What’s behind recent stock market falls?
Investors are worried that rising interest rates, and slower consumer spending, will bring the remarkable post-pandemic recovery to an end. After adjusting portfolios earlier in the year, we are well placed to weather the latest bout of volatility.
In our outlook for 2022, we warned that equity markets were likely to be more volatile this year. With global equities fast approaching “bear market” territory – a 20% drop from their highs – this is now very much the case.
While the US has significantly outperformed other global markets in recent years, that has not been the case in the latest sell-off. The S&P500 has fallen close to 17% this year, very slightly underperforming the MSCI World Index.* This is partly explained by the strength of the US dollar, which reduces the value of the overseas earnings generated by US multinationals. The US market’s higher exposure to sectors that have been particularly out of favour – such as technology –is another factor that has contributed to the weakness.
Our base case remains that we will see global economic growth slow over the next twelve months, but remain in positive territory. We also expect to see a continued rise in corporate profits, but again at a far slower pace than in 2021. On this basis, we retain a “neutral” exposure to equities, in-line with our long-term asset allocation. As we explore below, we have made some changes within our equity allocation reflecting our somewhat more cautious stance.
The end of the cycle?
The key driver of the ongoing sell-off is the concern that the post-pandemic recovery is coming to an end. Inflation has caused consumer confidence to fall sharply, with the potential for spending to follow suit. Higher interest rates will also make life more difficult for businesses and those with debt to finance.
In an ideal world, the Fed would be able to raise interest rates slowly enough to engineer a so-called “soft-landing”. However, this will not be easy given that inflation is still very high and may require a significant increase in interest rates to bring it back to target. This looks all the more likely given that “stickier” prices such as rent and wages have also been rising quickly. In other words, inflation is not simply a reflection of what is going on in volatile commodity markets.
Schroders’ Chief Economist Keith Wade notes: “Past experience shows the recessions of the 1980s and 1990s followed a similar pick up in inflation to that being experienced today. While there was much talk of achieving a soft landing during these periods, this was not to be”.
Still, a hard landing is not a certainty. In late 2018, equities suffered heavy losses amid concern that global growth would be derailed by higher interest rates. The Fed subsequently reversed direction and signalled it would cut – rather than raise – interest rates. Markets swiftly rebounded. It is possible we could see something similar happen if inflation does start to cool, allowing the Fed to back away from its current “hawkish” stance.
Focusing on quality
More speculative areas of the stock market have been under pressure since late last year. However, the sell-off has since become more broad-based, encompassing more cyclical sectors that were set to benefit from the pandemic recovery. This suggests growing concern of a more generalised economic slowdown.
In this environment, “higher quality” businesses with strong balance sheets and resilient margins are better positioned. This is very apparent in relative performance. Taking the technology sector as an example, a Goldman Sachs index of non-profitable US tech companies has fallen 51% this year (on a total return, sterling basis) – compared to a 16% fall for a quality tech basket.* A similar pattern can be observed in other sectors and markets.
High levels of retail participation in the US stock market could mean this sell-off has more of an impact on consumer confidence than is normally the case – especially when coupled with the rise in living costs. Many retail investors gravitated to areas of the market that have been hardest hit – such as non-profitable technology. Reversal of the huge flows into these areas provides another reason to stay focused on higher quality areas of the market.
We have been positioning for a more “stagflationary” environment – a period of higher inflation and low or slowing growth – as well as higher volatility. This has helped us to withstand the recent drawdown in both equity and bond markets.
Within our equity allocation, we have reduced our exposure to small- and mid-cap companies. At the same time, we have tilted portfolios towards higher quality companies with stronger balance sheets and greater ability to pass on cost increases.
We are also in the process of increasing the defensiveness of our fixed-income holdings. We are reducing our exposure to emerging market debt, which could remain under pressure in more volatile markets. We are also slightly increasing our allocation to shorter-dated government bonds. We think these now offer a relatively attractive yield compared to cash and could help protect portfolios in the event of a recession.
We continue to hold alternative assets such as gold, commodities and absolute return funds which we think will help protect portfolios against continued high inflation.
*Based on closing price on 23 May 2022