15 Dec 2021
Volatility seems destined to increase in 2022
The success of a small group of mega caps has masked weakness in more speculative corners of the equity market
As policy is tightened, more ‘mini bubbles’ will burst
FOR PROFESSIONAL AND/OR QUALIFIED INVESTORS ONLY. NOT FOR USE WITH OR BY PRIVATE INVESTORS. CAPITAL AT RISK. All financial investments involve taking risk which means investors may not get back the amount initially invested.
After a fantastic year for most asset classes the case for significantly increased volatility is easy to make.
That isn’t, however, primarily due to the emergence of a new variant of Covid-19. Even with Omicron, Covid remains manageable. The world now understands its enemy far more clearly than it did back in March 2020. The virus will continue to evolve and claim lives, but it won’t fundamentally change human civilisation. The weapons that we use against it may need to be tweaked and adapted. Fundamentally, however, vaccines work. The virus is getting more virulent but – hopefully – less deadly.
The Omicron variant doesn’t take the world back to where it was in March 2020 – but it can still sway the decisions of governments and central banks. It isn’t clear how they will react or what they will prioritise. Familiar orthodoxies – whether concerning acceptable levels of inflation, debt-to-GDP ratios or even how to manage geopolitical tensions or individual personal freedoms – have been rejected or altered.
Share of central bank speeches in the developed economies mentioning inequality
Source: BIS, Deutsche Bank as at 30 June 2021
Policymaking in almost every area is less mechanistic than it once was. Sudden pivots – whether they be central banks becoming more interested in inequality than inflation or the US government deciding overnight to withdraw its troops from Afghanistan – can have an unsettling effect. Markets always prefer the familiar and predictable to sudden change.
In many parts of the market, valuation doesn’t matter – yet. This phenomenon isn’t confined to meme stocks or cryptocurrencies – it’s also evident in the multiples being awarded to high-quality but not particularly rapidly growing large-caps. L'Oréal, for example, currently trades on 55x historic earnings, the kind of multiple once reserved for hyper-growth tech companies.
Since the start of the pandemic, valuations in many parts of the market have been pushed higher by fiscal and monetary stimulus acting in the same direction. That is about to change: fiscal stimulus can’t get any looser and it isn’t a question of whether central banks are going to tighten monetary policy – but when.
As liquidity begins to be withdrawn, our suspicion is that the ‘greater fool’ approach to investing is about to be put to the test. Indeed, in some areas, that already seems to be happening…
Some ‘mini-bubbles’ are already beginning to burst
Source: Goldman Sachs non-profitable tech index, Bloomberg
Focus on headline market indices and you might have missed it, but a number of ‘mini’ bubbles have started to pop. The market is expecting tightening and liquidity withdrawal (higher rates, higher input prices, higher working capital requirements and higher wage costs). The result has been extreme concentration in market leadership. Aggregate market levels fail to tell the full story: the success of a small cohort of mega caps has papered over the cracks that have begun to appear in some of the frothier, more speculative corners of the equity market. Chinese tech stocks, profitless tech-stocks and ‘concept stocks’ in general are down sharply.
Over the year to the end of November, the MSCI ACWI index, which includes over 3000 stocks, had returned 14.0% in US dollar terms. Strip out returns from 285 US-listed growth stocks, however, and that return falls to just 1.6%. Of 3765 stocks in the Nasdaq, just five companies (Microsoft, Google, Apple, NVidia and Tesla) account for 71% of gains made over the year to date. Indeed, almost half of the stocks in our global benchmark are down by more than 20% from their year-to-date highs.
Elevated uncertainty means this is not an environment in which to take undue risk or experiment. So, relative to pre-Covid times, we’re investing in higher-quality stocks with stronger balance sheets; we have fewer ‘deep value’ names. But we don’t own luxury goods companies or e-commerce consumer stocks trading on the kinds of multiples usually awarded to rapidly growing tech stocks.
Where does this leave us? The coming year could prove to be a profitable one for equity income investors. At the same time, delivering returns in a world where the old orthodoxies no longer apply appears certain to demand hard work, nimbleness and an openness to change.