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A message from Joe Prendergast, Global Strategic Advisor, after a volatile week for markets
The opening weeks of 2022 have certainly lived up to the ‘lower returns and higher volatility’ theme that we anticipated for this year. As interest rates rise, it is to be expected that risky asset markets like equities and credit suffer some re-pricing, especially among those richly valued companies whose valuations rely most heavily upon future growth expectations.
This is not a simple unwind of the impressive rally of 2021. The Energy and Financial sectors have in fact extended their strength from last year. By contrast, technology companies, many of which are not yet profitable, have fallen most sharply. This volatility is part of the journey through the cycle – a rotation away from pure growth and back towards value and dependability of earnings, back towards sectors that are more likely to benefit from rising interest rates and depend less on central bank accommodation.
Should we extend this trend of January to the rest of the year? We think not. January is most often a positive month, but a weak January says little about what is to follow. Indeed, January 2021 was a down-month that started a stellar year. And 2018, the only meaning full down-year for stocks since 2008, started with the strongest January we had seen for two decades. We stick with the fundamentals as our guide for the year ahead.
Beyond the volatility, our cautious outlook emphasised that strong economic and earnings growth trends should underpin the broad market in 2022 and beyond. We remain overweight equities, with a strong bias towards sectors less vulnerable to rising rates and less challenged by valuation. Bond yields have risen, and this will help returns going forward, but until central banks signal comfort with inflation there may be more fixed income pain to come – we keep portfolio duration short for now.
Market views
- The US Federal Reserve (Fed) was centre stage last week as it moved to clear the way for ‘lift off’ in March. Chair Powell’s press conference sounded aggressive leaving all options open, but it remains data dependent and therefore could end up quite different.
- More persistent inflation pressure is the reason for the change in tone. But most of the excess inflation is still being caused by excess demand rather than cost push, so equities still provide the best hedge against this.
- In the US, the yield curve flattened with the main weakness in the one to five-year spectrum. This led to some reversal of equity trends. Developed markets held up better in the last week than Asian and emerging markets. Sector leadership was also changing. Rising interest rates and a flattening yield curve favour quality and dependable growth. But what is performing poorly in January is probably what you want to hold for 2022.
Sector special: US banks
- Recently, US banks reported their 2021 results, which were generally better than expected, supported by loan loss provision releases. Meanwhile, their outlooks for earnings are good.
- Bank revenue is geared to interest rates and the Fed is poised to hike rates. Consumer balance sheets and incomes are strong, and they are spending. What’s more, companies are investing in production capacity and inventories. Loan growth is now positive, banks are deploying excess liquidity and interest rates are higher.
- Capital markets activity has slowed but remains well above pre-pandemic levels. Together, this should drive revenue growth, while credit quality remains strong.
- However, some guidance has spooked markets, resulting in share price weakness and the reversal of some recent gains. For the most part, the issues are company specific, rather than general themes, but there has been a lot of disappointment.
Chart of the week: Banks are moving with bond yields
This chart illustrates the strong positive correlation between US bond yields and US banks’ performance compared to the US equity market. We expect yields to trend higher as the Fed raises rates and reduces its balance sheet. However, higher rates are already factored into market expectations, earnings forecasts, and valuations. As the economic expansion matures, growth scares and credit quality concerns will increase. A faster or greater increase in policy rates could accelerate this. The banks’ party probably isn’t over yet, but we are standing close to the door.
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