Markets have started the year in dramatic fashion, with global share markets down, bond yields up and oil prices soaring. The VIX index, also known as the fear index, provides a measure of market volatility. After remaining relatively subdued for most of 2021, it has risen since the start of the year. These pronounced market movements, along with the continued uncertainty around COVID-19 and high-profile geopolitical risks, make for a challenging investment environment. With that said, history has shown that this type of investment environment creates opportunities for long-term investors who are willing to accept a certain level of risk.
What has been driving the recent market volatility?
Since the GFC, global economies have experienced an era of turgid growth and low inflation. To help combat this, central banks took on a much more prominent role, slashing interest rates to record low levels and implementing quantitative easing programmes, with the aim of stimulating higher growth and inflation. The success of these policies on real economies has been limited. Instead, this loose monetary environment has been very positive for financial markets and property, with substantial increases in asset prices.
While the human and social cost of COVID-19 has been devastating, the economic impact has been profound. When the scale of the pandemic became clear, there was a need for massive financial support to prevent economies from collapsing under the weight of higher mortality, lockdowns and higher unemployment. With interest rates already sitting at historically low levels, the ability of central banks to cut them much further was limited. Therefore, governments stepped in with record levels of spending and, in an escalation of the trends since the GFC, supported central banks as they unleashed extraordinary monetary stimulus.
This response can be deemed a success, as economic growth bounced back strongly. The relatively quick production and roll out of effective vaccines, allowing economies to reopen, has also supported the strong economic recovery, particularly via robust demand for consumer products. The combination of monetary and fiscal stimulus and strong economic growth was highly supportive for share markets and other higher risk assets, particularly growth stocks such as technology companies, up until around the end of 2021. The MSCI All-Country World Index, in USD terms, was up about 90% from the market low in March 2020 to the end of 2021.
This policy success, compounded by the intense COVID-19 related supply shocks and disruptions that continue to reverberate around the world, has, however, created a severe supply-demand imbalance. This, in turn, has contributed to a sharp increase in the level of inflation, globally. For instance, US inflation hit 7% in December, the highest in about 40 years. New Zealand’s inflation rate, which sat at 5.9% over the year to 31 December 2021, is the highest in about 30 years. In the face of this higher inflation, global central banks, including our own, have faced the challenge of having to distinguish between transitory price increases (such as those caused by supply shortages) and underlying sustained inflation pressures (such as increased wages caused by structural changes to the labour market).
Up until recently, the US Federal Reserve (Fed) and other key central banks around the world, appeared to take the optimistic view that inflation would be transitory. As such, they had not been inclined to act quickly on inflation by cutting off the monetary spigots. However, over the past couple of months the message from the Fed has changed, as it expects high inflation to be more persistent than previously expected.
In December 2021, the Fed announced that it would accelerate the reduction of its monthly bond buying programme in response to rising inflation. A policy statement on 26 January 2022 reinforced the Fed’s new stance, as it signalled that it’s likely to start raising interest rates in March 2022. The Fed Chair, Jerome Powell, said that he won’t rule out rate hikes at every meeting this year. On the back of this and based on signs that higher inflation is unlikely to be going away any time soon, bond yields (which move in the opposite direction to bond prices) rose significantly.
Higher bond yields and the expectation of further interest rates rises have led investors to reduce exposure to some of the riskier investments that they held. In particular, those higher growth stocks (especially in the tech sector) that have performed very well over the last two years and look expensive from a valuation perspective, have taken a battering. Lower quality technology companies, such as those that aren’t currently profitable, have been particularly hard hit.
Other risk factors that are bubbling away in the background, such the current conflict between Russia and Ukraine, China’s regulatory crackdown on its technology sector, missile attacks by Houthi rebels in the United Arab Emirates, and of course the continued uncertainty around COVID-19, have added to share market woes. Continuing higher oil prices, which currently sit around US$90 a barrel, also continues to feed into higher inflation.
What is the outlook over the near to medium term?
Higher inflation is expected to continue in the near term, but the medium-term outlook is less certain. What is clear is that global central banks, in particular the Fed, are now focused on bringing inflation back down towards target levels. But this brings its own potential problems. A rising interest rate environment is likely to act as a headwind to share and bond returns in the near term. Furthermore, aggressive rate increases, particularly during a time of change and uncertainty, risks pushing fragile economies into recessions. A recessionary environment would be bad for share markets and other risky assets. As such, central banks, with the support of further government intervention, will have to walk a fine line between containing inflation and sparking an economic downturn.
If they can achieve this, then we should expect to see global markets pick up, although, given how expensive financial assets appear to be, they are unlikely to achieve the high level of returns that we have become accustomed to over the past few years.
What does the increased volatility mean for your portfolios?
The recent jump in inflation expectations and the dip in investment performance is a timely reminder that there is risk associated with all investing – even for those clients that invest in one of our more conservative strategies. That said, ups and downs are part and parcel of investing and most investment markets have had a strong run since the GFC, and the COVID-19 crisis in March 2020.
BNZ’s investment portfolios are well-diversified across asset classes, countries, securities, and investment styles. They are managed by a team of professionals that uses an approach that places a particular emphasis on quality (when markets fall, higher-quality investments tend to hold their value better and bounce back quicker when things improve) and liquidity (the ability to buy and sell when you want to). This approach aims to provide a certain level of built-in protection to help shield portfolios during difficult market conditions.
Our active asset allocation (actively increasing or decreasing exposures to certain asset classes) approach also provides an added layer of downside protection. This approach is based on an assessment of asset class valuation (i.e. how cheap or expensive each asset class looks), fundamentals, and market sentiment. Global and domestic share and bond markets have appeared to be expensive for a while. As such, our strategies carry an overweight exposure to NZ Cash and an underweight position to equities and bonds. Positioning the portfolios in such a way should provide some protection against the current volatility.
Furthermore, the overweight NZ Cash position provides optionality, allowing us to reallocate this exposure to shares and bonds if they become more attractive from a valuation perspective.
The current uncertain investment environment is likely to continue for the foreseeable future. A rising rate environment is likely to act as a headwind for investment returns. With that said, markets are forward looking, and signs that inflation is slowing without curtailing economic activity too much is likely to be favourable for financial markets.
Any views expressed in this article are the personal views the author and do not necessarily represent the views of BNZ, or its related entities. This article is solely for information purposes and is not intended to be financial advice. If you need help, please contact BNZ or your financial adviser.
Neither Bank of New Zealand nor any person involved in this article accepts any liability for any loss or damage whatsoever which may directly or indirectly result from any, information, representation or omission, whether negligent or otherwise, contained in this article.