Volatility, inflation, and rate hikes: why context is key

While the rollercoaster start to the year may feel uncomfortable in the short term, we believe there is little reason for investors to panic.

First, volatility – particularly in equity markets - is nothing new. Broadly speaking, the industry definition of a market correction is a +10% drop from the most recent high. Based on historical data, the S&P 500 index experiences such a drawdown every 12 months or so.

Despite these bumps along the way, not too long ago the index was at all-time highs, and it has generated a total return of more than 450% over the last 20 years, or 9% a year (This is based on our in-house assessment of historical Bloomberg data from the time of writing – 27 January 2022. Past performance is never a guarantee of future performance).

Second, while some areas of the equity market have suffered more than others, the overall volatility, as measured by the VIX index, is still relatively low. In other words, the current bout of uncertainty may feel much worse than it actually is, simply because we, as investors, have got used to equity markets going only one way since their COVID-19-driven trough in March 2020: up.

In line with our previous comments on the topic, we continue to anticipate bouts of volatility in 2022. But these should be relatively short lasting.

What’s driving current volatility?

In this particular case, January’s volatility is a sign that markets are adjusting to life with coronavirus. It means that supportive central banks can start moving from survival mode to stabilisation mode, and start to normalise monetary policy.

The reality is beginning to hit home that big spending and static interest rates simply can’t continue, especially in the context of growing inflationary pressures. This change of paradigm was always likely to unsettle markets and require some adjustments after months of unlimited support.  

High-growth, low-profitability stocks have been the most vulnerable to the recent rate-shock, as their valuations heavily rely on future cash flows. Most of the initial selling pressure was focused on this group of stocks, before expanding indiscriminately to the rest of the market in a broad-based risk-off move.

The Fed’s next move

On Wednesday 26 January, the US Federal Reserve (Fed) signalled its intention to start hiking interest rates in March. Investors had been gradually pricing in this eventuality. From one single rate hike being anticipated for 2022 back in October, ahead of January’s Fed meeting, markets anticipated as many as four hikes this year.

The hawkish tone struck by chair Jerome Powell, during the press conference on 26 January, has seen a further repricing, and a fifth hike is now being discounted for this year. While there seems to be a race among forecasters as to who will call for the highest number of hikes, we remain more balanced in our interpretation of the central bank’s message.

Yes, the central bank wants to prevent inflation expectations from running away but it also wants to remain “nimble”. While the market may have interpreted this statement as “more aggressive than usual”, we believe the Fed was simply trying to convey the message that adjustments will be required along the way.

If, as we expect, inflationary pressures subside, they we would expect the Fed to slow down the pace of normalisation.

Five Reasons to stay optimistic

4. Volatility is a feature of equity markets

As mentioned earlier, the real anomaly was the unprecedented move we’ve seen since the pandemic trough. We regularly write about the importance of keeping our composure in the face of heightened volatility. History reinforces this view. In April 2021, we looked at recent pullbacks and showed that staying invested is (always) the right move and that time plays in investors’ favour.

Our view

We were expecting 2022 to be volatile and the first few weeks of the year have already (over) delivered. Remember that markets are inherently volatile. They operate like a pendulum, swinging from optimism to pessimism, and never settling right in the middle.

In addition, the current set up (initial move higher in a straight line, demanding valuations, change in monetary policy, and geopolitical tensions) is also conducive of large swings. As such, one should not be scared about the recent weakness. This, in our opinion, is another one of these opportunities when markets overreact, allowing for attractive entry points for long-term investors.

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