Investment Market Volatility – What’s Going On?

Once again, we find ourselves in the midst of volatile investment markets across all asset classes. In this article we look at what is occurring across investment markets, what is causing the moves; and the opportunities that begin to arise for the astute long term investor.

1. Inflation 

• Affecting both developed and developing markets
• Drivers and levels of inflation are different in each country i.e. demand from too much covid stimulus; supply firstly due to covid, then war, then Covid again in China.
• Need to pay close attention as to whether it’s mostly demand driven, supply driven, or a combination of both.
• Demand driven can be solved for by tighter monetary policy (higher interest rates) i.e. less disposable income for people to spend.
• Supply driven can only be solved by government i.e. less bureaucracy, free trade, private sector incentives etc.
• Higher interest rates will crimp demand and thereafter lead to less pressure on supply.
• However, if your central bank is going to hike rates fast and high, they better be certain that most of the inflation they’re attacking is demand driven, otherwise recession risks rise quickly.
• Inflation is impacting market pricing across all asset classes. In the case of equities – higher costs are hurting profit margins, whilst supply issues are hurting volumes. In addition, if you’re a company who has decided to overstock to avoid supply issues, you better be certain you can clear that stock, otherwise you’ll have stock wastage and/or need to significantly discount to clear stock.

 2. Interest Rates

• Interest rate markets are aggressively pricing in central bank rate hikes. This includes 10 plus interest rate rises by the Federal Reserve in the US in 2022; and almost 10 for the RBA in 2022.
• Markets are effectively assuming:

• Inflation is so high and entrenched that it needs rates significantly higher to bring it under control.
• Inflation is so high that you need to cause a recession through higher rates to bring it under control.
• Inflation is the only thing central banks worry about.

• We don’t necessarily agree with any of these premises.
• Yes, central bank cash rates need to be higher, but only as high as the economy (or market) can handle, and we question whether the economy can handle too much.
• Moving interest rates higher has slightly different effects in each country, depending on the level of consumption and the level of debt in an economy.
• In the USA, it has a significant effect on consumption.
• In Australia, it has a significant effect on the housing market.

 3. Equity/sharemarket movements 

• Equity price movements have largely been confounding since the start of the year.
• Confounding because they’re not linked to fundamentals i.e. mostly all noise and irrationality.
• Australian companies reported reasonably strongly in February.
• More than 80% of the largest US companies have beaten expectations in March quarter reporting.
• Corporate balance sheets are largely in excellent shape.
• Return differences between countries and sectors are some of the widest we’ve seen in decades.
• Valuations aren’t overly stretched at all – 1 year forward P/E (Price to Earnings Ratio):

• US – 19 times
• World – 17 times
• Australia – 16 times
• Europe – 12 times
• Asia – 11 times
• Emerging Markets (EM) – 10 times

• Value stocks/style are clearly winning out over Growth stocks/style, this is somewhat of a reversal of Growth winning out over Value over the last 5-7 years;  this is to be expected and we have seen this play out with the Allan Gray Australian Equity Fund performing extremely well in portfolios, having a ‘Value’ style.
• Within the Growth complex, the high-flying high P/E stocks with little cashflow/earnings to back up their valuations are being hurt
• The point to note is, there is a large portion of companies/stocks classified as ‘Growth’ that are actually cashflow/earnings rich, that are being caught up in the sell-off. These better quality companies are held by the fund managers in our portfolios and the drop in prices is creating plenty of opportunity for active managers. For example, the Apple share price is down approximately 15% and Microsoft approximately 20%. Do you think people will keep buying their products into the future? We think so!
• Even within Value it’s quite tough, as you need to have been significantly overweight Energy, Materials, and Banks to be winning right now.
• The problem could be, if inflation sticks around for longer, Value stocks generally don’t have pricing power (i.e. they’re price takers, not price makers) which means they can’t pass on cost increases, whereas Quality and some Growth stocks can – like the ones owned by the fund managers in the Financial Keys model portfolios.
• In addition, if central banks do go crazy on rate hikes (again, we don’t expect this), Value stocks generally have weaker balance sheets or balance sheets that will become strained quicker, whereas Quality and some Growth stocks don’t.
• There may well be more short term pain for Growth/Quality stocks, equally though, the Value trade might be short-lived
• Likewise the anti-Emerging Market equity trade might be short-lived if the USD starts to fall
• A balanced equity positioning is key until things settle down

4. Bonds 

• Has been very tough recently given how aggressively the interest rate market is pricing in central bank rate hikes.
• This has resulted in short term bond yields rising aggressively, whilst long term bond yields have risen more slowly.
• A flattening or inverting yield curve doesn’t paint a very good economic growth picture ahead i.e. recession risk.
• It could also mean that short term bond yields have risen too aggressively and will fall from here if central banks fail to get rates much higher (i.e. economic growth and/or inflation falls much quicker than they expect).
• Credit spreads have also widened due to risk-off sentiment.
• Interestingly, we aren’t seeing bad debts or defaults, so bond losses are paper losses only, considering bonds are issued at par and mature at par. They continue paying income over this time.
• Whilst yields have been rising, that means the income being generated in bond portfolios is now almost 2-3 times higher than it was 1 year ago e.g. some of the bond funds we use now have yields to maturities of 3.5%. This is still much better than interest on a bank account or term deposit.
• Bond managers are using maturing bond proceeds and coupons to re-invest in higher and higher yields.
• If central banks can’t get the 10 rate hikes that the market is expecting, falling bond yields will ensue which then provides for potential capital gains.

5. Currencies

• Very volatile at the moment.
• USD is roaring ahead based on expected interest rate differentials in the period ahead. Also stronger due to the anti-euro (war) and anti-Emerging Market currency trade.
• Interestingly, the USD usually falls during a US rate hiking cycle (no signs of that as yet).
• Commodity currencies (AUD, CAD, NZD, BRL) benefiting from higher commodity prices but then also coming off on risk-off trading days.
• Chinese growth concerns also having an impact on commodity currencies.
• It is expected that the AUD is likely to trade between US72-77c

What we’re seeing:

1. Noise
2. More noise
3. Even more noise

Noise can result in both opportunity and risk. Opportunity for those with a long investment horizon and greater risk tolerance. Risk for those that get caught up in the emotion/sentiment and sell at the bottom or crystallise losses.

The key is not to add to the noise by making portfolio changes that aren’t based on fundamentals. Trading and portfolio changes based on emotion and past performance is never a good idea.

Please refer to the charts below including valuations, earnings growth, and a breakdown of price movements.  What you can see is that valuations look reasonable, earnings growth looks strong, and almost all of the asset price falls year to date are due to P/E multiple changes (i.e. sentiment) whilst earnings have held up well. We can also see that global equities are providing the most opportunity, coming off the most since earlier this year; and showing the highest earnings per share growth numbers. Particularly in the Emerging Markets as we see China and India around the top of the list.

Finally, the chart below refers to the Australian share market and shows that on average, the market drops by approximately 14% every year, but finishes positive in most years. In the years it does finish negative, there is usually a recovery in the following year. This kind of theme can be seen across sharemarkets in other developed markets around the world. This shows us that this kind of market volatility is completely normal and through history equity markets have always recovered.

The appropriate strategy as a long term investor is to hold on and ride out the volatility to achieve longer term gains; and those that have surplus cash and are comfortable with the volatility, to consider these times as buying opportunities.