Are we close to the end of the most recent market correction? Paul O’Connor, Head of the UK Multi-Asset Team, argues that, while there is more froth to blow off, investors now have plenty of downside hedging in place, having looked bullishly complacent coming into 2022.
- Markets have endured a difficult few weeks as investors price in the rapidly changing outlook for US monetary policy.
- The US Federal Reserve has signalled that its asset purchase programmes will soon be ending, and investors should now expect the Fed to start shrinking its balance sheet from around the middle of this year.
- Measures of investor sentiment and positioning indicators suggest that market correction is well advanced, but the near-term outlook for financial markets remain unusually uncertain.
Volatility has returned to financial markets with a vengeance in 2022. While there are several factors in play, the biggest one by far is the awkward attempt by investors to price in the rapidly changing outlook for US monetary policy. The rethink has been unusually abrupt. While back in September 2021 markets were pricing in just one interest rate increase of 25 basis points (0.25%) from the US Federal Reserve (Fed) in 2022, four or five hikes are now generally expected. Alongside these developments, the US central bank has signalled that its asset purchase programmes (QE) will soon be ending, and investors should now expect the Fed to start shrinking its balance sheet from around the middle of this year.
While many had hoped that this week’s Fed statement and press conference would push back against these recent shifts in monetary policy expectations, they had the opposite effect. Chair Powell’s comments were generally interpreted as being hawkish on all fronts. In broad terms, he appeared to be much more concerned about inflation getting out of control than he was about markets pricing in too much policy tightening.
The Chair’s discomfort is understandable. With US inflation at 30-year highs and the economy close to full employment, it is not hard to see the need for significant withdrawal of monetary accommodation (stimulus measures). This tightening cycle is starting unusually late, with US real policy rates (interest rates) at exceptionally low levels and with quantitative easing providing another layer of monetary stimulus. Starting from these conditions, it is hard to predict how much tightening is going to be needed before the process has even begun.
End of an era
Investors have enjoyed unusually benign monetary conditions in the US and elsewhere during the pandemic. The ending of this era and the adjustment back towards more normal monetary conditions was always going to involve some investor discomfort. Just as low interest rates and quantitative easing seem to have boosted asset returns and dampened market volatility, it should be no great surprise if a reversal of these monetary conditions ushers in a more challenging environment. This adjustment could take some time.
Still, we would be wary of getting too gloomy after the recent correction, which has seen a double-digit fall in the S&P 500 index in January and a mid-teens correction in the NASDAQ 100. Various measures of investor positioning in the options market – such as the VIX index rising above 30 this week – suggest that investors now have plenty of downside hedging in place, having looked bullishly complacent coming into the year. Survey evidence of retail investor sentiment paints a similar picture. Measures of investor sentiment and positioning indicators like these are usually fairly reliable contrarian indicators. The message from most of them right now is that the market correction is already well advanced.
However, while some indicators already support the case for buying the dip in equities, others still argue for caution. Scale is one such consideration. The correction in US stocks is only just over three weeks old. Most market corrections normally last twice as long. Also, where US stocks are concerned, the recent corrections still look modest compared to the gains accumulated over the pandemic. Across the two calendar years of 2020 and 2021, the S&P 500 Index returned over 50% and the NASDAQ 100 returned nearly 90%. Arguably, there is more froth to blow off. Also, while the Fed’s hawkish pivot in recent months seems to have jolted investors to try and reduce risk in their portfolios, there has been no capitulation. US retail investors came into this year with more of their wealth in stocks than at any time in history (Exhibit 1). Furthermore, investors poured money into global equities in 16 out of the first 18 trading days this year, amounting to a net cumulative inflow of US$84bn.
Exhibit 1: US retail investors’ allocation to equities is at a record high
Source: Refinitiv Datastream, Janus Henderson Investors, as at 24 January 2022. Allocation of US households to equities as a % of financial assets.
The near-term outlook for financial markets is unusually uncertain. The risks to US interest rate expectations now look more balanced, after the recent scramble to price in five potential hikes this year. However, even after these rate hikes are factored in, monetary conditions will still be unusually accommodative compared to the strength of the economic recovery. While expectations for short-term interest rates now look more realistic, real bond yields still seem very low. If the global economy proves to be as robust as we expect this year, then it is too early to conclude that markets have fully priced in the normalisation of monetary conditions.
Against this fairly complicated backdrop, we feel that a cautious view on risks assets remains appropriate. We continue to favour assets that benefit from the global recovery and stay wary of those most vulnerable to rising real yields. In equities, that argues for a tilt towards value and away from growth stocks. Regionally, we continue to favour eurozone, Japanese and UK stocks over the growth-heavy US market. The outlook for Chinese equities now appears more balanced, after last year’s washout and with the unfolding policy easing beginning to counterbalance growth concerns. We feel it is too early to rebuild exposure to duration in global fixed income markets but are beginning to see opportunities emerging in high yield bonds after the recent rise in spreads and yields.
Volatility: The rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility. If the price moves more slowly and to a lesser extent, it has lower volatility. It is used as a measure of the riskiness of an investment.
Monetary policy: The policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money. Monetary stimulus refers to a central bank increasing the supply of money and lowering borrowing costs. Monetary tightening refers to central bank activity aimed at curbing inflation and slowing down growth in the economy by raising interest rates and reducing the supply of money.
Quantitative easing (QE): An unconventional monetary policy used by central banks to stimulate the economy by boosting the amount of overall money in the banking system.
Inflation: The rate at which the prices of goods and services are rising in an economy. The CPI and RPI are two common measures. The opposite of deflation.
Market correction: Commonly accepted as a decline of 10% or greater in a stock market (or individual security or asset).
Options: Options are financial derivatives that give buyers the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price and date.
VIX (CBOE Volatility Index): A real-time market index that represents the market's expectations for volatility over the coming 30 days.
Hedging/hedges: Hedging consists of taking an offsetting position in a related security, in order to diversify or manage risk in a portfolio. Various techniques may be used, including derivatives.
Bond yields: The level of income on a bond, calculated as the coupon payment divided by the current bond price. ‘Real’ yield is the yield minus the rate of inflation. When yields are rising, this indicates that bond prices are falling, and vice versa.
Value investing: Value investors search for companies that they believe are undervalued by the market, and therefore expect their share price to increase.
Growth investing: Growth investors search for companies they believe have strong growth potential. Their earnings are expected to grow at an above-average rate compared to the rest of the market, and therefore there is an expectation that their share prices will increase in value.