Market upside remains despite recent correction

Recent market volatility was a correction within a bull market, says Lenny McLoughlin, senior investment strategist with Irish Life Investment Managers Ltd. And as far as he can see, the bull market remains intact for now. 

Speaking on the Soundbites podcast, McLoughlin said there’s still evidence of upside in equities, even as the market tries to find a floor.

“When we look at several sentiment and technical indicators, they’re at extreme levels and they do suggest that the worst of the selling pressure might be over at this point,” he said. “We think the fundamental backdrop for equities remains positive.”

McLoughlin said the current economic environment — mid-stage of a growth cycle, with rate-tightening in the offing — tends to be positive for equity markets.

“If you look at what happened to equity markets over last six rate-tightening cycles in the States, going back to the 1970s, equity markets still have managed to rise after interest rates have begun to rise,” he said. “On average, equity markets have been up 4% and 9% over the last six cycles, three and six months respectively after the first hike, and that reflects the fact that rates begin to be raised in an environment where we still have strong positive growth. We believe that’s the situation we’re currently in.”

Updated predictions

McLoughlin said despite the volatile start to the year, he still expects global growth in the range of 4% in 2022, and 3% in 2023, well above the trend line of 2.7%.

He pointed out that valuations have fallen significantly for global equity markets, which are currently trading on P/E multiples of about 16.5 times, compared to long-term average of 16.

And while the prognosis is favourable for 2022, he doesn’t rule out more volatility.

“There are a number of headwinds for equity markets evident in 2022 which weren’t there in 2021,” he said, including the tightening of monetary policy by central banks, ongoing concerns about inflation, concerns about Chinese growth, and political tensions on the Russian-Ukraine border.

Global risks

In particular, a Russian invasion of Ukraine would destabilize global oil, gas and metal prices, and threaten European growth. McLoughlin remains optimistic that a diplomatic solution will be found, since sanctions, loss of life and the cost of maintaining a military occupation could cripple the Russian economy.

More pressing to global economic health is persistent inflation, he said, which could lead to more aggressive tightening of monetary policy by central banks and bolder interest rate hikes.

“If they were to do that, that would be negative for growth and would also potentially cause bond yields to rise, and that would undermine the relative valuation case of equities versus bonds,” he said. “And this is the biggest single fundamental risk out there in terms of our positive view for equity markets.”

But McLoughlin predicts inflation will begin to decline this year as supply bottlenecks ease and economies reopen.

“Disinflationary pressures from technology and automation, which have been there for a number of years, remain in place,” he said. “That hasn’t gone away. And, with that, we do see lower levels of inflation as you go through 2022.”

He expects to see headline inflation in the U.S. to fall to about 3% from 7% by the end of this year, and for Europe’s inflation rate to fall to 2% from 5%.

Reason for volatility

McLoughlin attributes the volatility seen early in the year to expectations for tighter policy from the U.S. Federal Reserve. That led to higher bond yields, with U.S. 10-year yields rising from 1.35% in mid-December to 1.79% on Jan. 31.

“When the pace of rise is very rapid, as we’ve seen over the last four or five weeks, when we’ve seen a two-standard-deviation move in yields in less than a month, equity markets in that type of environment can react negatively.”

Rising bond yields also impacted the tech sector. The higher yields devalued future earnings, leading investors to take money out of the tech sector in early January.

McLoughlin anticipates a speedy recovery, however, with many leading large-cap tech companies boasting healthy balance sheets and credible long-term business models.

“We do think the tech sector and tech stocks can recover, although we think the scope and scale and opportunity for the level of outperformance that you’ve seen from these stocks and sectors in recent years may be more limited by the fact that we are now in a higher-yield environment.”

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This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.