Volatility Starts to Bite

January 25, 2022

In the past two weeks, global equity markets sold off, with some segments like the NASDAQ already in correction territory, down 13% from its peak in November.

The key reason for this sell-off is a change in market sentiment, triggered by rising bond yields, a high headline inflation number, some disappointing outlooks from a few up-and-coming tech companies, and rising tension around Ukraine.

However, if we take a step back and focus on whether any of this has a real impact on the underlying business cycle, then the answer is likely no. It is not uncommon that a change in monetary policy direction – from stimulative to more restrictive – creates some wobbles in the market.

We have to keep in mind that bond yields are rising but are still at very low levels. Fourth-quarter earnings reported so far are solid, although the outlook became less certain, which is normal when there is a change of direction in monetary policy.

The Fed is indeed planning to raise interest rates as unemployment is nearly back to pre-pandemic levels and economic growth is strong. However, if the Fed raises rates four times this year (as the market expects) it would still only be two-thirds the level it was in January 2020. In other words, monetary policy is actually still supportive of risk assets.

Valuations of so-called long-duration stocks, which are based on expectations of strong future earnings, are always most impacted when interest rate expectations start rising because future profits become less valuable compared to profits today. That is why high-quality stocks that pay dividends, and are considered short-duration assets, outperformed in the past month.

High growth companies can regain market confidence by delivering, well, high growth. Most of the profitable large-cap technology firms are yet to report Q4 earnings. The current economic cycle should still provide ample opportunities for companies to do well.

Banks kicked off the Q4 earnings season in the US with generally positive results. Most major banks topped analysts’ estimates for profit. In the case of Goldman Sachs, although the $12.64 billion in revenue was above the $12.08 billion expected, the earnings per share of $10.81 fell below expectations of $11.76. Goldman blamed the miss on elevated expenses and revealed that higher wages pushed operating expenses up by 23%. A similar message was echoed by other banks, which also warned of headwinds from higher expenses going forward. This dampened the performance of bank stocks, which are down 10% over the past week and a half.

However, the results indicate that U.S. households, banks, and the corporate sector are in good financial standing. Lending picked up, pointing to a revival in borrowing. Given the positive macroeconomic backdrop, the outlook for credit performance is favorable. Moreover, there is an abundance of cash which suggests that the economy will be able to withstand higher rates. This environment can support equity markets in 2022. It would also support investing in credit yield solutions that have limited interest rate risk (low duration).

It’s important to note that commodities didn’t participate in the recent market sell-off, which is a potential sign of things to come from China stimulating its economy again. This will be positive for global growth. Indeed, the Chinese stock market has outperformed other markets so far this year, after having underperformed last year.

Chinese stocks currently have attractive valuations relative to the MSCI All-Country World Equity Index. Therefore, even though China’s cyclical outlook is still uncertain, it is possible that Chinese stocks will continue to outperform global equities over the near term.

Cryptocurrencies sold off sharply as they reacted to the same risk-off sentiment as high growth stocks. The crypto space is still mostly dominated by retail investors and sentiment is very much driven by the same risk-on / risk-off sentiment that is hitting growth stocks. This means that cryptocurrencies are less of a diversification than once thought but more of a speculative asset. One potential implication of this is that when market sentiment improves, crypto can potentially rally quite sharply again as well. Long-term, this does reinforce the case for holding precious metals and other commodities as part of a long-term portfolio diversification strategy.

DISCLAIMERS & DEFINITIONS

This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. 

Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.

Investing internationally carries additional risks such as differences in financial reporting, currency exchange risk, as well as economic and political risk unique to the specific country. This may result in greater share price volatility. Shares, when sold, may be worth more or less than their original cost.

Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices do not account for any fees, commissions or other expenses that would be incurred. Returns do not include reinvested dividends.

The MSCI ACWI Index is a free float‐adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI consists of 46 country indexes comprising 23 developed and 23 emerging market country indexes.

Investments in commodities may have greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.

Cryptocurrency is a digital representation of value that functions as a medium of exchange, a unit of account, or a store of value, but it does not have legal tender status. Cryptocurrencies are sometimes exchanged for U.S. dollars or other currencies around the world, but they are not generally backed or supported by any government or central bank. Their value is completely derived by market forces of supply and demand, and they are more volatile than traditional currencies. Cryptocurrencies are not covered by either FDIC or SIPC insurance. Legislative and regulatory changes or actions at the state, federal, or international level may adversely affect the use, transfer, exchange, and value of cryptocurrency.