A volatile transition

Chief Investment Officer's team

31 January 2022

Last week was, again, extremely volatile after the Fed confirmed its hawkish stance.

AT A GLANCE

Last week was, again, extremely volatile after the Fed confirmed its hawkish stance.
Markets are struggling to digest this policy shift, but at least don’t deny it anymore.
Equity valuations are improving, but uncertainty remains elevated.

Volatility continues to be the name of the game. To illustrate with stock markets, 3 out of the 5 largest intraday swings of the last decade happened in 2022. Last week was negative across asset classes: bonds were affected by rising interest rates and tightening spreads, while stocks were hit by risk aversion, even if Friday’s intraday reversal on US markets was positive.

The Fed’s FOMC meeting was a crucial moment. The US central bank confirmed three layers of tightening: an accelerated end to asset purchases, policy rate hikes, and a reduction of the balance-sheet. Over the weekend, in an interview with the FT, the Atlanta Fed Chief even said that he was not excluding the possibility of a 50 basis point hike in March, depending on the economic situation. This sounds quite extreme, but the consensus is now moving toward more than 4 hikes in 2022. It’s a serious change. A holistic and fast monetary tightening is actually as disruptive and as experimental as the holistic and fast deployment of support of the recent years. The impact on markets will depend essentially on how the economy deals with it.

Volatility should remain elevated in a busy week ahead, with quarterly earnings from big tech, key monthly economic data -from PMI to the US job report, policy committees from the ECB and BoE, and an OPEC+ meeting on oil output. We however note that between rising earnings and falling prices, equity multiples show a welcome improvement. It’s probably not totally irresistible yet, but as long as the economy keeps on growing and assuming that the Ukraine situation remain cold, the upside potential is only getting better.

We will share our detailed views on February 9th during our 2022 Global Outlook webinar. Stay safe.

Cross-asset Update

It is remarkable that US equities went through record losses in the first two weeks of 2022 as compared to the last ninety years in the same period, pointing to investors finally finding urgent reasons to want to dump overvalued assets, concerned about what could be coming next. It is the first time since the Covid crisis that multiples and profitability start to really matter, as the year-to-date dismal performance of the Goldman Sachs basket of non-profitable IT stocks proves. This change of heart is related to the large degree of tightening the Fed is minded to achieve to tame inflation pressures. And, since the tightening process is going to be long and winding, given the mammoth liquidity previously injected by the Fed in the system, it is reasonable to conclude that it will require time for equities to see new highs. For investors to regain visibility, we should get further into the withdrawal of liquidity. So, presumably we should first see the end of Quantitative Easing and the first rate hike, which would take us to March, and then get some insights into the shrinking of the Fed’s balance sheet, which would take us two more months down the road, before quite some uncertainty is lifted. In summary, volatility could well persist by and large for the first two quarters of the year. In the process, asset rotations as dictated by the shrinking liquidity pool are set to continue. The clear message from all of this is one and only: investors should be much more careful about what kind of risk they put in their portfolios.

A couple of examples may help better understand the full implications and guide the investment process. When liquidity was abundant, market participants were thrilled at the prospect of earnings or income streams, particularly if way above market-average, occurring even in a distant time in the future. This explains the meteoric rise of stocks tied to very innovative technologies, though loss-making in the shorter term, and explains the surge of the SPACs, special-purpose vehicles offering the promise of spectacular gains alongside limited visibility. It also accounted for spreads tightening even for the weaker credits, as long as the prospect for future growth was there. A shrinking liquidity pool should be reversing that logic, both in equities and credit. Profitability and visibility will come first, at the expense of what is more uncertain and related to a distant time horizon. So, expect the rotation from the most expensive pockets of growth equities into value to continue, and expect that the weaker and longer-duration credits are dumped, in favor of more solid and even somewhat lesser yielding ones. Call it the revenge of value and quality, or to an extent, of the old economy versus the new for now, if you wish, simply because in what is new and innovative there is simply a higher degree of risk.

Gold should offer another case in point. We still disagree with the viewpoint of some investment houses that are bullish on the yellow metal at the current levels. They disregard that across asset classes the tightening cycles of the 70s and the early 80s marked by higher inflation were more painful than the subsequent ones where inflation was much lower.

Fixed Income Update

The much anticipated January FOMC meeting is finally over. While the FOMC statement was benign, the post-meeting press conference set the cat among the pigeons. Chairman Powell’s answers in the Q&A session were more hawkish than anticipated. He never stepped aside from any probabilities regarding the amount or number of hikes. The Fed would be flexible rather than adopting the gradual pace of hikes that had happened in earlier cycles. As a result of such surprise, markets have started to price in 5 rate hikes, with some saying a 50-bps hike in March can’t be ruled out. On the quantitative tightening front, there would be a gradual reduction instead of any shock and awe measures that might be similar to what Janet Yellen had mentioned, akin to “watching paint dry” when she was the Fed chairperson. More important was that FOMC members agreed the Fed should essentially hold Treasuries as part of its assets which might translate to a faster run-off of its MBS book. That could negatively impact the spread of both the Agency and Non-Agency MBS. Moreover, Chairman Powell said they would have at least two more meetings to thrash out the details of the QT pace. It may be highly likely that the QT would begin in May or July of this year.

