February 2022 – Andrew Heath (Investment Manager KMG Investment Management)

What have we experienced?

After a strong 2021 it has been a difficult start to the year for equity markets.  Inflation, concerns about central bank tightening and tensions in eastern Europe roiled markets and led to a sharp increase in volatility.  Rallying oil and gas prices and higher US Treasury yields saw energy and financial stocks significantly outperform the rest of the market, which contributed to the largest monthly style-shift in more than 20 years.

In fact, January saw the worst weekly performance for global stocks since October 2020. US markets felt the burden the most, particularly technology shares. The tech-heavy NASDAQ index, home to names like Apple, Amazon and Microsoft fell into market correction territory (a fall of more than 10% from its peak) in January. It is the 66th correction since the index was created in 1971. While the catalyst was clearly the impending shift to higher interest rates due to rising inflationary pressures and slowing growth, concerns over stocks with above-average valuations witnessed indiscriminate selling regardless of their future profitability.

Global bond markets also fell significantly although they did not necessarily capture the same media coverage. Overall commodities provided better protection against the inflationary backdrop, continuing to rally in January.  Brent oil reached $90 a barrel for the first time since October 2014, driven by falling oil stockpiles in the US and rising political tensions with Russia.

The open-ended nature of rising interest rate expectations has been the trigger for this shift and volatility will remain high until the market can properly frame the increases in inflation and interest rates.  The US Federal Reserve has changed their rhetoric on inflation this year from temporary to something more entrenched and appears less sensitive to any market weakness.  Rates are moving higher because central banks are increasing rate expectations in an attempt to control inflation rather than as a result of rampant economic growth.

Inflation, at its simplest level, has been generated by an imbalance of supply and demand. Covid has created economic events that have culminated in market distortions, resulting in unpredictable supply of many goods and services.  It is logical to assume that over time supply issues will ease, and it is also possible that a slowing economy will ultimately reduce inflationary pressures down the line.

For now, rising inflation will increase costs for companies which can eat into their profitability.  Higher interest rates make the cost of borrowing money and servicing existing debt more expensive; both are bad news for companies needing to borrow money to fund future growth opportunities, or those with lots of debt.

Away from considerations of inflation and interest rates, markets also watched the situation on the Ukraine-Russian border which has impacted market sentiment due to the risks to economic growth, and its impact on energy markets due to Russia’s control of natural gas supplies to Europe.

During the market rotation value-stocks outperformed growth.  To understand why we must first understand the difference between these types of stock: fundamentally a growth stock is a company that typically will grow faster than the market and is often characterised by a higher valuation to justify the future growth.  Commentators often refer to technology stocks as high-growth companies, but the list is not exclusive to this sector.  In contrast, value-stocks are considered cheap companies trading at a lower price than the company’s performance may otherwise indicate.  These are often associated with older traditional industries such as banking, energy, and materials.

Recent concerns that growth companies were too expensive, particularly in a rising interest rate environment, took hold creating significant volatility. However, the rotation from winners into laggards is a frequent mean reversion tactic at inflection points and has shaken company valuations which had become stretched across many sectors and industries.  This has, and will continue to, create opportunities and the fundamental drivers remain unchanged: we still need to tackle climate change, and the infrastructure and technological investment required to achieve this is substantial, so we will continue to invest in the structural drivers of tomorrow.

The global technology market has suffered some short-term volatility as investor fears around inflation and rate changes have prompted a risk-off period to the start of 2022. However, a more long-term view recognises the enduring and solid fundamentals for opportunities in this sector, which have been bolstered by accelerated digital adoption from 2020 onwards.

It is important for investors to hold their nerve in times of uncertainty.  This can be the difference between investing success and failure over the long-term.  Market corrections come in different shapes and sizes and history has taught us that selling your investments on the worst days in the market could mean you miss out on the best days.  Focus must remain on the long-term opportunities, as guessing which way the market will go in the short term is near impossible.