A year of low visibility ahead

Chief Investment Officer's team

10 January 2022

2022 starts with inflation, growth and policy challenges questioning elevated valuations.

AT A GLANCE

After the procyclical exuberance of 2021, 2022 should transition to more normal returns
Our central scenario is reasonably constructive, but we expect volatility to be very significant
We have reduced the risk exposure of our TAA to enhance our potential to add on weakness.

There was nowhere to hide last week, as all major asset classes, except cash, delivered negative returns.

There are two pillars to the current market adverse narrative. First, the rapid spread of omicron will take its toll on growth in the beginning of the year. This loss of momentum was clearly reflected from last week’s avalanche of economic data: from tepid PMIs to a clearly disappointing US jobs report. Second, and probably most importantly, it looks like the US Federal Reserve doesn’t care: its hawkish turn from December was recently confirmed by several of its officials. We will get an accelerated tapering of asset purchases, before rate hikes and even a shrinking of the central bank’s balance-sheet. Indeed, such an extraordinary monetary support is not justified anymore, with high inflation, steady growth, and arguably a tight labor market.

Looking through the short-term to focus on the big picture is the challenge of 2022, and it’s not an easy one. As central bank liquidity evaporates, there is fog on the road ahead. The big picture remains constructive. Of course, omicron is poised to weigh on demand. But this should arguably be limited in time, at a time when global supply is slowly, but factually fixing its bottleneck issues. Once the current covid wave abates, the fundamental backdrop could combine steady growth with somewhat lower inflation. Having said that, the timing is unknown, and there is no shortage of concerns for markets to worry about.

This is why our Tactical Asset Allocation starts 2022 with less absolute and relative risk than a year ago. We have cut DM Equity and Gold to neutral, while increasing allocation to cash and hedge funds. We are ready to act nimbly on future volatility episodes. Stay safe.

Cross-asset Update

The Fed made a big hawkish shift at the December policy meeting, by going for an accelerated pace of tapering of asset purchases and projecting three rate hikes in 2022. As if that were not enough, a third layer of tightening was added, according to the FOMC minutes, with a possible shrinking of the balance sheet after the first-rate hike. If never an episode of the end of QE has ended without some form of market crash, one may wonder why such a sudden U-turn, after Powell repeatedly dangled the promised land of dovish policy before investors only until a few months earlier. A simple answer is that Powell must have realized by how much the Fed is late in tackling inflation, and now, being unable to catch up, has to resort to more than one tightening approach in order to avoid that price pressures become self-fulfilling. This means that, once wages start to rise in response to an already very tight labor market, prices will rise in turn, and so on in a loop. And, of course, that loop will be more amplified, the looser the monetary conditions. If this is the case, then we should think that the Fed, while still trying to strike a balance between tighter liquidity and lofty market valuations, in the end will have to partially sacrifice markets in order to crush inflation. Talking up the dollar has so far not been enough to cap inflation via more expensive imports, so something else had to be devised.

Investors should be mindful that all of prior QE programs ended with volatility spikes, and now that the tapering is accelerated, and the Fed balance sheet is larger, it could hardly be any different. Yes, Powell may have gained leeway by heightening his hawkish rhetoric, well cognizant that at some point he will have to use that leeway to at least partially backtrack and limit market damage. Treasury markets are on his side, as yields are still low, both in nominal and real terms. His choice, to go for accelerated tapering which affects longer-dated yields, should steepen the yield curve, as more tapering means more tightening and less need for prolonged rate hikes, which impact the shorter-end of the curve. Indeed, the year has started with some curve-steepening, and this should continue if the accelerated winding-down of asset purchases goes on unabated. While in the shorter term we can expect more asset volatility, in the longer term the terminal rate, the highest one in the hiking cycle, becomes relevant as well. The Fed aims for a terminal rate of 2.5%, pointing to a 10-year yield of 3%, if we add a term premium of 0.5% for inflation. That must be compared to an expected longer-term return for US equities of about 4.5%, hardly an appealing proposition for the additional risk.

In summary, as equities are priced off bonds, if the Fed goes for the full gamut of tightening, cracks would be springing large, as some little number-crunching highlights. However, past history has shown that the Fed is likely to stop way before implementing the full plan.

Fixed Income Update

Fixed Income investors hoping for a respite have been sorely disappointed. The 10-year Treasury yields have increased by c.26 bps YTD to end the week at 1.76%. The ongoing bond rout has resulted in the worst weekly performance for the US Treasury market (-1.19%) since the first week of 2021, culminating in a -1.28% return. The rout was hastened by the release of December FOMC meeting minutes. The majority of the members agreed that FED balance sheet normalization should happen after the rates lift-off, which means that the balance sheet run-off will be a 2022 event. Markets interpreted such wordings as a more than expected hawkish surprise. In addition, the December 2021 employment data indicated the job market is tight as unemployment rates fell below 4% and wages increased. This has resulted in a March hike probability rising to 90%, while markets price close to 3.5 rate hikes for 2022. Some analysts from JPM and GS are also predicting four rate hikes for the year. Moreover, the terminal rate indicated by the three-month Euro-Dollar futures of December 2024 has crossed 2%. The upcoming week has 3/10 and 30-year auctions, which would give us some direction on the market demand.

