In the early part of 2022, equity markets have fallen sharply and volatility in markets has risen. The main driver of this correction has been due to a view that high US inflation is stickier than previously expected and that interest rates will need to rise faster than previously anticipated. As a result, investors have repriced equities downwards.
The economic outlook remains strong with growth expected to be above trend in 2022. However, the US Federal Reserve is expected to raise US interest rates by at least 1% over the year and to remove liquidity from markets. As equity market valuations are quite high relative to history, the US Federal Reserve actions are likely to be a headwind to equity markets if they occur as expected.
We note that interest rates around the world, and particularly in the US are currently extraordinarily low, which is stimulating growth in the US economy when it is already at full capacity. The coronavirus with its different, increasingly infectious variants is putting additional pressures on supply chains and labour supply. This puts further upward pressure on inflation. Markets are expecting that the Federal Reserve will successfully manage the current inflation problem, with inflation expectations remaining well anchored over the medium term.
Given current policy settings and the economic backdrop, central banks are in a difficult position. They are at heightened risk of policy mistakes, which would impact on economies and on market performance. On the positive side, an easing of supply side pressures which should occur when the pandemic eases and supply chains are strengthened would see a rebound in market performance. History tells us that equity markets experience frequent bouts of volatility. Current conditions are the latest example of this.
A wide range of potential outcomes are possible from here and, as always, we continue to invest in markets with the long term in mind. At this stage, we are not expecting a major correction in markets. We continue to monitor markets and economies for evidence that we need to change our portfolios, keeping in mind that over the medium to long term we expect that equities will outperform cash and bonds.
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