Glass half full or half empty?

The worst start to the year for US stocks since 2008.

How did it all go so wrong, so quickly?

Well in the same way as investors chose to ignore many risks in 2021, many have awoken to the harsh reality that sentiment has turned and what didn’t matter in December is now a potentially big headache in 2022.

The negatives have been well flagged by pockets of the investing community. Mike Wilson from Morgan Stanley has to his credit been on the mark over 2021, with the prospect of a tightening Federal Reserve into a mid to late cycle US economy.

Or simply, interest rates will rise while economic growth may well be slowing.

The main concern for the US Central Bank is whether inflation expectations are becoming embedded in the consumer and employee psyche.

The central banks around the world have been trying to create inflation since the 2008 GFC and it took a one in one-hundred-year pandemic to deliver their wishes.

Supply chain constraints (as increasingly identified in the US quarterly results and the upcoming Australian earnings reports) have been a problem.

The virus has impacted economies in ways I suspect not even the most seasoned economists would have predicted; from supply shortages to pent up demand for durables rather than services, and major structural shifts in the labour markets.

Baby boomers have been retiring early, immigration has declined, and people fear going back to work because of the virus, thus labour markets have tightened back to peak levels not seen for over a decade.

As usual the devil is in the detail. Tighter labour markets are a desired outcome by central banks, but major labour shortages cause wage inflation demands to break out above the 2-3% band and that is not desirable.

Hence why many expects are arguing investors should buckle up for the about turn from cheap money (zero interest rates) to higher interest rates.

This has been well flagged including by Shareplicity in our last few BLOG posts. However, the central banks will be led by the economic data, so only time will tell how `persistent or transitory inflation is.

Higher rates but how high and for how long?

This is the real nub of the problem. One camp believes inflation will remain higher for longer versus the second camp holds that inflation will start to trend down year-on-year in 2022, particularly in the US, where the rate has been notably high at 7%.

The head of Norway’s Sovereign Wealth Fund (which according to the FT owns 1.5% of every listed company in the world), is in the first camp and expects returns to be considerably lower as rate rises and inflation bite.

Inflation matters because while some inflation is good and desired, too much inflation is bad for our economic prosperity. That’s why, in January, the US Central Bank issued a more hawkish tone than previously raising the possibility of increasing the Federal funds rate by as much as 50bpts (0.5%) at the March meeting.

The markets are now what is called ‘pricing in’ (expecting) 7 rate hikes over 2022.

The adjustment to the higher interest rates although flagged in 2021 has become more probable than possible in the mind of Mr Market and this, alongside ongoing supply chain problems and earnings downgrades, helped take markets down in January.

Remember that as interest rates rise, valuations are lowered particularly for growth stocks that have a longer lead time for future earnings growth. High flying tech and bio tech stocks in the US have been nothing short of crushed from their 2021 highs. Zoom and Moderna, down almost 70%, are often cited as the pandemic stocks that experienced extreme FOMO and meme like behaviour.

In Australia some tech favourites have also been hit such as Xero (-30%) and Wisetech (-27%).

Where to in 2022?

Well so far, all the predictions of volatility that is wrought by tightening central banks has come to fruition. Australia won’t be immune, although we are not the US, and our inflation rate is more than half of the US’s current rate.

Whether the more hawkish predictions come to pass will depend on how the monthly inflation readings evolve.

There remains a lot of uncertainty to rattle markets, including earnings reports where misses on either results or guidance can create big selloffs – Netflix (-25%) and Ansell (-20%) – or where better than expected results and good earnings guides can create positive moves, such as Apple (+7%) and Microsoft (+2%).

US quarterly reporting will continue for a few weeks and Australia’s earnings season starts in February.

This year there is also geo-political risk with Russia posturing on Ukraine’s borders in a show of brinkmanship and the West pondering the perennial question: will China reclaim what they believe is theirs, Taiwan, after the Beijing winter Olympics?

There is a lot happening to unsettle markets, not only shares, but the bond and currency and commodities sectors.

Then there is a Federal Election in May in Australia and the midterms in the US in November.

Markets don’t like uncertainty and with so many narratives and trading strategies around, not to mention the computers whose black box algorithms can flip a 2% market fall into a 2.5% positive gain in one day, it makes it challenging for most retail investors.

The real issues in my mind are will central banks like the Federal Reserve cause a recession? And how embedded are the secular trends of 21st Century (as discussed in Shareplicity books) versus the return to a higher inflation world of more value/cyclical stocks?

While my thinking may align with some schools of thought more than others, i.e. secular trends will remain in place, I’ll keep tuned in to the risks in share markets this year and accordingly have a reasonable amount of cash on the sidelines to be deployed.

Companies that have strong balance sheets, proven track records of resilience in earnings during tough times and strong brands or market positioning have the potential to keep-on-keeping-on for investors.

Then it becomes a question of valuations and these will largely depend on when stock markets form a bottom. Some stocks have been so sold off so much that surely the bottom has been reached?

As is usually the case with share market corrections, the bottom is only visible in hindsight, and. when a stock price forms. a bottom may not necessarily be in step with when an index bottoms.

Arguably, with a further 10% to 15% sell off in markets, one would have to question how resilient big tech prices would be in the face of more index selling?

Conclusion

There is a lot of uncertainty and many ‘what-if’ narratives in share markets.

Having grown up in the 1970s, when I witnessed my mother’s grief and stress at losing jobs, and her struggle with the cost of living in times of high inflation, I am hoping that the inflationist camp does not prove correct and would say ‘careful what you wish for’.

Central banks will stay in tune with the ongoing economic readings, and an ongoing pandemic could well delay a resumption to normal in supply chains.

Markets and stocks usually overreact to the downside and the upside, bringing more volatility and, for me, that means keeping cash on the side lines to buy the quality stocks in the sell offs.

Disclaimer: Shareplicity offers information that is only general in nature. It does not take into account your personal financial situation, needs or objectives. Nor does it take into account the financial needs of any specific person. You should consider your own personal financial situation and needs or seek financial advice before making any decisions based on this information.

The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, nor is it intended to serve as the primary basis for an investment decision. Prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. Past performance is not a reliable indicator of future performance. Investment involves risks. The value of an investment and any income from it can go down as well as up.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass.

 

A simple approach isn’t simplistic