Financial markets have started the year on a weak note, what’s behind the moves and how are we seeing things?
Interest rates are the foundation of financial markets. Low interest rates have stoked economic growth and the prices of assets, including shares. It is now becoming clear that central banks have left interest rates too low for too long. Inflation has surged to 7% in the US and the Federal Reserve (the US central bank) is playing catch up. Investors are now rapidly repricing their expectations for interest rate rises in many countries including the US, Australia and New Zealand. This process started in New Zealand last year and is one of the key reasons NZ shares were an underperformer. Now the US is going through the same adjustment and this is driving significant market volatility. US fixed income markets are now pricing in around four 0.25% interest rates hikes in 2022, compared with only pricing in around two hikes a few weeks ago.
Usually, market volatility coincides with expectations of economic weakness. This is not currently the case. Whilst growth is expected to slow due to the Omicron wave, rebounds are expected later in the year and global recession is far from likely. With reasonable economic growth, company earnings should also be good. Market volatility in the past few weeks is simply a hangover from the 18month period of strong sharemarket performance, fuelled by easy monetary policy.
In our recent communications we have warned that this year investors will likely experience higher levels of volatility. This should not detract from long-term investing goals. As active managers, we will try and manage our exposures and position in stocks to take advantage of the opportunities that market volatility provides. Recently, this has included reducing our exposures to government bonds and growth companies – both parts of the financial markets that we thought were most at risk. In addition, we have been increasing exposure to cyclical companies (like banks) as these had much more attractive valuation levels and benefit from rising interest rates.
Market volatility is likely to remain a feature this year. Despite this volatility, medium term return expectations are positive, and investors should remain focussed on long term investment goals. Swings in prices can be concerning, but we see this volatility as an opportunity to try and outperform asset markets.