Commentary: Not Happy Jan!
Investors are positioning for significant changes to monetary policy in 2022 which is increasing market volatility. Much has already been factored into interest rate structures, but the actual pace and size of tightening will hinge on inflation. If inflation reverts, central banks will have greater flexibility in their decisions.
Januarys like the one we have just witnessed are rare. Since the 1970s, we’ve only witnessed three other instances where an equity market drawdown in the first month of the calendar year exceeded 8%. Those years were 1990, 2008, 2016 and 2022. Of those years, the only one ‘rhyming’ with this year is 2016, when the US Federal Reserve was also at the early stage of raising official rates. Back then, after 7 years of holding the Fed Funds Rate near zero, the Fed had only completed one 25 basis point hike, and the market feared that move was excessive. Admittedly, not each of those occasions were at the same point of the Fed rate ‘cycle’ however in each of those historical instances it was clear the market thought that the prevailing interest rate policy was too tight for the economic outlook. Each of these instances of perceived policy mistakes has been priced more rapidly than the last. Fast forward to 2022 and the market is pricing in a negative scenario potentially just two months in advance of the first official rate increase.
The market is rotating
Two aspects strike us as interesting in the current market. Firstly, despite some headlines suggesting the indiscriminate dumping of stocks, the market is still rewarding winners. Higher interest rates have had an outsized impact on high growth stocks because their (outsized) profits are usually expected to be delivered furthest into the future; that is, they are long duration assets. At zero interest rates, those long-dated profits receive little discounting to today for a net present value (NPV) calculation, yet as interest rates rise the NPV of those profits quickly falls. While many of the high growth Nasdaq names have tumbled, companies that are delivering today and above expectations are being rewarded by the market. For example, American Express surprised the market with fourth quarter earnings increasing 20%, resulting in a 9% rally on a day when the S&P 500 was down 1.2% in volatile trading.
The second observation is that thus far, high yield credit spreads have barely moved higher during the equity selloff. There are various explanations for this from differentiated investor bases between equities and credit and a continued search for income, but it could simply reflect that while higher rates will impact long duration assets, the current expectations of Fed rate hikes will not meaningfully impact the default risk of even the riskiest companies. What is clear is that we are witnessing a considerable amount of rotation within equities, yet the fundamental outlook for the economy and company earnings remains relatively unchanged. This reaction to higher rates is one of the reasons that we have continued to hold a value and quality bias within our equity exposures, as our underlying companies are able to weather higher rates more readily.
Inflation and politics are factors to watch
The key metric we continue to focus on remains inflation. We have long held the belief that the current elevated levels of inflation in the US will prove to be transitory and start to revert in the next few months, settling in the 2-3% range by year end. This is driven by our analysis of base effects, cyclical versus non-cyclical inflation, supply chain disruption and transport costs, as well as measures of lockdown which limits spending on services relative to goods. This base case is also supported by the current expectations for the Fed rate hiking cycle, which now stands at five 25bp increases over the next 12 months and which should also continue to lower future inflation expectations.
One area of risk that we think the market might be too sanguine on is geopolitics. The obvious areas of ongoing concern are Russia, China and of course North Korea. Even with the increasingly heightened prospect of war between Ukraine and Russia, the Russian ruble has only underperformed broad emerging market currencies by 1% over the past three months. Admittedly, this is an overly simplistic comparison due to supportive idiosyncratic factors such as higher oil prices and interest rate differentials, but it hardly reflects the economic risks for a country about to wage war. While conflicts such as these are obvious geopolitical risks, we are also cognisant that investors aren’t yet focused in on upcoming election risks, and what a change in government might mean for fiscal policy. Elections are scheduled for 2022 in South Korea, France, Canada, Brazil, the USA and of course Australia, all of which have the potential to surprise the market and create investment opportunities. As we move through the first quarter we will be paying special attention to domestic politics and the campaign policies, as well as the polls, to ensure we insulate the portfolio from any voting surprises.
Wrapping up with COVID-19
Lastly, a final comment on the pandemic, but hopefully a positive one. With 81% of the population vaccinated, Denmark has made the decision to lift all COVID restrictions with COVID-19 no longer considered a ‘socially critical sickness’, according to the government. We also note that political debate has shifted in Japan with regards to downgrading COVID-19 to an endemic, now that they have reached 80% fully vaccinated status. What this signals is that economic disruption from subsequent COVID waves is likely to be far less going forward, and the political appetite and public acceptance for future lockdowns is very low. Hopefully, 2022 will be a more normal year.
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