2022 so far. What’s impacted the markets?

looking in rearview mirror | wealthify.com
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In January, we provided an update talking about how financial markets had a bumpy start to the year. However, the extent of this turbulence caught many investors by surprise, and unfortunately, it doesn’t look like this volatility will be ending any time soon.

That’s because there are still multiple risks and uncertainties currently upsetting the markets, which we’ll talk about here.

Some turbulence is a normal part of investing

When markets are volatile, it’s completely natural to worry about your Investment Plans dropping in value. But it’s worth remembering that stock markets go up and down all the time (especially over the short-term), and this type of movement is normal to experience.

2022 isn’t the first-time that markets have fallen due to investors feeling negative about the state of things. In a recent update from Mike Fox, the fund manager of the Royal London Sustainable Leaders Trust, he called out that it’s pessimism that sells and the commodity we’re shortest on at the moment is ‘optimism’. Very poetic words from a seasoned investor who has successfully navigated several market downturns.

Historically, we’ve seen markets recover from these corrections, and investors who hold their nerve are likely to benefit from sticking to their long-term strategy as it could give them the opportunity to ride out dips. Although it’s worth remembering that past performance is not a reliable indicator of future performance.

ups and downs of the stock markets

The above chart clearly highlights the benefits of taking a long-term approach to investing. For example, if an investor had bought in at the top of the ’dot com bubble, an extended crash that saw many investors selling, they could have achieved strong returns by simply staying in the market. We know this can be difficult to believe, especially when the value of your investments keeps going down, but these charts don’t lie.

Looking Ahead

Market volatility is an ever-present part of investing and something that is to be expected, as it’s by accepting this risk that you could open the possibility for higher potential returns compared to keeping your money tucked away in your bank or a traditional savings account.

We’re now over halfway through 2022, and it’s been an interesting year for markets to say the least - although not in the way we wanted.

At the beginning of the year, we thought the key factors that would shape 2022 would be Covid-19, higher inflation rates, and politics. And while all these factors are still very much playing a part, so many other events have unfolded this year that have had a significant impact on the markets.

Here we’ll go through some of the main themes and events that we’ve seen this year, some old, some new. We’ll be looking at how markets are changing, and the decisions that we’ve made.

Inflation

At the start of the year, we believed we were experiencing ‘transitory’ inflation – that’s when high inflation it isn’t expected to last for long – but this belief faded rapidly as 2022 continued. Instead, we saw the post-pandemic recovery hit a rising wall of inflation, which has been accompanied by sharp interest rate hikes in a bid to get this under control.

We’re still optimistic for our long-term goals, but we know that the near-term outlook is uncertain, and it’s likely that we’ll continue to see major central banks carefully balancing the act of cooling down inflation with keeping economic growth on a positive trajectory. As this sharp inflation is due to demand outstripping supply, this is a rather rare occurrence, and it has led to inflation reaching multi-decade highs across much of the world.

This is a different situation from last year, as the main driver of higher inflation in 2021 was essentially stop-start lockdown restrictions. These restrictions created a large spike in the number of physical goods being purchased online with consumers shifting their spending away from the likes of restaurants and holidays.

This became a problem as it happened at a time when supply chain difficulties made it hard for corporates to meet the increased demand.

Covid in 2022

Going into 2022, the expectation was that the re-opening of the global economy after Covid would help to ease inflation as it would drive more consumers to purchase services instead of goods, which – in theory – would help to reduce the supply chain bottlenecks. While there has been some evidence of this shift, we still have not seen transitory inflation subside, and instead, the global economy has experienced further setbacks.

The ongoing implementation of China’s ‘covid zero policy’ has continued to see strict lockdowns of important financial and manufacturing hubs. These shutdowns have caused further complications to the easing of supply issues, shipping routes etc.

Interest Rates

Rising inflation also presents the threat of rising interest rates, as the two are married at the hip. Most credible central banks follow inflation targeting as a mandate, which essentially means that they have a target level of inflation that is acceptable.

In the US and the UK, this target is 2%.

The aim of these central banks is to ensure price stability, which helps to provide economic stability.

However, it’s important to note that inflation in small doses is normal and a sign of good economic activity, showing a healthy relationship between the demand for goods and services.

Rampant inflation in the mid to high single digits is a problem, as it threatens to continue rising due to wage bargaining. This essentially looks at inflation as a phenomenon that is affected, in part, by expectations of inflation – so if people expect prices of goods to go up, then they will look for a wage increase to match these expectations. These increases will then add to the next round of inflation and so on, and so on, driving inflation even higher in a self-fulfilling way.

