What’s behind the recent sell-off in stock markets?

Global equity markets have endured a challenging start to the year. The VIX index, a widely-tracked measure of stock market volatility, has risen to nearly twice the average levels we saw in 2021 and sentiment indicators have fallen sharply. Investors are pricing in a shifting economic and monetary policy backdrop, as well as the potential implications of ongoing Omicron disruption and escalating tensions between Russia and the Ukraine.

So far in January, global equity markets have fallen 5.7%[1] in sterling terms. Although certain sectors have seen far more significant moves, at an index level this fall is far from unprecedented. Since 1988, January’s moves are only 30^th on the list of largest monthly losses. It is important to remember that equities are fundamentally “risk assets” and periods of elevated volatility are possible.

The headline figure does mask some of the larger declines we have seen, however. “Growth” sectors like technology have underperformed “value” sectors including energy and financials by around 8% on average. The most extreme falls have occurred in companies that were previously trading on high valuation multiples and, although they may have strong future growth prospects, are not currently profitable.

Biggest monthly global equity losses since 1988

^{Source: Cazenove Capital, Bloomberg.}

Year-to-date total return to 25 January 2022

^{Source: Cazenove Capital, Bloomberg.}

What has caused these moves?

Stimulus measures from central banks and high levels of fiscal spending have provided a safety net for risk assets since March 2020. However, investors are now anticipating a very different environment, with higher interest rates, shrinking central bank balance sheets and declining support from government spending. Bond markets are now pricing in four interest rate hikes this year in the US and UK.

This raises two potential concerns. Firstly, if inflation remains at elevated levels, the Federal Reserve and other developed market central banks could be forced to raise interest rates to the extent that it constrains economic growth. Secondly, higher interest rates could result in greater headwinds for “growth” sectors which have tended to benefit from both excess liquidity and low interest rates, allowing them to borrow cheaply to invest for future growth.

Given these concerns, and the rich valuation of many growth companies, we have seen a re-pricing of risk and expected returns – particularly for higher risk areas of the market. They have underperformed on a relative basis this year, after a period of very strong performance.  

Omicron is another worry for markets. In many countries, Omicron cases continue to rise and restrictions are being re-introduced. Economic activity indicators have already weakened as a result. While the experience of South Africa and the UK suggests this could be short-lived, Omicron has increased the uncertainty about global growth, further dampening investor sentiment.

Potential conflict between Russia and Ukraine is also a source of concern. Tensions have been escalating and the probability of a military conflict rising. Russia has been warned of “unprecedented sanctions” from Western nations if it invades Ukraine. We could see even higher European gas prices if Russia limits supply in retaliation, exacerbating inflationary pressures.

What’s the outlook?

We anticipate robust global economic growth this year. This appears to remain the market’s view as well, with the recent outperformance of more economically-sensitive equities suggesting that the recent sell-off is not about fears of a recession. The earnings outlook remains relatively positive, though with more modest growth rates than we saw in 2021.

While tightening liquidity conditions may test investor sentiment and result in periods of volatility, the solid fundamental backdrop and continued earnings growth should mean that drawdowns are less likely to be prolonged.

Our base case remains that central banks will be able to tighten monetary policy at a controlled rate and manage the impact on economic growth. While inflationary pressures are likely to persist in the near term, there are already signs that supply chain bottlenecks are easing and this should continue as Omicron restrictions are rolled back. Interest rates and bond yields are likely to rise further this year, but they will remain at low levels relative to long-term averages. Companies should continue to be able to borrow and invest profitably.

We are happy to maintain our allocation to risk assets in general and equities in particular. However, a focus on strong companies with the ability to protect margins in an inflationary environment will be important. As we have noted, more speculative, unprofitable businesses – often in the technology sector - have been hardest hit this year. Higher quality companies within the sector have performed far better on a relative basis. This trend could continue.

^{Source: Cazenove Capital, Bloomberg.}

[1] Performance of MSCI ACWI Index. Data to 25^th January