Welcome to Soundbites, weekly insights on market trends and investment strategies brought to you by Investment Executive and powered by Canada Life. With last week’s market volatility, we thought it would be a good idea to get a little perspective from Lenny McLoughlin, chief investment strategist with Irish Life Investment Managers. He offered his views on the tensions on the Russian border, and about this year’s surprise tech sell-off. We started by asking what led to the recent market volatility.

Lenny McLoughlin (LM): The reason we’ve seen this increased volatility mainly relates to the expectations for tighter policy from the U.S. Fed. Now these concerns really emanated from the release of the Fed minutes in early January, which pointed to a faster pace of reduction of the balance sheet and that led to higher bond yields. Typically, when bond yields are rising in a positive or strong economic backdrop, equity markets continue to rise. However, 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. Now, in terms of where markets are likely to go from here, we think the fundamental backdrop for equities remains positive. We see growth of over 4% for the global economy this year, over 3% the following year, and on a relative valuation basis, equities still look very attractive versus bonds. So, overall, we do still see further upside in equity markets.

Ongoing risks that could come into play.

LM: One of the most imminent risks for markets is the Russia-Ukraine crisis. The greatest risk relates to Russia’s importance in the production of a number of commodities, particularly global oil and gas, with Russia accounting for about 17% of global gas production, about 12% of global oil production, and about 4% or 5% of many metals production across the world as well. So, if we were to see an invasion and sanctions being imposed, there is a risk that we could see a significant spike in commodity prices. Sanctions would impose severe costs on the Russian economy. We think the risk of loss of Russian lives and the costs associated with maintaining a military presence would also be quite severe. So, we believe ultimately that a solution can be found which will avoid the worst-case outcome. Another risk — the biggest fundamental risk out there, I think — is if inflation were to remain persistently high. That would mean that central banks would need to be more aggressive in terms of the tightening of monetary policy. If they were to do that, that would be negative for growth and it would also potentially cause bond yields to rise, and that would undermine the relative valuation case of equities versus bonds. However, our own view is that you will begin to see inflation decline as you go through the remainder of this year. We think headline inflation will be closer to 3% and we think European inflation will be below 2% by the end of this year.

What was behind this year’s tech pullback?

LM: One way to value stocks is by discounting their long-term cash flows and this is particularly relevant for the tech sector, where the value for many tech stocks is based on future earnings. As we’ve seen yields rise and that discount rate rise, the future discounted value of earnings for those stocks and for tech in particular falls. And I think tech in particular has been badly hit by that. In relation to the outlook for growth for tech stocks and the tech sector, it does remain quite strong. Many companies within tech have very, very strong balance sheets and that should improve the potential for shareholder returns.

And finally, how he’s amending his predictions for 2022.

LM: When we look through the remainder of this year, we are still positive in equity markets, and we do see them recovering from current levels. On a relative valuation basis, equities continue to look very attractive versus bonds, even after the rising yields that we’ve seen. At current levels of bond yields, equities would need to rise close to 20% to get to fair value versus bonds. When we look at the levels of real yields in bond markets, despite the rise that you have seen in those yields, they remain deep in negative territory and are well below long-term averages, and are still at levels that would be consistent with strong gains in equity markets. The global growth outlook remains robust. While growth is slowing in the global economy this year from just under 6% in 2021 to a little over 4% in 2022, that still remains well above trend growth for the global economy at 2.7%. At this stage, we do see double-digit returns from current levels and we still see a healthy market overall for 2022, although we do think we will see more volatility as we go through the year.

Well, those are today’s Soundbites, brought you by Investment Executive and powered by Canada Life. Our thanks again to Lenny McLoughlin of Irish Life Investment Managers. Join us every Wednesday at InvestmentExecutive.com where you can sign up for our a.m. newsletter and never miss another Soundbite.

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