As the pandemic continues into its third year of gripping lives, headlines and markets worldwide, we take a look at how different financial markets have performed recently.
From surging inflation stemming from a major recovery in demand to the veil of volatility hanging over cryptocurrencies, there are many recent developments that have shaped and continue to influence the markets.
The elephant in the room: inflation
No market review in the current climate would be complete without at least a comment on inflation. As a result of growing vaccination rates and the less fatal omicron variant, recovering consumer confidence is causing demand to surge.
However, supply chain constraints stemming from worker isolation and the restructuring of major industries are yet to subside and, in combination with demand-push inflation, are driving prices up massively.
The result of this all is the growing inflation that we are witnessing now, with the UK’s inflation rate rising to its highest level in almost 30 years at 5.4%.
Many investment analysts and economists expect inflation to peak in the coming months before decreasing in the second half of this year, so it is important to bear this in mind when analysing any market because higher inflation erodes the real purchasing power of currency (for reference, you can look into the Fisher approximation).
A very major recent development is the announcement by the Federal Reserve in late January indicating the very strong possibility of an interest rate rise in the US, similar to the monetary policy tightening of many other countries in addition to the withdrawal of fiscal stimuli that have propped up many economies since March 2020.
The 10 year US Treasury yield is rising towards 2% which could adversely imply volatility ahead for stocks (covered later in this article).
In summary, monetary policy has been left very flexible by the Fed and, as a result of this uncertainty, investment managers have scrambled to protect their corporate bond portfolios from possible mass sell-offs of bonds. One consequence of this is a massive spike in credit derivative sales, in particular low-rated credit default swaps.
Nevertheless, this uncertainty and prevailing economic conditions provide many opportunities for certain classes of investors to capitalise on. For example, aid received by local authorities in combination with the ongoing economic recovery in the US make municipal bonds attractive for those in higher tax brackets and analysts recommend increased exposure to these instruments in the current investment climate.
Contrary to forecasts at the start of 2021, the US dollar had a strong year owing to a bullish mid-year period. The dollar forecast for 2022 is positive too, but if the deviation from 2021’s forecast is anything to go by then analysts may have got it wrong once again.
Rather than another strong year for the dollar, it could just move sideways with period fluctuations in value.
Economic theory would suggest that the dollar should appreciate following a rise in central bank rates, and from empirical data we see that the dollar does in fact appreciate… but after the announcement, not the rate rise itself, as a result of investor expectations adjusting to the news.
If anything, the dollar typically falls after the rate rise is formally executed, and we are currently in the lull between the announcement and the actual rate rise.
Furthermore, with other central banks making similar monetary interventions, the Fed’s influence over the dollar will be weakened. Therefore the US dollar is likely to have already peaked for 2022 so many investment experts have advised that reducing exposure at this stage is a sensible move.
Emerging market currency valuations are down significantly compared to their levels last year as they become weaker, but these cheap valuations mean that any inflows from them will be comparably better for investors and add significant value to portfolios; hence, for less risk-averse investors, they may be a class of currencies to keep an eye on over the next few months.
January 2022 was one of the worst months for the equity markets; as shown by the diagram below, major market indices such as the S&P 500 plummeted. IT and consumer discretionary were hit hardest over January and contributed to levels of volatility not seen since the pandemic began.
There have been many firm-specific events in recent days and weeks, such as the major fall in value of Meta shares and the failed acquisition of Arm by Nvidia for USD$60bn which has left the firm torn between a London or New York IPO.
Q4 earnings beat rates were around 5% which was not only weaker than expected but also lower than the 18 month average since the start of the pandemic; this prompted major sell-offs. There was also less spending on particular sectors such as durables, technology, electronics and the travel and leisure industry.
These market swings over the past month have caused many companies to opt away from IPOs and towards private investments or buyouts as capital-raising strategies so there is a lot to play for in the coming months in the equity markets.
However, it is clear that market trends that have dominated since the start of the pandemic, such as the meteoric rise in tech stock valuations, may no longer continue at the rates recently witnessed as many consumers and investors gear themselves for a return to normality and away from pandemic habits such as working from home.
Usually regarded as very different to the traditional instruments reviewed above, cryptocurrencies have seen explosive growth in popularity since the first Bitcoin was mined back in the late 2000s.
Nonetheless, there have been hurdles along their path to the centre of many investors’ discussions and there are ongoing scandals surrounding them such as US officials seizing USD$5bn in laundered crypto.
Even with these developments, many digital asset managers are beginning operations similar to typical trading desks but with specialisms in cryptos, an example being Dare (formerly VCMT), which trades oil futures and is exploring establishing a crypto-focused unit.
Another example is KPMG Canada adding cryptos to its balance sheets, similar to many of its peers normalising cryptocurrencies into the financial markets.
In addition to firms, what is perhaps more significant is how different countries are approaching their regulation of cryptos.
There is an entire spectrum of regulations for crypto investors to choose from; on the one hand, Portugal offers 0% capital gains tax for cryptos whilst, on the other hand, Kazakhstan is considering a 500% increase on mined Bitcoin. Surprisingly, Russia has slowed its march towards stringent crypto regulations.
Cryptos are still closely associated with economic indicators and so may be useful to hold in combination with defensives in order to diversify portfolio risk.
For example, they have previously spiked after the Fed rate rise announcements and, more recently, recovered their market capitalisation when equities partially bounced back in late January, as discussed in the equities section.
Summary and defense against inflation
With inflation set to subside in the second half of 2022, there is the potential for considerable ‘upside’ surprises if the current high inflation continues beyond the next few months and defies investor expectations.
Analysts are recommending defensives over cyclicals over the next few months and optimal portfolio compositions will vary according to the demographic of investors (e.g. tax bracket, income level, long-term vs short-term horizon).
To protect against inflation risks, possible investment solutions include investment in precious metals such as gold, which are known for holding their value because they are tied to a tangible asset, and TIPS (Treasury inflation-protected securities); these both, however, are sensitive to real interest rates and expected rate rises may make these less effective buffers.
These could be made to work, however, at the hands of a nifty investor that is agile when reacting to market and political developments.
As ever, precision and speed are the name of the game in this investment climate.