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What’s causing stock market volatility?

In recent days stock markets have started to experience volatility in the wake of inflation pressures, expectations for interest rate hikes and geopolitical tensions. Julian Broom, our Chief Investment Officer, takes a look at what’s happening.

The opening weeks of 2022 have seen stock market volatility ramp up, with investors reacting to expected interest rate rises from both the Federal Reserve and other Central Banks globally. As of 25 January, the S&P500 had declined 7%, whilst the tech-focused Nasdaq Composite lost 11%, with particular focus on ‘Growth’ stocks, many of which had risen to lofty valuations since the start of the pandemic.

The cause of this re-rating in equities is largely to do with levels of inflation globally, which has risen because of worldwide supply chain shortages from locked down economies. In the US for example, the Consumer Price Index climbed to 7% in 2021, the largest 12-month gain since June 1982. This, combined with record levels of fiscal and monetary spending, has created an imbalance of excess demand and limited supply.

In response, Central Banks have acknowledged that inflation is far from ‘transitory’ (a narrative that the Fed adopted for much of 2021) and have instead been signalling that they are willing to reduce asset purchases (or Quantitative Easing), to start raising interest rates and finally, to reduce the size of their balance sheets. The impending tightening of monetary policy has led to stock markets – already trading at elevated levels over much of 2021 – being re-rated by investors, with particular focus on the technology sector. As Growth stocks exhibit greater sensitivity to rate rises, owing to their reliance on longer term profits, they typically suffer more from the discounting effect of rising interest rates.

Adding to this mix, it’s clear that tensions between Russia and Ukraine are also causing some concern amongst investors, particularly given how unpredictable Russian President Vladimir Putin can be. Whether this is just political posturing or more a genuine threat is hard to tell at this stage – further developments are likely over the coming week.

What’s the outlook?

In many ways, investors shouldn’t be surprised by recent stock market volatility; certain pockets of the market had been trading at elevated levels for much of the pandemic, not necessarily reflecting its true fundamental value.

Inflation had also been rising for a number of months and it was clear that policymakers were underestimating its more entrenched nature. Markets often have sell-offs like this – we’ve seen it before in 2013 with the ‘taper tantrum’ – but this doesn’t necessarily mean that it will continue or that there aren’t still opportunities.

Much of last year was predicated on the philosophy of ‘buy-the-dip’ and we have already seen some investors use recent volatility to do just that this year. There are also likely to be more opportunities in stocks with less interest rate sensitivity and which had already been trading at wide discounts to other sectors. As ever, the key to managing volatility is a well-diversified portfolio, designed for all types of market environment.

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