It's important for investors to understand the key factors driving stocks, bonds and other assets
Thursday 12 May 2022 Author: Tom Sieber

Many investors are frustrated that a lot of the stocks, funds and bonds in their portfolios have fallen in value this year. It’s been a chaotic time on the markets and negative events keep unfolding.

Inflation is at levels not seen for decades, the first major European war of the 21st century has broken out, and after years of ultra-low interest rates central banks are starting to tighten monetary policy.



Investors face a tricky task of determining when things might get better and what they should do with their investments in the meantime. Sitting tight and staying invested is a good strategy, but more active investors might be interested in tweaking their portfolios based on the outlook.

In this article we look at what the experts are forecasting for inflation, economic growth and interest rates and what market observers think has already been priced in. Our aim is to give a picture of how bad life could get or whether things might already be starting to improve.

UKRAINE SHAPES THE OUTLOOK

There is one key source of uncertainty which makes gauging the outlook difficult, namely the progress of the tragic conflict triggered by Russia’s invasion  of Ukraine.

As Andrew McCaffery, global chief investment officer for asset manager Fidelity, observes: ‘The war in Ukraine has already caused significant economic damage, and it will continue to shape the near-term outlook for global economies, particularly Europe. Outcomes over the coming quarter will be heavily influenced by the timeline to a resolution and the easing of trade disruptions.

‘In the meantime, any hopes for a moderation in energy prices and supply-chain disruptions have been dashed. Together, these dynamics will continue to dampen growth and put upward pressure on already high inflation.

‘This paints an extremely complex picture, both for policymakers and the markets. We believe the market has yet to reflect the full range of possible outcomes, which span extreme left and right tail risks.’

These ‘tail risks’ refer to more positive or negative outcomes than expected. In this context it’s useful to see what is being anticipated by forecasters and what are the best and worst-case scenarios.

Trying to second guess what happens next in Ukraine is difficult. Chief Europe economist at consultancy Capital Economics, Andrew Kenningham, says: ‘Unfortunately assumptions about the war have steadily got worse over the past two months. We were hoping and assuming the conflict would ease towards the end of the year.

‘Without forecasting exactly what will happen on the ground we are now working on the assumption the conflict will continue with no early resolution but also no major escalation.’

Assuming this reasoning proves correct, companies and countries may be able to adjust to the disruption but if the conflict widens or deepens in any way this could present a new risk for financial markets.

INFLATION

The supply chain issues and high food and energy prices which have contributed to rising prices remain in place. The reintroduction of Covid restrictions in China, the so-called factory of the world, has only added to these inflationary pressures.



However, there are reasons to think we are close to peak levels of inflation. Investment bank Berenberg expects US inflation to peak at 8.1% and UK inflation to peak at 8.6%, both in the second quarter.

Jennifer McKeown, at the consultancy Capital Economics, says: ‘Globally inflation is going to come down this year thanks to very strong base effects linked to the reopening of economies in the second half of last year.’

Saying that inflation has peaked, for now, is not the same thing as predicting a rapid fall in prices. Berenberg forecasts inflation will remain above 6% in the final quarter of 2022 in the US and the first three months of next year for the UK.

Consensus forecasts on UK inflation may not go far enough. Panmure Gordon chief economist Simon French was already on record as saying UK inflation could hit double digits in 2022 before the Bank of England surprised many observers with a prediction for inflation to peak above 10% at the end of this year.

This would represent the highest level in 40 years but doesn’t seem too extreme given UK inflation data, up to the end of March, is yet to reflect Ofgem’s lifting of the energy price cap by 54% at the beginning of April, with a further big increase expected in October.

The chances of wholesale energy prices easing substantially are limited by attempts on the part of European countries to wean themselves off Russian gas and oil. The US, which is effectively energy independent by comparison, is more insulated on this front.

Tight labour markets, particularly in the developed world, are also contributing to inflation as wages increase. 

Eurozone unemployment hit a record low of 6.8% in March and the US reported record job openings for the same month.

