2022 has been an unusually volatile year for markets. After a 10-year bull run (bar the odd quarter of underperformance), many investors felt an air of invincibility around equity markets and thought this run still had some legs in it. However, this year we have seen almost all investment types being sold at material discounts and negative returns in all but one month of the year so far.

Whenever I meet with clients, I encourage them to ask as many questions as possible. There is no such thing as a stupid question when it comes to financial planning. Recently, I have had a few clients ask me questions like, “why does inflation matter to equity markets?” and “why does the conflict in Eastern Europe affect me?”. This article may be overly simplistic in certain areas for some readers, but I still think simplifying these issues is the best way for investors to understand why their returns have been so poor this year and how the situation could unfold in the next 12-18 months.

Inflation 

Inflation has been the big point of discussion in 2022. It is almost impossible to speak about market performance without mentioning it. This year we have seen a rise in inflation across most developed and emerging market economies. At time of writing, US inflation print has just come out at 8.30%, 20 basis points above the expected 8.10%. Why does this matter? Well, firstly inflation can have disastrous effects on an economy as spending power decreases. I’m sure everyone reading this has heard phrases such as ‘the cost-of-living crisis’ where people are struggling to afford basic goods and services. From a South African standpoint, we felt this dramatically at the pump where petrol costs have risen nearly 30% since the start of the year. Therefore, to compensate for this decrease in purchasing power, central banks tend to hike interest rates. The theory behind this is to incentivise consumers to both spend less (as rates might continue upward) and save more, thereby reducing the excess demand.  By increasing interest rates, central banks try to curb excess liquidity in the economy which will, in turn, reduce inflation.

Simultaneously, these interest rate hikes (that we’ve seen all over the world this year) tend to have a negative effect on risk assets. Increases in interest rates result in a shift of assets from equity to safe-haven assets that offer a guaranteed or at least more predictable and less volatile return. This is essentially because the risk-reward ratio changes. Here’s how: Let’s say cash previously offered returns of 4% p.a. and is now offering 6% p.a. due to an increase in interest rates. Suppose equity returns remain constant at 12%; the risk-reward ratio has gone down from 3 times (12%/4%) to 2 times (12%/6%). As interest rates keep on increasing the risk-reward ratio keeps dropping and this is one of the main reasons why investors shift from equity to debt or safe-haven assets. 

Global inflation has been exacerbated by the ongoing conflict in the Ukraine. The EU and UK region have felt this most materially. The UK pledged to phase out Russian oil imports by the end of the year while the EU unveiled a new energy security proposal to diversify supply away from Russia. The G7 also announced plans to strip Russia of ‘most favoured nation’ status, with the U.S. House of Representatives approving this measure on March 17.  Whilst these sanctions have been welcomed from a political standpoint, they have had adverse economic effects. At time of writing risk of recession is extremely high in the EU due in part to Europe's reliance on Russian oil and natural gas, which is squeezing the consumer sector and causing production bottlenecks. 

What is the outlook for 2023?

Now that we’ve discussed some of the reasons for market underperformance throughout 2022, it is time to look at what the short to medium term may look like in 2023 and beyond. It is important to disclose that there is no crystal ball present here and these comments should not be taken as fact. Again, we need to have a brief discussion around inflation and what to expect in the coming months. Many analysts believe that (UK aside), inflation has reached its peak. While the recent above expectation print of 8.30% in the US shows inflation may stick around a while longer than initially predicted, it does seem like the worst may be behind us. In fact, in the US, there are growing predictions that the Fed will pause and lower rates in response to lower inflation and recessionary conditions from Q3/Q4 next year. This should (in theory) give markets a boost. Couple this with Putin potentially engaging with Western leaders, and finding a resolution to the conflict in Ukraine, and you end up with the perfect outlook for strong growth in global equities.

In the equity market, it is important to remember how quickly things can change. As an example of this, I will use the returns of one of South Africa’s biggest balanced funds this year. By the end of June (2^nd quarter) the fund was down 6% year to date. At time of writing the fund is up 7.5% for the 3^rd quarter. Admittedly, market returns have been poor this year and it has been a bitter pill to swallow for investors. You do, however, unfortunately need to take the good with the bad if you are a long-term investor. The below chart shows how bull markets almost always follow bear markets. Furthermore, these bull markets tend to be more material in nature (from a return perspective) and tend to last a lot longer. When the market turns it usually does so in a quick and material manner and, in order to benefit from this, it is important to have skin in the game and stay the chase wherever possible.

Source: First Trust Advisors L.P., Morningstar. Returns from 1926 - 3/31/17.

When markets are volatile and confidence is low, searching for reassurance is human instinct. Your path to future certainty lies in a financial plan crafted by a team of professional wealth managers and financial planners with the skills, knowledge and independence to empower you with the security you seek and the financial rewards you’ve earned. Contact us today 

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This article was published on Moneyweb, 6 October 2022. To read more from Jono, click here.