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What a difference a few weeks can make in the equity market. The sharp, swift sell-off through the first month of 2022 is raising some difficult questions for investors, chiefly: Are we just witnessing a long-overdue short-term correction in the more speculative areas of the market, or perhaps something more fundamental (and enduring) that could foreshadow a broader unwinding of equity risk?

My take: I suspect the market is, in fact, in the midst of recalibrating to a new environment in which liquidity is going to be tighter, real interest rates higher, and corporate profits a bigger driver of share prices. This potential regime change could show up in sporadic and sometimes violent reversals of the multi-year outperformance of momentum and growth-equity factors.

In that vein, I expect the nascent rotation from growth stocks to their value-oriented counterparts (FIGURE 1) to continue and think now may be an opportune time for investors to consider upgrading their equity portfolios to higher-quality companies that have taken significant market hits but are growing revenues and profits.

 

FIGURE 1

A Tale of Two Narratives: Market Rotation and Speculative Valuations
Growth vs. Value vs. Speculative Stocks, Normalized (1/1/21-1/25/22)

Past performance does not guarantee future results. Indices are unmanaged and not available for direct investment. Speculative stocks are represented by a large exchange-traded fund (ETF) that is widely considered to be a good proxy for such stocks, particularly those that fit into the theme of innovation. Russell 1000 Value Index is an unmanaged index measuring the performance of those Russell 1000 Index companies with lower price-to-book ratios and lower forecasted growth values. Russell 1000 Growth Index is an unmanaged index which measures the performance of those Russell 1000 Index companies with higher price-to-book ratios and higher forecasted growth values. Source: Bloomberg, 1/22.

 

Five Key Points About the Recent Sell-Off

1. Bubble-like conditions: Extremely easy financial conditions in the post-pandemic era, combined with accommodative monetary and fiscal policies, supported a risk-on market environment that, in my view, became largely divorced from underlying fundamentals in many instances. Many of the most richly valued risk assets1 outperformed cheaper ones due to the meteoric rise in bitcoin, SPACs,2 meme stocks, initial public offerings, and high-flying growth companies. In 2021 and into 2022, that trend has clearly begun to reverse (FIGURE 1). As of this writing, the recent underperformance of growth-style equities has been concentrated mostly in the frothier parts of the market—for now anyway.

2. Geopolitical turmoil: A new exogenous risk that equity investors must contend with is the potential for military conflict between Russia and Ukraine, which could trigger a spike in oil prices, feed into higher inflation, and damage the global cycle. Notably, 40% of Europe’s gas supply and more than 50% of Germany’s comes from Russia. While the risk of a Russian invasion is tough to handicap at this juncture, I do think it implies a higher probability of a stagflationary global-economic outcome (i.e., one with high inflation combined with high unemployment and stagnant demand).

3. The Fed factor: The equity market is still in the process of adjusting to the US Federal Reserve’s (Fed) new playbook of sooner, more aggressive monetary-policy tightening. Starting with tapering its large-scale asset purchases, the Fed should quickly follow that up with interest-rate hikes and balance-sheet runoff later this year to control US inflation expectations. Real rates are rising and liquidity is tightening. High-flier companies that are trading at multiples of sales rather than earnings are bearing the brunt of the market’s sell-off, but longer-duration3 tech companies (which dominate the major indices) with distant, less certain earnings prospects are also in the market’s crosshairs.

4. Omicron’s impact: This latest variant of COVID-19 has swept across the world relatively quickly, although case numbers have been falling in the US, the UK, and parts of Africa. Omicron-related labor shortages and supply-chain disruptions should be relatively short-lived, in my opinion, allowing COVID-19’s negative market impacts to (hopefully) gradually fade in the months ahead.

5. Recession risk: Global monetary policy remains loose (as reflected in negative real rates), with some central banks not tightening yet (and even the Fed apt to hold off if markets tank), while household and corporate balance sheets are generally strong. The main risk is that of a potential policy mistake in which the Fed could tighten too much or too fast and tip the US economy into a recession. I’m also monitoring consumer behavior, along with China’s economy as authorities there maintain their zero-tolerance for COVID-19 stance.

 

Investment Implications

  • Expect higher market volatility: After a period of plentiful fiscal and monetary liquidity due to the pandemic, the specter of less liquidity going forward may continue to weigh on markets, especially stocks of companies that have relied on liquidity rather than earnings for multiple expansion.
  • Think about upgrading your equity portfolio: With this month’s market sell-off, many investors are finding opportunities in higher-quality companies with growing revenues and profits at potentially attractive entry points.
  • Consider diversifying your equity exposure: Investor portfolios appear to be still biased toward growth equities, as the market share in large-cap growth mutual funds is currently around twice that of value funds (according to Morningstar). Asset allocators may want to consider shifting some of their growth exposure to value, where (as noted) I expect continued outperformance.
  • Respect the possibility of regime change: No one can know if this time is different, but given today’s backdrop of higher and stickier inflation, policy tightening, and geopolitical risks, I believe it’s prudent to be prepared for that possibility and to favor real assets, value-oriented equities, commodities, floating-rate credit, and TIPS4 over US Treasuries.

The views expressed here are those of Nanette Abuhoff Jacobson and Wellington Management’s Investment Strategy Team. They should not be construed as investment advice. They are based on available information and are subject to change without notice. Portfolio positioning is at the discretion of the individual portfolio management teams; individual portfolio management teams and different fund sub-advisers may hold different views, and may make different investment decisions for different clients or portfolios. This material and/or its contents are current as of the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management or Hartford Funds.

Talk to your financial professional about how you can position your portfolio for potential market volatility.

 

1 Risk assets refer to assets that have historically exhibited a significant degree of price volatility, such as global equities, commodities, high-yield bonds, real estate, and currencies.

2 A special-purpose acquisition company (SPAC) is a company with no commercial operations that is formed strictly to raise capital through an initial public offering for the purpose of acquiring an existing company. SPACs are also known as “blank check” companies.

3 Duration is a measure of the sensitivity of an investment’s price to nominal interest-rate movement.

4 Treasury Inflation-Protected Securities (TIPS) are Treasury bonds that are adjusted to eliminate the effects of inflation on interest and principal payments, as measured by the Consumer Price Index (CPI).

Important Risks: Investing involves risk, including the possible loss of principal. • Fixed income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. • The value of inflation-protected securities (IPS) generally fluctuates with changes in real interest rates, and the market for IPS may be less developed or liquid, and more volatile, than other securities. markets. • Loans can be difficult to value and less liquid than other types of debt instruments; they are also subject to nonpayment, collateral, bankruptcy, default, extension, prepayment and insolvency risks. • Foreign investments may be more volatile and less liquid than US investments and are subject to the risk of currency fluctuations and adverse political, economic and regulatory developments. Investments in commodities may be more volatile than investments in traditional securities. • Investments focused in specific sectors may be subject to increased volatility and risk of loss if adverse developments occur. • Different investment styles may go in and out of favor, which may cause an investment to underperform the broader stock market.

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About The Author
Nanette Abuhoff Jacobson Headshot
Managing Director and Multi-Asset Strategist at Wellington Management Company LLP and Global Investment Strategist for Hartford Funds

Nanette Abuhoff Jacobson consults with clients on strategic asset allocation issues and works with investment teams throughout Wellington to develop relevant investment solutions across asset classes.

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