GDP

Surging inflation is one of the key reasons economists have been busily revising down growth forecasts this year. In its latest World Economic Outlook, published in April, the International Monetary Fund lowered its global growth forecast to 3.6% in 2022 and 2023. This was 0.8 and 0.2 percentage points lower respectively than in the January report.



There is little debate over whether the post-Covid economic recovery has been hit by the Ukrainian conflict. The question is whether it could be derailed entirely. We are already facing stagflation, which is a toxic combination of slowing growth and rising prices.

The yields on two-year and 10-year US government bonds recently inverted, i.e., the longer-dated debt offered a lower yield than the more short-term debt, which is often seen as a signal of recession and US GDP unexpectedly contracted 1.4% in the first quarter.

Nonetheless, non-profit research organisation The Conference Board does not believe a US recession is likely in 2022 – even under its modelling of some extreme scenarios, including oil hitting $200 per barrel.

COVID STILL A PROBLEM

The two main risks to this view are policy mistakes on the part of the US Federal Reserve and mutation or resurgence of Covid-19. Remember the pandemic continues to rage in some parts of the world.

There seems to be a greater risk of recession in Europe. Russia and closely linked emerging European economies look particularly vulnerable to a downturn but developed Europe too could risk slipping into a slowdown.

Capital Economics’ Andrew Kenningham says: ‘For the Eurozone overall we are forecasting almost flat second and third quarters with Italy and Germany at risk of falling into technical recessions; France and Spain should avoid that.’

A technical recession is defined as two consecutive quarters of negative growth and while the Bank of England thinks this fate can be avoided, it is forecasting a 0.25% contraction in UK GDP for 2023.

Outside of the US and Europe, China may be on a different trajectory with the easing of restrictions as Covid cases come down, helping growth to increase through the course of the year. Whether it can hit Beijing’s target of 5.5% is open to question.

INTEREST RATES

The finely balanced outcomes on inflation and economic growth create a tricky backdrop for central banks. It seems certain the Federal Reserve, Bank of England and, even the laggard of the three, the European Central Bank will end the year with higher interest rates.



However, the exact pace and trajectory of those increases remains in question. In its latest update (4 May) the US Federal Reserve lifted rates by 0.5 percentage points for the first time since 2000 but signalled it was not considering a 0.75 percentage point increase in rates for now.

The central bank did nothing to suggest consensus expectations for rates to finish 2022 somewhere around 2.5% were out of whack.

Nick Clay, who runs investment manager Redwheel’s global equity income team, observes: ‘I think the Fed’s been boxed into a corner. It will lead on this, but bond yields particularly in America have already priced a lot of that in.

‘Corporates and governments because of their levels of indebtedness are going to find it difficult to suffer higher interest rates for any length of time. By the time we get to the end of this year we will look back at this period and realise this was the peak in interest rates within the bond yield even if the Fed is still raising rates.’

The negative economic assessment which accompanied the Bank of England’s latest rate hike to 1% (5 May) suggests it may look to avoid hiking rates materially from here. Consensus expectations are for UK rates to reach a high of 2% next year but not everyone agrees with this assessment.

Capital Economics’ chief UK economist Paul Dales says: ‘We think longer-lasting domestic price pressures will mean the MPC (Bank of England’s Monetary Policy Committee) ends up raising rates to a peak of 3% next year, which compares to the peaks of 2.5% priced into the markets and 2% expected by other analysts.’

The European Central Bank may not have moved on rates yet, but it opened to the door to a July rate rise at its meeting in April.

The central bank faces an even more difficult task than the Fed and Bank of England given it needs to balance the needs of economies with very different dynamics. Inflationary pressures are also more acute in the Eurozone given its heavy reliance on Russian energy imports.

Berenberg forecasts two 0.25 percentage point interest rate rises in the third and fourth quarter of this year which would still leave Eurozone rates a long way behind those in the US and UK.

WHERE WILL THE MARKETS END UP?

How much of the increase in rates, reduced growth prospects and higher inflation have been factored in by the markets?

There is no question that investors have reacted to these events. The first quarter saw bond and stock prices fall in tandem for the first time in nearly 30 years.

