Markets are having a tough start to 2022 with the S&P 500 Index and the Nasdaq Composite Index tumbling into correction territory, down approximately 8% and 12% respectively1. While the TSX Composite Index has held up better with less tech exposure, it too is down, approximately 3% YTD1. What’s happening?
In our opinion these market moves remain in the realm of a healthy correction following the spectacular 20% plus returns for major markets in 2021. The key catalyst for this correction is a re-pricing in market expectations for the Fed’s monetary policy path. More specifically, markets are pricing in the Fed preparing to hike rates soon. This has significant implications for companies that need to borrow aggressively. Unfortunately, these are also the type of companies heavily owned and traded by speculators since 2020. A correction was not unexpected and is something we highlighted earlier this month.
Our core view coming into 2022 was economic fundamentals in developed markets remained strong and the recovery from the pandemic was set to continue. The U.S. economy rebounded strongly from the COVID-19 delta variant driven slowdown last summer and is entering 2022 with significant momentum. It may be tempered by the recent omicron strain but is unlikely to be derailed. With its economy growing at an expected 5% pace, core CPI inflation hitting 5.5% and unemployment below 4%, the U.S. is currently booming. And against this robust emerging data the Fed pivoted to a more hawkish stance on the need to withdraw its pandemic monetary stimulus faster than previously indicated.
Given the underlying strength of the U.S. economy, the Fed absolutely should be tightening policy and increasing interest rates, but this does have implications for markets. Higher rates and reduced liquidity will drive a re-pricing lower for equities, particularly in speculative market areas. The current correction started in mid 2021 and has seen the most volatility in crowded and speculative corners of the markets. For example, bitcoin has declined about 50% from its peak and the ARK innovation ETF is down close to 60%. Areas such as tech, crypto and SPAC’s have experienced frenzied speculative flows since the second half of last year, often with the use of leverage and options. As a result, these were in our opinion, ripe for a significant cleansing. That process was well underway coming into 2022 but has faced accelerated selling in January.
While many speculative stocks are in the tech sector, we do not want investors to confuse them with others that have solid cash flows, like Apple, Microsoft and Alphabet, to name a few. These companies will continue to play a big role in our daily lives with or without central bank policy changes.
Over the past week there has been some contagion into the broader markets, but it has remained limited. We do not perceive anywhere near the degree of imbalances or froth as was seen in the more speculative areas. Nor are we seeing any significant contagion from the equity sell-off into other broad asset classes such as rates or credit. We anticipate the Fed to withdraw stimulus gradually and be extremely sensitive so it does not cause a recession in the near term. The Fed’s recent tone change has already caused speculative market areas to correct aggressively and speculators to exit. The Fed should feel relieved one battle is fought.
To us, the current correction remains consistent with market behaviour at the start of many tightening cycles as expectations and fears are re-priced around rates and liquidity. Bonds have not gotten more attractive as yields remain below inflation for the U.S. and Canada. Appetite for quality equity investments should increase with fallen prices and valuations.
We do not see a significant change in underlying economic fundamentals. We are at the very beginning of the Fed’s monetary policy tightening, not the end of the cycle. This means policy will still be more accommodative than normal even if the Fed hikes rates four times in 2022, as it has hinted. For active managers the current market sell-off offers a good opportunity to add to positions in risk markets. We continue to see 2022 as a year to be tactically opportunistic as the early stages of a tightening cycle tend to see equities outperform other asset classes but with modest absolute returns and several bumps along the way. This is one of those bumps, keep your seatbelts fastened.
1Source: CI Global Asset Management and Bloomberg Finance L.P., as of January 24, 2022