The current market environment poses a challenge to investors that stands apart from other periods of financial stress and economic uncertainty we have seen since the start of this millennium, if not longer.

Global equity markets are now undeniably in bear market territory, having fallen more than 20% in US dollar terms since the start of the year (sterling-based investors have fared somewhat better thanks to the weakness of the pound, with global equities down 9.8% in GBP terms). At the same time, global economic growth is slowing as China’s restrictive Covid policies and elevated inflation, largely a result of the ongoing Russia-Ukraine conflict, take their toll.

Ordinarily, we might expect central banks to cut interest rates to support financial stability and mitigate the impact of slowing growth. However, today the market is anticipating that interest rates will be around 3% higher in the US and 2.3% higher in the UK a year from now¹. The reason for this is inflation which is both elevated and proving to be stubbornly persistent.

Simplistically, most central banks have a dual purpose of maintaining positive economic growth whilst managing inflation levels. The main tool they have at their disposal to control inflation is interest rates. Theoretically, when rates are high there is a greater incentive to save money rather than spend it, demand falls and prices adjust accordingly, cooling inflationary pressure.

With inflation in both the US and UK at 40-year highs, and interest rates still at low levels despite recent moves, the expectation is that central banks will need to raise rates further and faster than previously anticipated to bring inflation back under control. This was demonstrated by the Federal Reserve’s decision to raise US interest rates by 0.75% at its June meeting, the largest increase since 1994.

It has been a long time since a market sell-off has been met with higher interest rates. Central banks are unlikely to provide the "safety net" which investors have grown accustomed to and it is this uncertainty which has been driving the high levels of volatility we have seen recently.

What next for equity markets?

An important question for equity market investors is to what degree has all this been priced in? Having reached elevated levels at the start of last year, as a multiple of expected earnings, the MSCI All Country World Index has now returned to around long-term average valuation levels.

MSCI ACWI Index 12m forward P/E multiple

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