The table shows how global stock markets have performed year-to-date and it paints an ugly picture in most places. The UK’s FTSE 100 index is doing best thanks to its strong commodities exposure. In the US, the Nasdaq receives the wooden spoon as investors turn away from highly rated growth stocks.

Rupert Thompson, investment strategist at asset manager Kingswood, comments: ‘The falls in both bonds and equities have been driven by the move towards stagflation, the unpalatable combination of high inflation and stagnation in economic activity. Worries on this front have been bolstered by recent developments.’

 



Will there be more pain to come for stocks? In early April, investment bank Goldman Sachs updated its year-end forecasts for the S&P 500 index in the US for a closing level at the end of December of 4,700.

This would represent a modest drop versus 2021’s closing level of 4,766 and compares with a current level of 4,125. This represents its best-case scenario. In the event of a recession the bank thinks the index could fall to 3,600.

Bank of America says there have been 19 bear markets in the past 140 years. A bear market is a 20% decline or more from recent highs.

The average price decline in these 19 bear markets was 37.3% and an average duration of 289 days. It says: ‘Past performance is no guide to future performance, but if it were, today’s bear market ends on 19 October 2022 with the S&P 500 at 3,000 and the Nasdaq at 10,000. The good news is many stocks are already there, e.g., 49% of companies in the Nasdaq are more than 50% below their 52-week highs.’



Elsewhere, Morgan Stanley forecasts the S&P 500 to end 2022 at 4,200, JPMorgan predicts 4,900 and Barclays estimates 4,800.

Gains for US stocks have been driven by the big technology companies and as Redwheel’s Nick Clay says, ‘They are very expensive. Even the best company in the world at the wrong valuation becomes the riskiest company. Your expectations are so high they can’t even deliver on those extended expectations.’

Corporate earnings are holding up well. On 29 April Factset said that of the 55% of companies in the S&P 500 which had reported results for first quarter to that point, 80% had reported earnings per share above estimates, which was greater than the five-year average of 77%.

As we write, about half of the STOXX 600 companies in Europe have reported so far and 71% of those have topped analysts’ profit estimates according to Refinitiv IBES data. Typically, one might expect just over half of companies in this index to beat estimates in a quarter.

The question is whether results for the first three months of 2022 reflect the full impact of rising input costs and reduced consumer spending. After all, some businesses are still enjoying a post-pandemic recovery in demand and may also have been able to react to inflation by driving efficiencies.

It will be worth keeping close tabs on the second quarter and first half reporting season to see if earnings can continue to beat forecasts or if mounting inflation and weaker demand start to have a wider negative impact.

Clay at Redwheel says: ‘I think interest rates aren’t going to go up as much as people ultimately fear they might have to, and therefore by the end of this year we’re going to start talking about when they are going to stop raising rates and start cutting them again. The backdrop has plateaued. We’ve had the worst of it.’

WHAT SHOULD INVESTORS DO?

Many readers will be nursing portfolio losses but it is important not to panic. It is worth having a good look at your investments and if any specific holding has performed very poorly, particularly if it has fallen more than the 13.4% year-to-date decline in the MSCI World, then it is worth taking a good look at why.

However, unless anything fundamental has changed on an individual investment then it is worth staying invested and riding out the volatility if you have time on your side. Time in the market is better than trying to time the market.

Asset manager BlackRock found that if you had invested a hypothetical $100,000 in the S&P 500 index of US stocks between 1 January 2001 and 31 December 2020 you would be sitting on $424,760 if you stayed invested but by missing just the best five days that number dropped to $268,277. Often the best days follow some of the very worst.

One way of smoothing out the impact of volatility and remaining invested in the markets is to invest regularly. By doing so you benefit from an effect called pound cost averaging.

When markets rise, a monthly contribution buys fewer shares or units in a fund. When markets fall the same contribution buys more shares or fund units.

In terms of what you should invest in, Fidelity’s Andrew McCaffery says: ‘We believe focusing on high quality companies, rather than sector selection, is the best approach given the rising geopolitical and stagflation risks.

‘Companies with pricing power and the ability to protect margins should perform relatively strongly in this environment. Equities should still provide a robust source of income, now that balance sheets have been repaired following the worst of the pandemic.’ 

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