There have been three significant rate hike cycles in the past 30 years 1994-1995, 2004-2006, and 2016-2018. 10-year yields moved 150 bps during the first cycle, and moves came after the first rate hike. In the second instance, the yields moved up by 50 bps before the first rate hike and then fully retracted once the hike started, which was described as a conundrum. Finally, in 2016 the yields increased by 100 bps before the rate hike and retraced half of the increase in the following six months. That was also the only cycle that coincided with a FED balance sheet run-off from 2017-2019. While FED’s hawkish pivot has resulted in yields increasing, we would be cautious in revising our year-end targets since US Treasuries demand from foreigners and real money will remain strong in 2022, while the lower fiscal deficit would result in much lower issuance as compared to 2020 and 2021. These two factors should keep a lid on the rise in yields and could repeat the “conundrum” that we had seen 2004-2006 cycle.

The spreads across credit segments have behaved well. Only the tightest segments such as US High Yield have seen spreads widen by 21 bps YTD. Even with that, the High Yield market remains at the top of weekly returns. Fund flows from long-duration bond funds turned negative last week, with outflows crossing $2bn as investors remain apprehensive about the MTM losses due to the increase in yields. On the other hand, EM Bond funds saw the first positive weekly inflows since the beginning of November.

The primary issuance market in the emerging markets is off to a slow start to the year with $19bn of bonds priced. As expected, MENA region issuers are yet to come to the market after a strong $90+bn issuance last year on the backdrop of firm oil prices and lower financing requirements.

Equity Update

Global equities are down 1.5% in the first week of trading in 2022, with U.S. equities faring worse at -1.8% and the high growth tech sector selling off, the Nasdaq Index fell 4.5%. The US and tech sector fall started midweek following the release of the hawkish minutes from the Fed's December monetary policy meeting and it seems the Fed could be more aggressive in their tightening campaign than expected. The Treasury yield curve steepened weighing on the growth-related sectors, Technology and Communications Services, and pressuring the interest-rate sensitive Real Estate sector. Amid a third-straight weekly gain in oil prices, the rise in yields, persistent inflation pressures, and still solid economic and earnings growth, cyclically-natured sectors—Energy and Financials outperformed. Weighing on `Fridays U.S. performance was the December nonfarm payroll report, job growth missed forecasts, even though the unemployment rate dropped more than expected. Consumer credit however has soared to it largest level on record, positive for bank earnings. Overall markets seem to be more resilient to the rapidly-spreading omicron variant as its impact looks to be less severe and more reactive to Central bank policy tightening as a result of persistent inflation pressures. European equities finished the week marginally down. Economic data has been good except inflation numbers. Emerging markets fared better last week than their developed market peers though still down. Stocks in Asia finished mixed with India up and China down. We have begun 2022 with a neutral stance to developed markets as the path to policy tightening will create volatility but also opportunities to buy on dips. We have a very slight overweight to emerging markets on better valuations.

Value was the trade of last week and UAE markets saw the better valued Dubai Index up and Abu Dhabi down. After last year’s 76% gains, Abu Dhabi equities are trading at 2.2X price/ Book whereas Dubai equities with only half those gains are at a very attractive 1.1X Price/ Book. We remain overweight the UAE with more upside expected, with a number of new listings in 2022.

Friday sees the start to the U.S. Q4 earnings season, a focal point for the markets as the big U.S. banks begin to deliver results. 22% earnings growth is expected for S&P 500 companies and eco data is supportive. In Q2 S&P 500 earnings grew 91% and CY 2021 should see a 45% earnings growth. Our expectations for 2022 are at 10%. In 2019, the last full year before Covid-19 began affecting the U.S. economy, earnings were down about 0.1% for the year. Looking through corporate results in the coming weeks it’s not just about earnings but how companies got there. While managers are facing rising costs for everything from raw materials to labor to shipping, many have succeeded in passing expenses on by raising prices. The net profit margin for the S&P 500 was 13.1% in Q2 2021, the highest level in data going back to 2008, according to FactSet. It slipped to 12.9% in the third quarter and is expected to fall to 11.9% in the fourth., ,The guidance by corporates will affect markets more than the earnings number themselves – with the focus on how the spread of the Omicron variant could affect business, the impact of wage increases and higher transportation costs.

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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