How to put the market sell-off in context
Global equity markets had their worst week since early 2021, driven by concerns about tighter Federal Reserve policy, the current tensions between Russia and Ukraine, and disappointing earnings calls from some high-profile companies.
The S&P 500 and Euro Stoxx 50 ended the week down 5.7% and 1%. Emerging markets also declined, but overall outperformed most developed markets, in part due to strength in commodity prices and cuts to key interest rates in China.
By global MSCI sector index, staples (–1%), healthcare (–2.6%), and energy (–0.8%) outperformed, as investors favored defensive and commodity-linked sectors, while technology (–4.4%) and consumer discretionary (–4.4%) underperformed due to concerns about rising interest rates and the impact of higher inflation on corporate margins and consumer spending.
In rates markets, the US yield curve flattened as markets priced higher interest rates in the short term (US 2-year yield +5bps to 1.01%) but weaker growth and inflation in the long term (US 10-year yield –4bps to 1.76%). The Japanese yen and Swiss franc strengthened (0.4% and 0.3% on the week respectively) on safe-haven flows.
How do we interpret this?
For much of the last decade, market volatility has been calmed by the notion that the Federal Reserve and other global central banks have stood ready to step in to support the economy in the event of weakness, exogenous shocks, or an unexpected tightening in global financial conditions. Today, with inflation still elevated, that support feels less certain, and this week’s Fed meeting is likely to underscore its shift in policy priorities away from supporting growth and toward fighting inflation.
The sense of market insecurity has not been helped by weak results among some of last year’s big stay-at-home winners. Quantitatively, the earnings season has been pretty good so far: Earnings have come in 5% higher than estimates on average. Yet market fears about margin pressures were accentuated by results at some US financial companies.
Rising tensions between Russia and Ukraine have created a tail risk, which can be difficult for investors to interpret and price. The 2014 Crimea crisis had a limited effect on global markets. However, disruptions to oil and gas supplies at a time when the supply-demand balance in the market is already tight could trigger much higher prices in the short-term and disrupt global economic activity.
Taking all this together, an increase in market volatility and a growing sense of investor unease are understandable. Yet there are some important facts to keep in mind:
Ø The current sell-off says as much about the recent lack of volatility as the presence of it in 2022. The S&P 500 is now 8.3% off its highs, and the past week was the worst for global equities since early 2021. Yet such sell-offs are far from unusual. On average historically, the S&P 500 suffers two drawdowns of greater than 5% per year.
Ø The scale of the current drawdown is now consistent with other previous “real rate” shocks in recent history. Since 2010, there have been six episodes when real interest rates have risen more than 0.4% in three months. During these events, the S&P 500 fell 6.7% on average. So recent history suggests that further equity market downside may be limited.
Ø Negative sentiment can be a good contrarian indicator. The latest weekly survey from the American Association of Individual Investors showed that only 21% of respondents expect stocks to rise over the next six months. This is lower than 97% of all readings since 1987. When the ISM is higher than 55—the latest reading was 58.7—and less than 25% of respondents in the AAII survey are bullish, stocks have on average risen 19% over the following year. The worst 12-month return on the same parameters was a loss of just 3%.
Ø Interest rate hikes are not an unambiguous negative for equities. Since 1983, stocks have risen by an average of 5% in the three months before the Fed’s first rate hike. And, while volatility can pick up just after the Fed starts to hike, stocks have risen by a further 5% in the six months after the Fed starts to raise rates.
Ø Data on COVID-19 has been reassuring. So far, 2022 has brought mostly good news around the primary market fear in late 2021: the omicron variant. Although uncertainty remains about potential supply chain disruptions in China, restrictions on movement are being eased in many developed markets with growing evidence that healthcare systems should cope with the highly transmissible yet relatively mild variant of COVID-19.
With a number of critical market factors still in flux, the short-term market direction can remain volatile.
But for longer-term investors, we don’t think it is a bad thing if market volatility takes some air out of the more speculative corners of the market. Nor is it a bad thing if current volatility means that some secular growth names are being offered at their best prices in months. It’s important to remember economic growth remains robust, which should support cyclical and value sectors in the short term. We keep our end-2022 S&P 500 price target of 5,100.
What should investors do?
1. Look for parts of the market less sensitive to interest rate hikes.
In our Year Ahead report, we highlighted that our preferred sectors included energy and financials, both of which have outperformed year-to-date and should remain relatively insulated against (or even benefit from) rising interest rates. Within fixed income, we also like US senior loans, whose 4.4% yield and floating-rate structure should also be attractive for investors seeking income.
2. Balance cyclical exposure with healthcare.
We continue to like healthcare as a defensive sector as it combines some insulation from economic and policy uncertainty with structural growth qualities. The global healthcare sector offers a beta of 0.8 to the overall market, and we see valuations as cheap relative to their long-term average. Over the past 20 years, MSCI ACWI Healthcare has traded at an average 9% price-to-earnings premium to MSCI ACWI, but today is at parity with global equities.
3. Consider commodities as a geopolitical hedge
As a whole, we would expect equities to suffer in the event of a severe escalation in the Russia-Ukraine stand-off. However, energy stocks and commodities would likely rally. Independent of the geopolitical situation, energy stocks are cheap given recent oil prices and our medium-term outlook.
4. Use volatility to build longer-term exposure.
A period of elevated volatility in the short term can be used as an opportunity to build long term exposures. In our Year Ahead, we highlighted our view that the ABCs of technology—artificial intelligence, big data, and cybersecurity—offered some of the most attractive earnings growth rates over the next decade. Volatility-selling strategies can enable investors to earn a yield while waiting to potentially buy into secular growth at a discount.