US Equity Markets Decline In 6 Week Sell-Off Amidst Global Uncertainty

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US Equity Markets Decline In 6 Week Sell-Off Amidst Global Uncertainty

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  • S&P500 in US off 16 percent in 2022
  • Rising inflation, higher interest rates, supply chain bottlenecks, war on Ukraine are creating widespread market uncertainty
  • Tight labour market is a complicating factor for Central Bank interest rate policy settings
  • Uncertainty has reduced market liquidity, exacerbating market decline and price volatility
  • Markets are in ‘adjustment phase’, while China COVID lockdowns and war on Ukraine persists
  • A focus on company earnings prospects and not the market, appears the right choice for now

Global uncertainty weighing down on equity markets

Global equity markets have continued their six week decline with US equity markets falling steeply again on Monday. The S&P 500 fell 3.2 percent while the Dow Jones Industrial Average fell 2 percent and the NASDAQ was down 4.3 percent. European and Asian share market indices declined too. The decline extended to the Australian market this morning with the ASX200 lower by 2 percent.

A confluence of events has caused nervousness and uncertainty in global equity markets, including rapidly rising inflation, leading to a sharp increase in interest rates, and exacerbated by stringent COVID lockdowns in China. paralysing the supply chain of essential components of manufactured goods around the globe. Supply chain bottlenecks are creating shortages that are in turn pushing up the price of goods. The war on Ukraine, with no end in sight, has added to the uncertainty, pushing energy and food costs higher, putting household budgets under pressure, as well as adding to the inflation rate. Inflation in the US, as measured by the cost of living, is running at 8.5 percent in March, after a 7.9 percent lift in February. The annual Eurozone inflation rate hit a record high of 7.5% in March, compared to 5.9% in February. Australia’s most recent inflation data is showing a headline inflation rate of 5.1 percent and an underlying inflation rate of 3.7 percent. This is well outside the RBA’s stated inflation target range of 2-3 percent and the largest annual increase in inflation for more than 20 years.

The only positive economic news is that unemployment is at a 40-year low. However, full employment is generally consistent with higher wages, which are a significant input cost of manufactured goods, leading to higher inflation. These inflationary pressures require a response from Central Banks around the world in the form of higher interest rates. This goes to the heart of the problem; being the combined impact of rising interest rates to fight inflation, which runs the risk of slowing a fragile global economy, while dealing with a global pandemic that threatens the orderly supply of goods around the world. Rising inflation driven by supply chain shortages and elevated energy and commodity prices, together with rising interest rates, leading to a slowing economy, are the seeds of stagflation. While it is early in this chain of events to point to stagflation, it is on the mind of investors and accordingly is a key factor affecting investor confidence in equity and bond markets around the world.

Is a rebound likely?

Trying to anticipate upswings and downturns is not an investment strategy; it is a trading strategy, while perfect timing is a hindsight phenomenon.

On the other hand, discerning investors know that corporate earnings drive share valuations and interest rates drive price earnings ratios. Understanding these fundamental investment principles takes the emotion out of investment decisions and enables investors to focus on and profit from market opportunities over the long term. The decline in global equity prices over the past six weeks is the necessary adjustment process occurring in the market, following an extended period of elevated equity and other asset prices, driven by low interest rates. The adjustment process is made necessarily more pronounced when interest rates are at an all-time low.

This explains the current market volatility as investors work through this adjustment process.

Markets are likely to remain volatile while China COVID lockdowns persist and the war in Ukraine continues. Both events have contributed to the current bout of inflation and the issue for investors is whether their inflationary impact is transitory or entrenched.

The other key issue is the extent to which Central Banks round the world will increase interest rates. This is partly dependent on the resolution of current events in China and Ukraine. The complicating factor is the low level of unemployment, and the prospect of wage rises adding fuel to inflation. These factors have led to investors sitting on the sideline waiting for them to play out, leading to reduced market liquidity, which itself adds to further market volatility.

Looking over the economic horizon beyond these events, is the broader economy and the outlook for corporate earnings. The economy is well supported by strong employment growth arising from the extraordinary tight labour market.

To the extent that economic growth, as measured by Gross Domestic Product (GDP), is steadily maintained over the medium term, the outlook for equity markets is mildly positive, after a remarkably long period of sustained economic growth. This is based on the belief that corporate earnings, driven by the level of GDP, is the underlying driver of equity markets. GDP has grown throughout history so economic growth isn’t about luck, it’s how the world works.

A deliberate focus on individual companies comprising investors’ portfolios and their earnings outlook, rather than worrying about the market per se, is a wise choice in the current circumstances.

Louis Mosmann

Louis Mosmann is a Private Wealth Client and Research Assistant at KOSEC- Kodari Securities. Louis covers macroeconomic events, global markets and ASX300 company announcements, allowing clients to make more informed investment decisions. Email Louis at l.mosmann@kosec.com.au.

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