The 10-year Treasury yields were highly volatile last week, moving up by ten basis points on Wednesday and coming down by seven the next day. The treasury curve has flattened significantly as most of the impact was on the front-end rates, with markets still unsure about the long-term terminal growth rates. The Dec 2024 Euro-Dollar futures still indicate a peak rate of around 2%. Market participants are not confident that the Fed can achieve its terminal rate target of 2.5%. The upcoming March meeting would be a significant one, and Fixed Income markets could be very directionless in the meanwhile.

Credit spreads have been pretty stable except for developed market High Yield. While some risky asset classes are down between -7% to -10%, credit indices across the segments have been relatively stable, losing between -2% and -2.5%. This showcases the importance of asset allocation in investor portfolios and fixed income as an asset class even during a rising-rate environment. High yield spreads have widened by 50 basis points since the start of the year to reach 424 bps losing close to -2.63% compared to -2.93% for Investment Grade credit that has a longer duration. EM Debt has been relatively stable, with spreads widening only by 19 bps since the start of the year. As liquidity is removed from the market, the expensive segments and spreads will mean revert, allowing investors to dip their feet into the asset class.

MENA primary issuance has been taking a hiatus due to the volatility forcing issuers to put off their bond sales. The latest issuer to announce a mandate is ADNOC (Aa2/AA/AAA), which held investor calls last week. This will be an inaugural issuance for the company, and we expect the pricing to be in line with the Abu Dhabi Sovereign curve with 10-20 bps of new issue premium.

Equity Update

Global equities fell a percent last week and year to date are down 6.5%. Though negative year to date and a rough week, EM equities are outperforming DM and vindicating our small EM overweight positioning. The U.S. markets managed a strong Friday close and ended the week positively, after 3 weeks of losses. The S&P 500 was up 0.8% while the Nasdaq flat. Intraday volatility remains high with the Nasdaq in correction territory and the S&P 500 skirting dangerously close. The main driver is a potentially more aggressive Fed tightening campaign than expected. The Nasdaq could possibly have its worst month since the 2008 financial crisis. European equities continued into a fourth week of losses. Weighing on Europe are Russia Ukraine tensions and the possible impact on gas supplies. EM equities fell last week with both China and India falling. The UAE was an exception gaining 2%. Global sectors continued in the same pattern as the first three weeks of January and energy continues to lead sector returns.

The path toward monetary policy normalization will be bumpy, hence demand and growth indicators remain important. In the near term, policy decisions and market expectations will be dependent on both economic and inflation data. Inflation seems to be the centre of market movements, hence our focus on corporate margins and selectivity.

Approximately one third of the S&P 500 companies have reported Q4 earnings; revenue growth is on track to grow +16 % y/y and earnings 30%. A very active week on the U.S. earning front with Apple, Tesla and Microsoft’s record results a standout, along with payment processor Visa. Apple product revenues were over $100 bn with the iPhone, Mac, and wearables growing market share notably and in China while iPad revenues disappointed. Gross margin at 43.8% is noteworthy. Visa payments volumes were up 20% y/y with growth in eCommerce and return to cross-border travel. Key in guidance across industries was the shortfall in semi-conductor supply. The global chip shortage has been caused by increasing automation and intensified by US sanctions on suppliers from China. The US remains reliant on overseas chipmakers such as TSMC. Chip inventories held by manufacturers have fallen to an average of just five days’ supply, down from 40 days in 2019. Mixed reactions from the market, but in line with valuation concerns as Apple and Microsoft gained but Tesla fell post earnings announcements. Caterpillar warned about Q1 margin pressure from supply and labor constraints.

Whilst above trend valuations remain worrying, with the higher rate environment the derating has already begun and the S&P 500 forward price to earning is at 20.1X at the 5 year average level and the European equity multiple is much lower at 14.5X. We expect volatility to continue into a tightening cycle but would add to quality names. Focus on strong businesses at valuations in the median of their sector and margins which will be not overly affected by inflation – both cost of raw materials and wages. No corporate is inflation proof but a good hedge against inflation are dividend paying companies with cash flows strong enough to raise dividends and energy producers.

Written by:

Anita Gupta Head of Equity Strategy , [email protected]
Giorgio Borelli Head of Asset Allocation , [email protected]
Maurice Gravier Chief Investment Officer , [email protected]
Satyajit Singh Fixed Income Analyst , [email protected]

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