitated a collapse in global demand and governments responded with a huge package of fiscal stimulus, in the form of furlough schemes and financial support packages, while central banks injected massive monetary stimulus with yet more QE.
This had the desired effect resulting in a rapid recovery in demand as the threat from COVID receded and economies began to reopen. This can clearly be seen in the left-hand chart below where demand contracted dramatically during the middle quarters of 2020 but has expanded rapidly again from 2021 onwards.
Less obvious, perhaps, was the impact on the supply side of the equation. Global lockdowns forced a global shut down of supply chains and capability, even greater in scale than the fall in demand. What was less understood was that supply capacity is much, much harder to switch back on. Indeed, the chart on the left above shows how supply has continued to contract month on month throughout 2021 and even today with most economies fully reopened, productive supply has yet to begin expanding meaningfully.
The net result of very strong demand coupled with very weak supply can lead to only one thing – inflation. This can be clearly seen in the right-hand chart above showing the double whammy impact of rising demand and falling supply on producer prices.
Central banks initially recognised that the inflationary spike was due to supply factors that would likely unwind naturally and resisted pressure to raise interest rates. This was the correct response. Higher interest rates will do nothing to ease supply side constraints, indeed they are more likely to make matters worse. Raising interest rates would be the correct response if the problem was a booming global economy in danger of overheating, which it is not.
In the end, Russia’s invasion of Ukraine tipped the balance. Putin’s decision to invade not only created a humanitarian crisis in Ukraine and humiliation for Russia, but it also triggered a global energy price shock that has exposed the western world’s foolhardy energy policies over the past two decades, ramped up input costs and exacerbated inflationary pressures.
With headline inflation numbers approaching double digits, central banks have been forced to respond by raising interest rates and tightening monetary policy. But they have a tight rope to walk. If they go too far or too fast, they risk tipping economies into an avoidable recession. With rising interest rates, inflation at 40-year highs and a deteriorating economic outlook, it is not surprising that financial markets have retrenched as they absorb this new reality.
Looking forward, the balance of risks is finely poised; our view is that they are increasingly now skewed to the upside and the news flow may soon turn more positive. If this is right, much of the bad news is now already priced in.
No matter how good Putin’s propaganda machine, it must be absolutely evident to the higher echelons of Russian society and in the corridors of power that the Ukraine war is a catastrophe for Russia, with a multi-decade decline in prospect. Putin himself must be realising this. Either he finds a way to reverse the situation, or it seems increasingly likely that others will. Either way, there is reason to hope that the war in Ukraine might end more swiftly than most fear and there is a real possibility of more fundamental change in Russia that could enable relations with the rest of the world to stabilise.
Progress in Russia would ease the pressure on energy prices and provide a substantial boost to the global outlook and sentiment. In addition, global supply chains are beginning to ramp up again suggesting that the supply side pressure on prices will ease over the coming months.
This, coupled with base effects working through and a dampening of the excess demand from higher interest rates and higher living costs, should see inflation first peak then start to fall back to much more manageable levels. These positive effects will become clearer in the data over the coming months even though the headline inflation numbers are unlikely to drop significantly this year.
With an improving inflationary outlook, central banks are less likely to overshoot on interest rates and the economic outlook will improve materially.
Meanwhile corporate earnings have remained remarkably robust. Excluding a handful of notable exceptions, the 1st quarter earnings season has been positive with companies demonstrating why they remain one of the best long-term hedges against the effects of inflation.
Better still, those high-quality companies represent significantly better value than they did a few months ago and, with interest rates and bond yields already resetting to much higher levels, the risk from further rises to yields diminishes every week.
One risk to this largely positive outlook is China which remains in various states of lockdown. China is key to the global recovery in productive capacity and global supply chains. The sooner China fully unlocks its economy and reopens its factories, the sooner the global economy will return to health.
We must expect to see further volatility in financial markets over the weeks ahead but, in our view, the reset is healthy and necessary to create the conditions for the next growth phase. It also provides a perfect opportunity to add to high-quality, long-term investments as valuations become increasingly attractive.
To discuss these opportunities or to review your investment portfolio please contact our Business Development team by email email@example.com or by telephone on +44 (0) 1624 654200.
Disclaimer: The views, thoughts and opinions expressed within this article are those of the author, and not those of any company within the Capital International Group (CIG) and as such are neither given nor endorsed by CIG. Information in this article does not constitute investment advice or an offer or an invitation by or on behalf of any company within the Capital International Group of companies to buy or sell any product or security or to make a bank deposit.