Investors re-assess as market volatility remains high

April was a weaker month for stocks, but the volatility spilled over into the beginning of May as well. On everyone’s mind has been the twin factors of higher inflation and higher interest rates. In a different scenario to what is typical, the inflation that has been suffered recently is due entirely to supply constraint and a lack of response as prices increase (price increases typically incentivise supply) which could be influenced by a number of post-COVID-19 factors.

Earnings season is also in full swing and, so far, growth is lower than in previous quarters (as the base effects are tougher and activity is softer due to supply or pricing uncertainty) but still better than expected, with Earnings Per Share surprising by +6% in the US and +9% in Europe. However, in stark contrast to the optimism in 2020/21 investors are much more sceptical and demanding, with companies that are missing estimates being penalised sharply – in this respect Netflix has been the sacrificial lamb this spring with underwhelming subscriber numbers and increased streaming competition leading to c.70% share price drop year to date. Big tech more broadly is under the microscope like never before as investors reassess their post-pandemic growth assumptions and wider market volatility remains high as markets continue to wrestle with inflation, the war in Ukraine, China’s COVID-19 outbreak, and interest rate rises.

China’s COVID-19 challenge continues

For investors, part of the conundrum is whether these short-term factors will reverse. There are grounds for some optimism. The delay in shipments from China due to COVID-19 restrictions has allowed the logistics market some opportunity to catch up, with freight rates dropping accordingly. Clearly that’s not universally good news, even from a supply perspective, as part of the reason for it is that Chinese factories aren’t producing as much.

We expect China to be able to manage its COVID-19 challenge by increasing vaccinations and eventually being able to relax lockdowns and note there is scope for the government to financially stimulate the economy, much like what happened here in 2020/21. The Chinese Communist Party’s recently reiterated objective (5.5% for this year) is likely to require assistance to be achieved in light of the COVID-19 issues and response.  In addition to monetary response, the Chinese authorities are ramping up infrastructure investment once more.

The benefits of a market which is desynchronised, and therefore not facing the same inflationary and monetary pressures as the rest of the world, could entice investors to revisit China but some may be reluctant to return to the table after being burned by the regulatory clampdowns of the past year.

Interest rates continue to rise in the US and the UK

Understandably, much attention is being lavished on interest rate setters in the current environment and two meetings in the first week of May, while not hugely informative in terms of the future direction of policy, managed to get pulses racing regardless.

The Federal Reserve meeting was remarkable in its lack of material shocks. The Fed raised interest rates by 0.5% and described the way in which 'balance sheet run off' would start in June at a pace of $47.5billion before accelerating in September to a pace of $95billion. During the preceding weeks the most currently hawkish FOMC member, James Bullard, had refused to rule out the possibility of a 0.75% hike, raising much speculation about whether one might be hinted at for the next meeting. But Fed chairman Jay Powell confirmed it was not currently part of the committee’s thinking, triggering a sharp, but brief, equity market rally.

Powell referenced the core Consumer Price Index (CPI) rate slowing in March to 0.3% month-on-month from 0.5% month-on-month in February. This is part of an essential judgement he has to make over whether higher prices are feeding into higher wages and vice versa, forming a so-called wage price spiral that can only be halted by aggressive central bank action. Adding to that was a reassuring set of employment data that showed a slower pace of wage growth despite a very healthy level of jobs growth.  If this continues it will give Powell the confidence to slow the pace of rate hikes. Ultimately there was very little information communicated and the US market continues to exhibit violent intraday swings which seems to be a function of increased retail participation via options.

When the Bank of England’s monetary policy committee (MPC) announced policy, the details were again in line with expectations, with interest rates rising to 1%. However, the Bank’s forecasts caught the eye with a surprisingly high estimate of inflation hitting 10% in the final quarter of this year, at which point it expects growth to slow leading to an overall decline during 2023. These forecasts could imply a period of slow growth that occasionally dips into negative territory, but it seems more likely that the Bank is expecting a recession, without explicitly using the dreaded “R” word. After digesting these forecasts and voting intentions, the markets decided that interest rates will not rise as fast in the UK as had been expected, causing bonds to rally and the pound to slump.

Economic distress continues in Russia

Being the most sanctioned country, Russia faces huge economic headwinds and sky-high inflation. The Russian central bank issued new projections that showed Russia’s economy may contract by 8-10% this year, while inflation is set to reach 18-23% by the end of this year. Economic distress will deepen in the coming months and supply chains will be severely impacted by a lack of imported components.

Russia has cut off gas to Poland and Bulgaria, and threatened to cut off gas supplies to any EU countries which do not pay in roubles. President of the European Commission, Ursula von der Leyen, meanwhile has set out plans to phase out Russian oil with the G7 similarly committing to phase out or ban the import of Russian crude. As the war progresses, although there seems to be no imminent disruption, the tail risk of gas being shut off to major EU economies like Germany and Italy will lead to terrible economic consequences as gas will need to be rationed, with many economists expecting an outright recession in such a scenario. So far, there is a lack of clarity on how European leaders will proceed, and developments remain very fluid.

Upside and opportunity

So, challenges lurk at every turn it would seem, and there are undoubtedly significant headwinds for investors to navigate, but with c.80% of S&P 500 companies and c.70% of STOXX 600 companies beating earnings estimates last quarter, there remains scope for upside and opportunity on both sides of the Atlantic.

Written and prepared for Crowe Financial Planning UK Limited by John Moore (Senior Investment Manager at Brewin Dolphin)