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.