- UK among strongest performers in volatile month for equities as old economy stocks continue to rally
- Concerns about more rate rises than predicted, including possible 0.5% hike from Fed in March
- Volatility may continue until we get clarity at that next Fed meeting
Geopolitics and central banks dominated sentiment amid a volatile month for equities, with markets suffering their worst period since the pandemic was first declared in March 2020.
Tech stocks bore the brunt of the selloff, with darlings such as Netflix and Facebook hammered on the back of lower earnings guidance and worries about the prospects for longer-duration companies against a backdrop of rising rates. But amid see-sawing markets, unlike in other recent pullbacks, there was also concern about slowing earnings from some of the value names that have benefited from rotations over the last 12 months.
In a tough period for equities overall, the UK was among the strongest performers as ‘old economy’ sectors (energy, materials, industrials and financials) rallied and most of our funds and portfolios benefited from asset allocation favouring what we continue to see as a cheap market. The underweight duration position in our fixed income allocation has also been positive as the asset class has struggled while central banks prevaricate over the timing and extent of rate rises and tapering.
Markets returned to their favourite pastime of central bank watching towards the end of the month, and Federal Reserve chair Jay Powell had the task of telegraphing a rate hike in March to quell the highest inflation in 40 years without terrifying investors suffering from the impact of low activity in Q4 due to Omicron. While equities tend to digest higher bond yields eventually during Fed hiking cycles – as long as the growth/rates mix is favourable – commentators are increasingly citing the risk that a rates shock could trigger a growth shock this time around. This explains why Powell is working so hard to lay the groundwork now, particularly as publication of more hawkish than expected minutes from the Fed’s December meeting, introducing the dreaded concept of quantitative tightening, was enough to spook markets.
As expected, the Fed refrained from any hiking in January but did signal an end to its asset purchasing in March (approving a final $20 billion in Treasury and $10 billion in mortgage-backed securities). All the focus was on what Powell said about rises to come and he confirmed a first step on the hiking path in March, ‘assuming that conditions are appropriate for doing so’.
As a reminder, after the December meeting, the central bank’s dot plot chart showed three hikes expected in 2022, and another five in 2023 and 2024, but Powell did not deny the possibility of rises at each FOMC meeting this year, which would be roughly double what the market is expecting. With US inflation now at 7% and the jobless rate continuing to drop, concerns are rising about a possible 50 basis point increase in March and markets are now pricing in a 94% probability of five 0.25% moves in 2022.
Needless to say, the impact so far – on top of growing panic around the situation between Russia and Ukraine – has been to further weaken risk assets, which had rallied before the Fed meeting, and continue to drive the growth to value rotation. Feasibly, we could see volatility continue until the March Fed meeting provides further clarity on the volume and quantum of hikes. Focus shifted to the Bank of England early in February and the Monetary Policy Committee pushed through a 25 basis point rise on top of its 0.15 percentage point hike in December as it looks to bring inflation to heel.
In contrast to most Western policymakers, the People's Bank of China unexpectedly cut a key interest rate for the first time in almost two years in January as figures showed its growth had slowed. To help boost the economy, the Bank is lowering the interest rate on 700 billion yuan’s worth of one-year medium-term lending facility loans to 2.85% as well as pumping another 200 billion yuan into the financial system. Emerging markets had a tough 2021, weighed down by China aggressively reining back certain sectors – impacting performance on our higher-risk funds and models – and it remains to be seen whether these measures can improve the backdrop. Another factor dragging on sentiment has been the heavily indebted Evergrande Group defaulting on its debts and China’s government is considering a proposal to dismantle the company by selling the bulk of its assets.
Volatility creates opportunities and recent selling has pulled many growth names down to their most attractive prices for months, if not years. From a broader perspective, as patient, disciplined investors, we try to look through short-term noise and identify opportunities we expect to come to fruition over the medium to long term. The past couple of years have provided an extraordinary – in the truest sense of the word – environment for investors to navigate; at times such as these, many end up extrapolating short-term trends into something more substantial and this will often generate plenty of heat but little light.
Over 2020 and much of 2021, many of the businesses that benefitted from the trend for people to stay at home enjoyed exceptional growth; some of that was justified by greater revenue, profit and prospects but some was probably overdone. Particularly when it comes to areas such as the US, we remain firmly in the overdone camp and have tilted our allocations away from expensive growth names to less loved parts of the market, which represent better value.
While we would certainly not see ourselves in the bearish camp (and remain positive on risk assets this year, despite January’s volatility), our view on valuations in the US does share some common ground with that of renowned perma-bear Jeremy Grantham from GMO. In a recent note, he called the recent run-up in US markets the sixth ‘superbubble’ of the last 100 years (after the US in 1929 and 2000 and Japan in 1989, plus US housing in 2006 and Japanese housing in 1989 again).
According to Grantham, all five previous superbubbles corrected all the way back to trend ‘with much greater and longer pain than average’ and he believes the distinct features unique to these previous events have already occurred in the current cycle. The penultimate feature of previous superbubbles was an acceleration in share price rises to two or three times the average speed of the full bull market, which we saw through 2020 and ended in February 2021, during which the Nasdaq rose 58%. The final signal has been a sustained narrowing of the market and underperformance of speculative stocks, which Grantham said occurred in 1929 and 2000, and is happening now.
What is unique about the current situation, according to GMO, is that we also have several other mini bubbles occurring simultaneously, namely global real estate, bonds and commodities. Ending, as expected, on a particularly bearish note, Grantham said that when pessimism returns to markets, we face the largest potential markdown of perceived wealth in US history, predicting a 50% drop in the S&P 500 from its November 2021 high in a recent TV interview.
We are nothing like as negative or definitive as this but would say that total returns from many equity markets, including the US, are likely to be lower this year after such a strong run post the initial Covid-inspired fall in March 2020. With the S&P 500 having risen close to 27% last year, history suggests that after a gain of at least 20% by the index, returns are comparatively muted over the following 12 months, with an average increase of around 8% according to Dow Jones data. The extraordinarily narrow nature of recent US performance is reinforced by figures from S&P Dow Jones indices that show just five companies (Apple, Microsoft, Amazon, Facebook, and Alphabet) contributed a third of overall S&P 500 returns over five years to end 2021. Debate over whether tech superiority can continue will rumble on but we suggest a situation where 1% of companies are producing 33% of US performance seems unsustainable, particularly with a rising rate environment more challenging for longer-duration sectors.
For the foreseeable future, the narrative around markets will be all about rates: if they rise quicker and more than expected, it could be tough for equities; if slower, this should be a healthier backdrop, especially for international and value stocks. While we agree that large parts of the US market are prohibitively expensive, with many 'stay at home' companies valued as if the world is still at home, not everything is priced to perfection and there are sectors such as banks, and value more broadly, that are cheap and projected to perform well as rates rise.
As economies are beginning to open up once more, we expect the coming year will be characterised by a gradual unwind of some of the extraordinary monetary and fiscal policies put in place to reduce short-term impacts of the pandemic. In such a reflationary environment, we expect the rest of the world to outperform the US equity market, value stocks to outperform growth and small caps to outperform large. These outperformances will not all come at once, however, so it is sensible to retain prudent diversification rather than making a significant gamble that one particular thesis pays off.
In terms of trading over January, we are in the process of broadening our passive exposure across the Liontrust Multi-Asset funds and diversifying the number of groups we use. In addition to our existing positions in iShares funds, we are introducing passive products from HSBC and L&G, two of the largest names in this space, to our core holdings.
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