Stephen Dover, Head of the Franklin Templeton Investment Institute, recently sat down with colleagues Scott Glasser, Chief Investment Officer of ClearBridge Investments, and Mark Lindbloom, Portfolio Manager for Western Asset, to discuss recent US market volatility.
Volatility Is to Be Expected
We are emerging from a period of unprecedented fiscal and monetary stimulus which flooded the markets with liquidity. Now this liquidity is slowly being withdrawn, as the Federal Reserve (Fed) seeks to combat inflation. Considering this, in conjunction with a once-in-a-generation global pandemic, and volatility is understood, if not expected. Equities, most notably growth stocks like those in the Nasdaq, are long duration assets. As such, they tend to be extremely sensitive to changes in liquidity. This market is probably as long in duration as any we have seen since the early 2000s.
A Transition to the “Old Normal”
As we move from a period of low inflation and excess liquidity to one with modest or higher inflation and less liquidity due to central bank tightening, we view this as a normalization of market conditions—a return to the “old normal” so to speak—with more regular periods of volatility. We may have forgotten that it is typical to have 10% corrections periodically. Volatility is a completely normal aspect of a healthy market as it allows for rotating leadership in terms of sectors, market capitalization, geography, and valuation.
This Isn’t the Inflation of the ’70s
Finally, as we look at what is happening with inflation today, it is important to recognize this is not the inflation of the 1970s. First and foremost, the current Fed is resolute in its intent to do what it takes to fight inflation, which was not the case until 1979 when Paul Volcker was appointed Fed chair.
Second, the secular headwinds of the last 40 years that have kept inflation in check are still in place, including technological progress, global trade dynamics, demographics, and an aging population. The supply chain issues that we are seeing now are very different than the shocks with oil supply that occurred then, and less likely to cause more lasting economic damage.
The near-term impacts of the factors above will likely keep volatility elevated in 2022 as growth expectations are being revised downwards. That said, this volatility leads to opportunities in both the equity and fixed income markets.
What Are the Risks?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds adjust to a rise in interest rates, the share price may decline. Special risks are associated with investing in foreign securities, including risks associated with political and economic developments, trading practices, availability of information, limited markets and currency exchange rate fluctuations and policies.
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