What is behind the current volatility

Paul Tarins, RICP®,WMCP®,CSRIC™

Markets have gotten off to a rocky start this new year. Here, we review the factors that ignited this bout of volatility, see how it stacks up to historical precedents, then conclude with our longer-term view on markets and the economy. Spoiler alert – the economic outlook remains positive, and we expect markets to work through this current choppy period in due course.

Diving in, here is a summary of current market-moving items:

1. Federal Reserve Change in Tone – Last year the Federal Reserve telegraphed that it would be reducing the unprecedented stimulus it provided to support the economy through the Covid shut-down. Markets initially ignored this news, forcing the central bank to double down on its messaging as inflation became apparent. This finally got the markets’ attention leading to a sharp rate increase and sizable repricing in bonds to start the year. In addition, with the bank reducing purchases for its own balance sheet, markets lost a major purchaser thus raising the odds for this overdue corrective move. Without a doubt, it will be good to get Wednesday’s first Federal Open Market Committee meeting for the year behind us so that markets may move ahead.
    
2. Inflation Has Come on Strong – Final inflation reports in 2021 indicated a +7% annual increase in consumer prices (AP News, “Inflation at 40-year High Pressures Consumers…,” 1/12/22). This was undoubtably a large print. However, as supply chains slowly rebuild their capacity ahead, this is expected to level off to a manageable +2.5% annually. In the short-run, a sharp increase in inflation rates can increase interest rates in bonds and decrease valuation multiples in stocks, especially in the growth arena. However, keep in mind that inflation is a major reason we invest in stocks to begin with! Companies have an ability to raise prices, allowing our investments to retain their buying power through the years. Also, rising interest rates can be a sign of economic health, enhance investor yields, and allow bonds to better serve as a buffer to stock market shocks.
    
3. Omicron Covid Redux – The Omicron virus has proven highly transmissible and yet mercifully mild for most people. Nevertheless, sick individuals mean missed work and slower sales, both of which may be putting a damper on current economic activity, not to mention extending the timeline for supply chains to return to normal functioning and leaving Fed watchers concerned about a policy misstep. The good news here is that there is evidence we are now coming past the peak of this variant.
    
4. Valuation Overhang – While it was terrific to see stock indices end on highs for the year, a concentration of returns among the largest technology stocks left the major indices at relatively high valuations, leaving them subject to some give back. We have seen a lot of air come out of these stocks at this time, greatly reducing that valuation overhang.
    
5. Global Tensions Mount – Russia has been staging military forces along the Ukrainian border from back in the fall. While worries over a possible invasion have been well circulated, recent talks to deescalate have deteriorated, and rhetoric appears to be escalating on both sides. Although this has fomented a rise in the global risk-premium for stocks, the chances of an all-out war ought to be low at face value.

That’s quite the collection of factors for markets to digest in a relatively short period of time. That said, a common theme among all these points is “transience.” In other words, “this too shall pass.” Yes, all these factors together have raised the immediate perception of risk, and we may well see intermediate slowing in the economy as compared to the post-Covid reopening era, but we need to emphasize the word “slowing”, as opposed to “contraction”.

Healthy annual growth in global GDP is expected at +4.1% (CNBC, “World Bank Slashes Global Growth Forecast…,” 1/11/22), and US corporate profits are still projected to post +8.7% annual growth (Forbes, “S&P 500 Notches 70 All-Time Highs…,” 12/31/21). Based on a positive economy and where we stand in the market cycle, stocks historically have continued to post positive returns 82% of the time despite three back-to-back years of significant gains. As we’ve stated since late last year, the one feature we can expect in the year ahead, is higher volatility, and that’s exactly what we’ve seen.

On a closing note, let’s look at how the current correction in the S&P 500 stacks up against historical data:

Above is one of our favorite charts produced by J.P. Morgan for their “Guide to the Markets” report. Note the average intra-year drop of 14% all the way back to 1980 even though more than three-quarters of years end positively! While it admittedly happened very quickly, what we are seeing right now with the S&P 500 having just recorded an intra-day correction of approximately -10% from its 2021 highs, this was long overdue and is quite normal and unextraordinary in the annuals of markets. Stock index levels are really only back to where they were at the end of last summer. While there could always be lower lows ahead, for a year where the end point is expected in the high single digits, that leaves nearly double the upside versus potential downside from this point forward into 2022 – and with an economy that is still fundamentally growing, those seem like very good odds to us, indeed.

Paul Tarins is an investment adviser representative of and offers investment and advisory services through Portfolio Medics, a registered investment adviser. Nothing contained herein should be construed as a solicitation for investment advisory services. Sovereign Retirement Solutions and Portfolio Medics are not affiliated.