By Tim Sharp
As the US Federal Reserve turns hawkish equity markets have entered a period of heightened volatility. We have warned before that the chance of a central bank policy misstep has risen and the rapid change in rhetoric suggests to us that the Fed and the Bank of England (BOE) are also now fearing that inflation is getting away from them. The earnings season has provided an element of support despite the spike in Omicron in the fourth quarter, however we believe markets are now focused on the possibility of monetary tightening causing significant contraction in global growth. By the end of a January re-pricing in equities, interest rate markets have priced in a potential five quarter point rate hikes by the Fed in 2022. Following Jay Powell’s press conference after the FOMC meeting last week prices also moved to reflect a heightened chance that this will start with a 50bps hike in Marchi.
The technology heavy NASDAQ index has seen many components move into correction territory as investors rotate aggressively into value stocks. While the headline index was down 8.98% during the month, tech heavyweights such as Netflix (-29.10%); Nvidia Corp (-16.75%); Zoom (-16.11%); Tesla (11.36%); and Twitter (-13.21%) have all experienced bigger falls, with many stocks down over 50% from their 52-week highs. The S&P500 index finished the month -5.26% with the underlying value index (-1.75%) outperforming the growth component (-8.42%) significantly, highlighting the extent of the style rotation despite both indices being in negative territory.
This can also be seen in the outperformance of UK equities where the makeup of the main indices shows a value bias led by banks, energy, and pharmaceuticals. The FTSE All-Share Index finished the month down 0.39% with the large cap FTSE 100 up 1.08% despite the UK CBI survey suggesting UK businesses are facing the tightest labour market conditions since the 1970’s. This may explain why the BOE was so quick to tighten rates at the end of 2021 and, should these conditions continue, it may prove more difficult to contain the inflation threat[i].
The extent of the adjustment in tightening expectations also reversed the direction in the US dollar which had started the year providing support for emerging markets. The US Dollar Index finished the month 0.60% firmer in line with the pricing in of aggressive Fed hiking timeframe and a reduction in the Fed’s balance sheet in the form of quantitative tightening. 2-Year US Treasuries now yield 1.16% as the 2-10yr curve flattens under the weight of tightening expectations which may look attractive to some investors when 2-year Gilts yield 1.04% and 2-year German Bunds are still -0.56%! The sterling trade-weighted index hit its highest level since 2016 during January and should be supported by expectations of further BOE tightening with a second interest rate hike expected this week.
Eurozone inflation registered 5% in December and will come under increasing pressure to address its policy responses at this week’s ECB meeting. Chief Economist Philip Lane has stressed that the criteria for a move in EU interest rates are not in place and are unlikely to be fulfilled this year. The ECB will continue to monitor any pickup in wage growth and household inflation expectations but at this time forecasts are for interest rates to remain unchanged until mid-2023[ii]. We believe that moves to adjust negative interest rate policy and to start quantitative tightening are more likely this year as the ECB maintains a cautious approach.
In the light of such significant prospects for tightening we would have expected corporate bonds to have reacted more negatively, however credit spreads have been resilient so far perhaps guided by macroeconomic developments such as Institute of Supply Management data and earnings results[iii]. Furthermore, we feel markets are also focusing on the likelihood that the implied terminal policy rate will be lower in this tightening cycle than in past cycles meaning less potential pressure on corporate balance sheets.
The tussle between negative real yields and a strong dollar has left gold without its usual safe-haven credentials in the face of rising inflation. Gold has fallen 1.74% so far this year following on from its poor performance last year and is unlikely to attract investors until they are able to better understand the current drivers of inflation plus the likely path of interest rates. The threat of a Russian invasion of Ukraine on top of the already difficult supply backdrop will likely create tailwinds for the oil price which was already up 19.63% in January at $94.03 (Brent). The inflationary environment is invariably good news for commodities and the WisdomTree Enhanced Commodity ETF was 6.40% stronger in January.
To summarise, January saw significant spikes in volatility quite often associated with inflection points in financial markets. The closing levels of many equity indices do not really tell the entire story of the level of market turbulence over the course of this month. The maximum drawdown in the S&P500 was 11.97%[iv] before the bounce into month end and this may prove to be a base. This does not, however, necessarily mean that the market will not re-visit these lows as the turbulence is set to continue, and we feel that it is likely assuming a second leg down into bear market territory does not materialise, that it will be early summer before equity markets recover their poise. The main fear will probably be whether the central bank tightening will bring forward possible recession and we believe future earnings will be a suitable indication of that likelihood. Our base case scenario sees inflation falling as transitory effects unwind and economies reopening following the recovery from Omicron. We believe a major question will be what level of the current inflation proves to be sustainable rather than short term because this will determine the terminal level of interest rates in this cycle and its effect on the global economy.
[i] Absolute Strategy Research – After the FOMC, Now It’s Europe’s Turn – January 31, 2022
[ii] Absolute Strategy Research – ECB = Extra Cautious Bias – January 18, 2022
[iii] Absolute Strategy Research – Technicals Essentials – January 31, 2022
[iv] Bloomberg Points of Return – Be Warned – the Turbulence This Time Is Different – John Authers – February 1, 2022
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