After an extended period of calm in the markets that provided relatively strong and stress-free results, the new year has begun with a significant increase in volatility and market weakness that we haven’t seen since the onset of the pandemic.

The volatility has created not just day-to-day swings in the major market indices, but also material intra-day swings whereby markets will open down, continue to sell-off over much of the trading day, and then reverse to move in to positive territory before the market daily close. And vice versa. Recall that markets dislike uncertainty. It is clear there are divergent views on the future path of the market, primarily based on the sustainability of current high inflation and the direction of interest rate, but I will address that below. The uncertainty and differing views are pulling the markets in different directions, with the outcome changing from one day to the next, or even a few hours to the next.

I think there are three contributing factors to this uncertainty and resulting weakness in the markets. In increasing order of importance, they are i) Covid; ii) geopolitical risks; and iii) inflation and interest rates.

Covid

Omicron appears to be more transmissible than other Covid variants before it, however, and fortunately, it appears to cause less sickness and death among infected individuals. This is likely a function of the virus itself and vaccination rates. And it appears it is becoming endemic after almost two years of a pandemic. The effects on human life, on economies, and on financial markets remains. We continue to see localized restrictions and impairments to corporate activity in an attempt to contain the virus. This will continue to have an impact on the markets for the foreseeable future, but the size of impact is continually waning.

Geopolitics

Escalating tensions between Russia, Ukraine and NATO forces have led to heightened risks of war in the region. Russia is concerned with the influence NATO and the west have over the countries that border Russia. The U.S. and NATO do not want Russia’s attempts to redefine its borders to be successful. Over the past few weeks, the tensions have increased as Russia pushes the U.S. and NATO to see how far it can go and the U.S. considers its options. While some sanctions against Russia are possible, a large-scale invasion and the threat of multi-regional involvement appears less likely for now.

Inflation and Interest Rates

The diverging views I mentioned previously relate to the extent to which inflation persists and the resulting action that central banks will need to take with interest rates. Is inflation transitory and a by-product of the Covid pandemic or is it more pervasive and long lasting than we have been anticipating? How quickly and aggressively will interest rates need to be raised to keep inflation within a target band over the next year or two? The answers to these questions, or rather, the uncertainty caused by the lack of clarity in these answers, is the primary cause of the current market action.

Yesterday was an important day as both the Bank of Canada and the U.S. Federal Reserve had meetings to assess their respective economic environments, determine whether an interest rate hike was warranted, and provide the market with their collective perspective to ensure inflation does not become a longer term problem. Neither central bank raised rates today, but both indicated future hikes are warranted, beginning as early as March, 2022. Both central banks acknowledged that inflation is appearing more persistent than initially thought, and inflation is beginning to reflect in wages and a broader list of goods. Both central banks indicated we are entering a monetary tightening cycle that will see multiple increases to interest rates over the remainder of 2022 and even into 2023.

One competing view is that the central banks are starting a rate hiking cycle from behind, which is a source of risk if they rush it and make a policy mistake. Hiking rates too quickly or too aggressively has the potential to extinguish growth, upend both credit and equity markets and push the economy into a recession. This will result in further market weakness.

The alternate view, and the view I hold, is that the spike in inflation has mainly been caused by Covid due to excessive and prolonged fiscal policy, supply chain bottlenecks and an imbalance in goods versus services spending. The generous fiscal initiatives that were essential support for most of the pandemic are having a lasting, bloated impact on the ability of the consumer to spend. These supports are ending and will soon right-size household spending patterns. Reduced inventories, reduced manufacturing capabilities, as well as port and transportation congestion are all well documented and will normalize over the coming months. The goods and services imbalance is significant as higher goods prices are the primary contributor to current inflation data. We have overspent on goods over the past few years. The pandemic caused excess demand and under supply was an outcome of lockdowns and restrictions. We are starting to see some weak data that is primarily goods related. As the pandemic recedes further and economies continue to recover, competition for consumer spending on services will balance the equation at the expense of goods. Central banks should be counting on this slowdown in the demand for goods to contribute materially to tempering inflation over the rest of 2022 and should result in avoiding an overly aggressive policy.

Both of these diverging views agree that higher interest rates will cause a repricing of risk assets. The difference is the speed and degree of repricing that is caused by central bank policy on interest rates. We have experienced the effects of this repricing of the equity markets over the past several weeks. Some days the leading view in the market is that inflation is a long term problem and central banks are already behind the curve and rate hikes will come quickly and aggressively. This view causes selling of all assets, all positions, as the repricing needs to be done at lower valuations. Other days the leading view is that central banks will manage inflation to a soft landing for their economies and interest rates are moving higher but in a controlled and manageable path. This view will provide ballast to the market and allow the mispricing to be selective, rewarding quality businesses with growing earnings and those with the ability to adjust to changing economic conditions.

Bottom Line

Volatility is higher than we’ve seen in some time. Markets have declined from their highs at the start of 2022. Portfolios have lost value over the past several weeks. And this can be cause for concern.

However, the economic backdrop remains supportive for continued growth in earnings, a key ingredient for markets. We are beginning another quarterly earnings reporting period, and to-date, the results have been encouraging. I believe our client portfolios own quality businesses with a demonstrated track record of adapting to changing operating and economic conditions. While the current uncertainty has led to some weakness, markets have in the past been resilient and ultimately remained on an upward course over the long term.