The past few weeks have seen equity markets suffer significant losses, most notably in the U.S. where the S&P 500 fell nearly 9% month-to-date at the time of writing, and the tech-heavy Nasdaq 100 fared even worse with 13.5% losses. Meanwhile, Canada’s S&P TSX has held up better with losses contained at about 3% during the worse of the January storm. Although we have been expecting equity markets to experience more volatility in 2022, we think the recent bouts of equity volatility have been largely fueled by investors’ concern that the U.S. Federal Reserve (the “Fed”) might remove monetary stimulus faster than expected. Not only by rising interest rates, but by also trimming its balance sheet, which is approaching a staggering USD $9tn in value (Source: Federal Bank of St. Louis).
Long-Term Perspective on Market Turbulence: Nothing unusual in January
Since 1950, the S&P 500 has experienced six violent selloffs which caused +30% drawdowns, and half a dozen more events which shaved between 20 to 30% in the price index. So, while the year-to-date performance of equity markets can shake investor confidence, we think it’s crucial investors examine the recent softness of equities by considering a longer historical perspective: 10% down moves over short periods of time are the norm, not the exception. In 2021, the S&P 500 experienced a remarkedly benign rally where investors endured relatively little pain as the maximum drawdown was a mere 5% soft patch. The year 2017 was also exceptional when the S&P 500 registered positive performance during every month and experienced the most benign drawdowns for a calendar year with the worse event shedding only 2.8% from the index. Such a smooth-sailing market environment is rare, but the recent market turbulence is a good reminder of what equity investing is about: it involves some manageable risks, which in turn allows for harvesting rewards.
Filtering Large Macro-Economic Shocks vs Market Noise: Investors should focus on economic activity and earnings
For investors, we think the biggest challenge their equity portfolios face are market turbulences caused by economic recessions. Because recessions cause a big dent in revenues and earnings, thereby fueling a spike in credit defaults and financial stress, while damaging near-term investor confidence, history shows that equities always struggle the most during recessionary periods. Furthermore, because economic activity typically rolls sharply into a recession, the cyclical throughs of equities are generally found in the early days of a recession, where investor confidence is the lowest and fear about the economic outlook often gets extrapolated too far negatively.
We think the main driver of fear for markets so far this month has been the scope of seeing significant tightening by the Fed into 2023. This week’s Fed’s decision confirmed market expectations that the Fed will normalize policy to tackle inflation (Source: Bloomberg), but we continue to think that it will be far more challenging to tighten policy in 2023 if interest rates approach their previous cycle high of 2.5% and the growth and inflation outlooks have largely normalized.
Geopolitical Risk: Time to fear military escalation in Eastern Europe?
News over Ukraine-Russia tensions have been worrisome in recent weeks, but we continue to expect the situation will be resolved by diplomatic negotiations. One of the key issue at play is for Russia to be able to initiate natural gas shipments to Germany–whose energy supplies have been a major concern in recent months–through the newly completed Nord Stream 2 pipeline (Source: Euro News).
Implications for Portfolio Positioning
Our 2022 base-case scenario assumes heightened market volatility for the year, driven both the policy outlook of the Fed and U.S. politics. Expectations of higher market volatility partly motivated why our tactical equity overweight is a bit lower than it was last summer.
Our game plan in recent months has been to tactically buy equities into episodes of market turbulence such as those experienced since September. Because our investment thesis calls for a solid macro backdrop that will fuel strong and better-than-expected earnings growth, while interest rates will drift higher, we continue to see equities as attractive versus fixed-income. Finally, considering our view that recent market developments seem exaggerated, we began buying equities late this month as we see equities overreacting to Fed-tightening fear.
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