How to handle hammer time…

By Julianne Smith, Business Development Executive

Steep market falls feel tumultuous and then you tend to get a bit of a bounce. Our co-chief investment officer Ed Smith explains here why we’re confident markets are going to rebound from their latest painful correction.

For the first few weeks of 2022, nothing seemed to matter except that bond yields were going inexorably higher, driven by concerns about central bankers starting to fight inflation with higher interest rates. Traders sold everything without bothering to distinguish the good from the bad. Equity exposures were at highs and short selling at lows. So as bond yields rose, they drove equity indices below levels that trigger algorithms to sell. Many traders will sell without any human involvement in their decision making – they will short the entire index and sell everything!

Such broad-ranging and indiscriminate sell-offs should provide opportunities to buy favoured stocks more cheaply. Many companies will continue to grow regardless of what central banks do with interest rates. But trying to catch a falling knife can be very dangerous. How will bond market dynamics affect stocks? What will happen when the US Federal Reserve (Fed) begins hiking rates? What exactly is the Fed’s outlook for inflation? How will all this impact the shape of the yield curve (the difference between the yield of shorter-term and longer-term bonds) – and ultimately dictate the positioning of securities within your portfolio? (Read Ed’s Investment Update here to find out more about how bond yields can impact on stock valuations.)

A time for balance

Does ‘sticky’ inflation mean that it will take broad market falls of 25% to 30% for the Fed to change its stance? Or are forecasts of overly strident interest rate increases getting ahead of themselves? I think 25% plus declines are unlikely. But there is a complete recalibration of valuations going on right now due to rising interest rates as we transition from ‘growth at any price’ to a more idiosyncratic, risk-focused scenario. As markets pull back, we believe it’s best to stick with quality stocks with limited debts and maintain diversification across sectors as well as styles. The wide dispersion of returns within sectors and styles suggests there will be a plethora of stock-picking opportunities. If central banks stop sounding so aggressive, it could well be a buy signal for many investors. In that scenario we’d expect to see those stocks that had been doing really well to enjoy a good bounce.

Energy, large-cap tech and financials are still expected to dominate in 2022, while the rotation towards ‘value’ stocks, long considered value traps but which now enjoy better fundamentals and more pricing power, will continue. Meanwhile rising interest rates will be a drag on unprofitable tech stocks, whose promised profits are far out in the future, making their values are more susceptible to increasing rates. Many analysts feel that the US has enjoyed a faster economic recovery than others, meaning that the Fed needs to do more (and more quickly) to get a grip on inflation than, for example, the European Central Bank. At the same time, most investors have been overweight the US and underinvested in Europe for a while. This further highlights the opportunities in less crowded markets.

Above all, we should expect plenty of corporate activity – companies have strong balance sheets and good free cash flows, giving them plenty of money to spend on dividends, stock buybacks and mergers and acquisitions. This trend will be compounded by the fact that many private equity and venture capital investors have enormous amounts of ‘dry powder’ to deploy and are, therefore, very hungry for (ever larger) deals.

Finding stocks with excellent growth prospects at reasonable valuations, may mean waiting until stocks stabilise at sensible multiples. But that could be sooner than you might think!