The latest market sell-off: Regime change in the making?

Nanette Abuhoff Jacobson, Global Investment and Multi-Asset Strategist
2022-03-31
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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 this year 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 portend a broader unwinding of equity risk?

My take: I suspect the market is in fact in the midst of recalibrating to a new environment where liquidity is going to be tighter, real interest rates higher, and corporate profits a bigger driver of share prices. As my colleague Trevor Noren suggests in his latest blog post, Value versus growth: Expect volatility more than a smooth transition of leadership, this potential “regime change” is likely to 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 their revenues and profits.

Figure 1
the-latest-market-sell-off-regime-change-in-the-making-fig1

Five key points about the recent sell-off

  1. Bubble-like conditions: Extremely easy financial conditions in the post-pandemic era amid accommodative monetary and fiscal policies supported a “risk-on” market environment that, in my view, became largely divorced from underlying fundamentals in many instances. The meteoric rise in bitcoin, SPACs, “meme” stocks, IPOs, and high-flying growth companies was a dynamic where many of the most richly valued risk assets outperformed cheaper ones. 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.
  3. The Fed factor: The equity market is still in the process of adjusting to the US Federal Reserve’s (Fed’s) new playbook of sooner, more aggressive monetary policy tightening, starting with tapering its large-scale asset purchases, to be followed quickly by interest-rate hikes and balance-sheet “runoff” later this year to control US inflation expectations. Real rates are rising, liquidity is tightening. High-flying stocks that are trading at multiples of sales (rather than earnings) are bearing the brunt of the market sell-off, but longer-duration tech companies (which dominate the major indices) with distant, less certain earnings prospects are also in the crosshairs.
  4. Omicron’s impact: This latest variant of COVID-19, which I addressed in a December 2021 blog post, 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’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 where the Fed could tighten too much or too fast and tip the US economy into a recession. I am also monitoring consumer behavior, along with China’s economy as authorities there maintain their “zero-tolerance for COVID” 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.

Diversify 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 should 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, “stickier” inflation, policy tightening, and geopolitical risks, I believe it is prudent to be prepared for that possibility and to favor real assets, value-oriented equities, commodities, floating-rate credit, and TIPS over US Treasuries.

Expert

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