With high inflation being driven by pent-up demand and acute supply shocks, major central banks have moved aggressively in 2022 to combat the threat of ongoing rounds of inflation. They are also working to keep inflation expectations anchored. Experts are forecasting that the Federal Reserve and the Bank of England to raise interest rates a further 3 and 6 times in 2022, a significant amount considering they’ve already raised their rates 4-6 times already this year. This represents a notable shift in the steepness and speed of rate hikes, which have all been driven by soaring inflation.

Falling bond prices

These interest rate hikes have caused a fair bit of volatility in the markets, with rapidly rising rates driving sharply higher yields, and therefore, lower prices from bonds.

There’s still a lot of uncertainty around both inflation and interest rates in the medium-term, and we expect to see more bumps in the road ahead.

One comforting factor for investors is that inflation and interest rates tend to follow cycles, which means that their effect on the prices of assets does too. By taking a long-term view, there is the potential to use these downturns to take advantage of by buying investments at cheaper prices and staying the course of any short-term market movements.

Russia/Ukraine Crisis

Russia’s invasion of Ukraine has been the most shocking and disturbing geopolitical development in 2022, which is still ongoing and continues to cause catastrophic damage and loss of life in Ukraine. The sweeping sanctions against Russia have caused a major disruption in both commodity and energy markets, and this has led to another source of surging inflation.

Russia is a commodity powerhouse and the sweeping sanctions by the West have led the country to halt exports of over 200 products.

While Russia and Ukraine are less than 3% of global GDP, Russia is the second largest natural gas producer and third largest oil producer [1]. Furthermore, Ukraine is the fifth largest wheat exporter and Russia is the largest [2] – which is crucial when it comes to food prices.

Ukraine is often referred to as the breadbasket of Europe, as many countries rely on food imported from the country (as well as Russia) to cope with any shortfalls in their domestic production. This conflict has disrupted Ukrainian and Russian exports of food and fertiliser, which has contributed to increased pressure on food pricing.

This disruption of key commodities to global supply chains has caused further price inflation across a range of products. [3] [4] One such example is Potassium Chloride, or Potash, which is a nutrient used all over the world to boost crop yields. In 2021, Russia and Belarus accounted for more than 40% of global potash exports.[5]

Both countries have been sanctioned by the US and Europe, which has severely damaged their ability to export the fertiliser, causing the price to soar over 150% in 2022 and directly impacting farmers across the world.

Energy prices

Energy also deserves a special mention here. As Russia is a key exporter of oil and gas, the war has resulted in throttled global supply which has increased prices – both at the petrol pump and the energy being used to power homes and businesses.

The oil and gas markets have their own nuances, however, and it’s worth remembering that the price of oil was already climbing before Russia’s invasion of Ukraine.

Sadly, there does not seem to be an end in sight to this war, and forecasts are shifting from expecting a short war to a long one.

Risk of Recession

Recessionary risks in major economies, including the US, UK, and Europe, are also on the rise. As central banks intervene with higher interest rates to subdue the demand-driven side, the main worry is that they will reduce the demand by too much. This could result in a downturn in economic activity which might lead to an economic contraction.

The US entered a ‘technical recession' at the end of July, as they have experienced two consecutive quarters of negative economic growth (which is the textbook definition of a recession). However, an official recession in the US isn’t necessarily pinned on these figures. It will actually be up to the National Bureau of Economic Research (NBER) a non-profit organisation made up of 8 economists, to determine whether an official recession is declared. To make this decision, they look at several other factors, the main one being the labour market, which continues to remain robust and provides some hope.

There is a well-known saying in the oil market: the cure for high oil prices is a high oil price. This means that people essentially lower their consumption in the face of high prices, and this reduction in demand then reduces the price.

The reason that central banks are aiming to lower demand follows the exact same reasoning – lower demand means that prices must reduce or at least stop climbing.

All eyes are currently on the US Federal Reserve, which at its last meeting raised rates by 0.75%, the second consecutive increase of 0.75% in 2 months.

The Fed’s Chairman in Chief, Jerome Powell, has signalled a clear intention to get inflation under control no matter what it takes. As rates continue to climb higher as we go further into 2022, and the effects become apparent on the economy (peaking inflation, slowing growth, or even sparking a longer-lasting recession), we believe that the Fed will eventually shift its focus back to growth and seek to stimulate the economy again. As we said earlier, everything works in cycles.

