Investment News & Views

Volatility, inflationary pressure and the Fed – the forces shaping the market in 2022

Over the past few weeks, all markets have experienced an exceptionally high amount of volatility and reductions in values. Investment Association funds have reported that 89.7% of funds have lost value so far this year, with 7.9% of IA funds down by 10% or more.

These losses are mainly due to concerns around inflation, which have put pressure on central banks to raise interest rates. Last October, the Fed were expected to raise interest rates once in 2022. The Fed made it clear that they did not want to hamper any recovery efforts, were looking at wider inflationary statistics, and would rather err on the side of raising rates too late than too early so it would not impact those most in need. At the time, the majority of the 6.2% inflation was considered to be transitory and caused by short term, reopening and covid-related issues such as increased costs in hotels, air fare, used car sales, and supply chain delays.

This year, inflationary pressure is no longer considered transitory, and has broadened to include energy, food prices, rent, and other ‘stickier’ parts of the inflationary basket. At the same time, unemployment numbers in the US have dropped to 3.8% (with a previous recorded low of 3.5%) while wage growth has been picking up. There has also been an unforeseen structural change in the labour market as many of those who are older and wealthier have chosen not to return to the workforce.

The expectation of potentially over 4 interest rate rises by the Fed this year from an expectation of only one last year has caused a lot of concern and disruption within equity markets. It is the Fed’s remit to ensure price stability, not market stability, so they are now working to bring inflation under control. They are not only planning to end quantitative easing and potentially raise rates more than 4 times but could also be considering quantitative tightening towards the middle of the year. Overall, we expect that the level of stock market volatility the Fed feels comfortable with will be higher than in the past two years. We still expect equity prices to increase but at a slower rate than we have seen in the previous two years and with a much bumpier ride.

The increase in interest rates will have a larger impact on high growth companies which typically have a higher amount of borrowing, lower earnings, and can be highly leveraged such as tech companies and green energy. In the long run these are still areas which should have the highest long-term returns and could be new industry leaders in the future.

The US market has struggled in the past few months against the FTSE 100, but in the past few years the S&P 500 has regularly outperformed the FTSE 100. Both of the US index funds which we hold in our Guardian portfolios have had returns of over 15% over 1 year, 32% over 2 years, rising to over 90% over 5 years while the FTSE 100 has had returns of 14.96% over 1 year, 4.81% over 2 years, and 26.22% over 5 years.

Our largest allocations continue to be to US, UK, and international funds, but we also have a diversified portfolio to help protect against market uncertainty including an array of fixed income bond funds, active bond funds, and property. Diversification has long been considered ‘the only free lunch’ in markets as diversifying a portfolio has been found to increase expected returns when non-correlated or less-correlated assets are combined.

Guardian Portfolios – As all assets have suffered since the start of the year, our Guardian portfolios have also lost in value as diversified portfolios with an international mix of assets and fixed income funds. So far this year based on trends and market expectations, we have reduced allocations to emerging markets, Pacific, and most bond tracker funds originally due to some concern around less vaccinated populations and the spread of Omicron, but more recently with consideration around their ability to weather interest rate increases. The trends have continued to recommend being out of these markets and we continue to monitor all our signals weekly.

Green Path Portfolios – Most ESG portfolios have a high proportion of technology and growth companies as the majority of these companies and sectors, such as solutions to climate change, clean energy, and battery technology, are still relatively new. As growth companies, they are more likely to have higher borrowing and at this point smaller levels of earnings and may therefore be more impacted by interest rate rises. Our ESG portfolios have been reviewed by JPMorgan and found to have had a more even balance of growth and value than most ESG portfolios, but they have still been impacted by the recent fluctuation in markets. We expect growth companies to continue to grow over the long term and provide investments in cleaner and more socially just companies.

Heritage Portfolios – Interest rate concerns have had a larger impact on high growth companies which in turn have had a larger impact on our Heritage portfolios. As investment trusts use gearing to increase their returns, this also has the effect of magnifying losses in the short term. When markets recover, this gearing should also have the impact of increasing returns at a higher rate than other investments. As you will be aware, these investments are not short-term investments, but long-term investments of at least 5 years.

We expect equity markets as a whole to continue to grow over the course of the year. The growth may not be as strong as the growth experienced since the rapid recovery from March 2020, but we do expect continued growth.

Our Heritage portfolios have been most heavily impacted by investments in China and technology and US growth stocks.

China

The Chinese economy has faltered over the past year as President Xi Jinping has been focused on ‘common prosperity’ especially given the incredible exponential growth in average annual income of China’s top 10%. The Chinese government tightened monetary policy throughout last year ahead of most other markets throughout the world. But, faced with Evergrande’s default and some concerns about a slowing economy, the Chinese government is now loosening fiscal and monetary policies and has already started to lower interest and mortgage rates.

Although growth expectations are lower than they have been, there is still room for more growth than is likely to be seen in developed countries. This could especially be true in the longer term considering the sheer scale of the population included in ‘common prosperity’ as these policies shift the socioeconomic status of millions. Investments in China by Scottish Mortgage and the JPMorgan China Growth and Income fund invest in companies which over the long term will recover and may have returns many times their original investment.

Technology and US Growth Stocks

These sectors may be more heavily indebted and could therefore be further impacted by interest rate rises. As they are growth stocks, they are expected to have much higher returns over the long term than value-based investments. As investment trusts are long term investments, they are able to invest in companies such as SpaceX, Tesla, Moderna, ASML – a semiconductor company, Illumina – a biotech company, etc. Some of these companies were once little heard of but are now household names.

Investment trusts are also able to invest in privately owned companies which have not yet listed and would be inaccessible for most private investors. These are companies which investment trusts believe have a high chance of extremely high returns in the future. Investments in companies such as these can take time to come to fruition. Given the large scope and scale at which investment companies can invest, the selection of a few exceptional winners over time, as has been shown through past investments, could have growth which more than eclipses other returns.

We continue to monitor all our funds and investment trusts. Investment trusts are more volatile investments but have the potential for much larger returns in the long run. We believe in the investment companies in which we are currently invested and feel that they will be strong investments for the long term.

Please feel free to get in touch if you have any questions, or if we can help in any way.

  • Wednesday, January 26, 2022

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Tomiko Evans

Chief Investment Officer

Tomiko is Chief Investment Officer of Crossing Point and holds the IMC qualification for Investment Management.