Market Flash: Navigating a challenging period in financial markets

It may not come as a surprise to you that the past five and a half months have been one of the worst starts to the year for investment markets on record. Equity markets have fallen substantially, with major US markets falling into bear market territory (a 20% decline from a recent peak), while bonds, which have historically performed well in times of volatility, have also fallen sharply.

Given the uncertain environment, we want to provide you with an update on what is driving the declines across markets, some thoughts from our Investment Management team, and a look into our key pillars of investing.

We understand that declines in investment balances can be concerning and probably raises many questions – both about what is happening and what we are doing. We will get into this, but first, let’s take a step back and put some things into perspective.

The S&P 500 Index and the NASDAQ 100 Index, two of the most prominent benchmarks for global equities, are higher than where they were in February 2020, just before the COVID-19 outbreak. The S&P 500 is up more than 10% from that level, and the NASDAQ 100 is higher by more than 15% (as at 16 June 2022).

This is equity markets in a microcosm: They go up, and they go down. But, if we step back for a moment, and focus on the long term, which is what investing is all about, markets recover – some faster than others, but they all recover. Whether it’s the dotcom bubble of the early 2000s, the 2008 Global Financial Crisis, or the COVID-19-induced sell-off in 2020, equity markets have a great long-term track record.

Now, let’s take a look at what’s driving the recent declines in equity and bond markets.

One question we are fielding is why are equities and bonds falling at the same time? The short answer is, inflation. However, let’s take a closer look.

Not since the 1970s and 1980s have we seen rates of inflation where they are at the moment – nearing 10% in some developed nations. The rise stemmed from a breakdown in supply chains during the pandemic, which meant that the pent-up demand in the post-lockdown economy outpaced supply, driving prices for goods higher.

As inflation rates remained sticky through the latter parts of 2021 and into 2022 (not helped by the war in Ukraine which drove energy prices higher), it became apparent that inflation would not be ‘transitory’; at the time, central banks held the view that inflation was being driven higher by a few sectors which would ultimately cool off.

As this dawned on central banks, which were operating historically accommodative policy, they pivoted to aggressively tighten policy, raising interest rates at an unprecedented pace – the Fed’s 75 basis point hike on 15 June was the biggest single hike in nearly 30 years.

This aggressive U-turn in policy saw interest rates head sharply higher, an environment in which bond prices tend to fall. Meanwhile, equity markets also fell, as a combination of a higher cost of capital for companies (which cut into their profitability), and a declining outlook for growth, weighed negatively on sentiment.

With inflation the key driver of recent moves, here’s what our Investment Management team is thinking regarding inflation.

“There are already signs that demand is starting to soften as the US consumer grapples with rising inflation. Retail sales fell for the first time this year in May, while home sales have fallen for three consecutive months and consumer confidence hit a record low in May/June.

We continue to expect inflation to peak, but recognise that monetary policy is likely to tighten considerably (into restrictive territory) before central bankers are comfortable pausing hiking rates. Both bond and equity markets have shifted to reflect more hikes and high inflation – a change in this narrative would produce a strong positive market reaction”.

We’re often asked how we look after your investments during a time of market volatility. The key is having a rigorous, disciplined investment process underpinned by proven investment principles.

We take an ‘active management’ approach to investing. This means using our experience, research capabilities and connections to select and manage investments on your behalf. We believe this gives you some protection when markets fall, but also allows you to take advantage of subsequent upswings in markets. Our approach is built on three key principles – quality, liquidity and diversification.

We consider these three principles in every aspect of our decision-making, including when we decide which asset classes to invest in, when selecting individual investments for the portfolios we manage directly, and when choosing a third-party investment manager to work with.

Here’s why we believe these factors are important.

Quality: Holding high quality investment assets means you should be better able to absorb any volatility in the prices of those investments. In tough market conditions, high quality investment assets tend to hold their value better than low quality assets. Low quality assets tend to be more volatile, meaning investors who hold them are likely to be in for a roller-coaster ride. Something else to note is the prices of higher quality assets tend to bounce back more quickly as markets recover.

Liquidity: When we talk about liquidity, we usually refer to how quickly we can buy or sell investments. Investing in highly liquid investments means we can divest quickly if we need to, or if our view on a company or an asset class changes. Investing in illiquid investments means there’s a chance we may not be able to ‘get out’ of an investment, and investors could be forced to hold onto it if the price of that investment continues to fall.

Diversification: Holding many different investments helps to smooth out the returns for our clients. Importantly, it means that if the price of one investment falls in value, its weaker performance can be absorbed by other better-performing investments elsewhere in their portfolio. Diversification ensures our clients have a spread of different types of investments, such as a combination of bonds, shares and property, and it also gives them exposure to different industries and geographic regions.

While investors may not have had the full benefit of diversification this year – with both equity and bond markets falling at the same time – they have benefitted from our international listed property and international listed infrastructure holdings – both of which have held up well, as these tend to perform better in high inflation environments.

As we have said, these volatile markets can be uncomfortable for any investors. That is why we would suggest if you have any ongoing concerns, the best things you can do is reach out to your Private Banker. They’ll be able to discuss this further with you and help you navigate these challenging times.