The biggest risk here is that the Fed uses monetary policy as a tool against supply-side effects, which it will have no impact on – supply is supply, after all, and increasing interest rates won’t help to produce more oil, for example. There’s also a risk that by depressing demand too far, we would see an imbalance on the other side, with supply outweighing demand.

However, if you’re thinking it’s all doom and gloom, then, fortunately, you’d be wrong.

Now for the good news

A recession, although not desired, isn’t as bad as you might think. Since the end of World War II, there have been 13 recessions and most of them have been shallow – which means the impacts they’ve had were not major.

The problem is that when most people think of a recession, the 2008 Global Financial Crisis (GFC) springs to mind. The GFC caused havoc for nearly a decade as it was a severe recession - but the impact of that recession is much more of an exception than the rule.

In reality, we may have a couple of quarters of slightly negative growth, but this has been happening since the start of the year. So, aside from an increased cost of living, the actual impact of a recession on many of our day-to-day lives would be minimal. Supply chains are improving, in part due to China’s manufacturing hubs coming out of their localised lockdowns, although it’s still under more pressure compared to historical levels.[6] The main contributors to rising inflation figures continues to be food and energy, showing that inflation coming from the service sector is starting to regain control.

Currently, the US dollar is very strong compared to the pound and euro. This means that US companies that are earning money from abroad appear to be making much lower profits. Yet despite this, the profit margins within the S&P 500 remains strong and allows companies to absorb these increasing costs. This provides some reassurance that companies still hold the power to determine their prices.

What central banks are trying to do is make sure that the economy will survive through whatever the year throws at us. We might see a lot more turbulence, or things could start to calm down - it really is impossible to predict what could happen. However, what we do know is that, historically, central banks have reversed their course at the first sign of trouble - so they would be likely to do that again.

How we’ve managed your investments through 2022

As you might imagine, most of the actions we have taken in 2022 have been to remove some of the risk to your Plans in an effort to limit losses. Below is a list of actions we have taken in the first half of 2022:

  • In March, we made changes to the weightings of shares in your Plans to get them closer to our benchmarks.
  • In April, we decreased your exposure to higher-risk assets by 5%, by investing in bonds with increased duration.
  • In May, we made the decision to hedge a third of your US Dollar exposure in the US equity funds back into sterling to help balance out changes in currency.
  • In June, we made a slight increase in cash allocation to reduce the volatility you experience and improve how efficiently we can manage your Plan.
  • In July, we reduced your allocation to higher-risk assets, particularly European and UK shares, and we extended our hedge against the US dollar to hold more in sterling.

Our Ethical Plans have underperformed when compared to Original Plans in the first half of 2022. The reason for this is simple; Ethical Plans have greater exposure to sectors that had a difficult start to the year (Technology and Healthcare) and lower exposure to Financial and Energy sectors which have had a slightly easier time. By design, our Ethical Plans invest in different sectors to our Original Plans, which means that there will understandably be deviations in performance between the two types. However, it is worth pointing out that historic longer-term performance indicates that these differences typically even out over time.

Our view is that the sharp decline in the market has triggered an overreaction, resulting in many sectors (perhaps unfairly) bearing the brunt of this downturn. But sadly, there may still be more to go. This is not a new phenomenon, and we are constantly monitoring market conditions while being cautious of chasing a trend that would see us move away from our preferred investment approach, which is focused on the long-term.

We have stayed invested because sharp sell-offs often see sharp turnarounds and missing out on those positive days could be more costly to our customers. We believe that markets will recover once uncertainty around interest rates lessens, and the outlook for growth should become more stable and reassuring.

As ever, we’re keeping a close eye on this situation and will look to make changes to your Plan as and when potential opportunities may arise to do so.

If you’d like more detail about your specific Plan’s performance, our Customer Care team are always on hand to help. You can get in touch with us Monday to Friday between 8am - 6:30pm and on Saturdays between 9am – 12:30pm, either online or by calling us on 0800 802 1800.

References

  1. bp.com/en/global/corporate/energy-economics/statistical-review-of-world-energy/country-and-regional-insights/russia.html
  2. https://www.fao.org/
  3. https://www.weforum.org/agenda/2022/03/russia-gas-oil-exports-sanctions/
  4. https://blogs.worldbank.org/developmenttalk/commodity-prices-surge-due-war-ukraine
  5. https://rmis.jrc.ec.europa.eu/uploads/220420_Briefing_Potash.pdf
  6. https://www.newyorkfed.org/research/policy/gscpi#/interactive 
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