Equity markets got out of the blocks enthusiastically as 2022 started, but had their wings clipped as it became clear that US monetary policy would be tightened sooner than anticipated due to persistent inflation. This left many investors scrambling for a new equilibrium and boosted market volatility.
The US Federal Reserve’s comments about possible ‘quantitative tightening’ came as a surprise as they marked a turning point for financial markets after years of the Fed and other leading central banks providing abundant liquidity.
Implied volatility rose to its highest since end-November/early December as it became increasingly clear that neither economic data, which could prove to be mixed in the coming weeks, nor pandemic-related risk – which appears to be fading – would cause the Fed to swerve from its roadmap.
Faced with inflation persistently above its 2% target and a large fall in unemployment, the policy-setting Federal Open Market Committee signalled that the federal funds target rate would be increased from 0% to 0.25% at the March 2022 meeting, that further increases could come at each of the seven FOMC meetings this year, and that steeper 50bp increases were possible.
Updated expectations on rates now have economists forecasting six to seven US rate increases this year. The market’s estimate of the terminal rate at the end of the cyclic is, however, still below the Fed’s long-term rate estimate.
Rising bond yields are obscuring solid equity fundamentals
As monetary policy expectations changed, bond yields rose, impeding equities. Growth stocks, which so far this year are underperforming value stocks, were hit hard. The rise in nominal 10-year yields was accompanied by higher real yields, up from -1.08% at the end of 2021 to -0.71% at the end of January, after touching -0.60%, the highest yield since March 2021.
Equities, though, face a reasonable growth outlook, even if the latest results from some big name companies have disappointed and fewer companies have surprised to the upside than in recent quarters. That said, profit growth appears generally positive.
Some CEOs have been cautious on the outlook, perhaps due to limited visibility on the course of margins.
A tech sector tumble
Monetary policy jitters sent indices reeling in much of the world. The MSCI AC World index lost 5.0% in January (in USD terms), hitting a May 2021 low. Emerging market equities fell by a smaller 1.9%, supported by higher commodity prices.
At -5.2%, the US S&P 500 posted its biggest monthly decline since March 2020. Highly valued and interest-rate sensitive tech stocks suffered in particular: The Nasdaq composite had lost almost 15% by 27 January.
The eurozone EURO STOXX 50 benefited from its more favourable sector make-up and brighter economic news, losing a more modest 2.9%. In Japan, the Nikkei 225 lost 6.2% as surging Omicron infections led to the re-imposition of a broad state of emergency.
Globally, the technology sector also lagged markedly. However, energy stocks outperformed on the back of higher oil prices. Banks did well. A steepening eurozone yield curve enabled European financials to outperform their US counterparts.
US market developments dragged eurozone bonds lower. The yield on the 10-year German Bund rose from -0.18% at the end of December towards 0%, a level not seen since April 2019.
The Fed’s more hawkish tone and doubts about the ECB’s insistence on the rise in eurozone inflation being ‘temporary’ fuelled market expectations of an increase in key ECB rates. However, the front end of the euro curve rose by less than in the US.
While the ECB is now signalling that it will take ‘all necessary measures to ensure that its 2% inflation target is met over the medium term’, it could opt to cut back its asset purchases in support of growth by more than announced previously if it felt it needed to counter the inflationary pressures.
This kind of ‘quantitative tightening’ would precede any considerations of higher policy rates. Such a scenario differs markedly from the more assertive path that the Fed now appears to have embarked on.
Build back selectively
After concerns over the outlook for the services sector – and wider growth – in late 2021, there now appears to be greater confidence that the global economy can grow at well above its long-term average in 2022 as successful vaccination drives allow governments in many developed markets to ease Covid restrictions.
There are hopes that the less virulent Omicron variant could be the first sign of Covid-19 becoming endemic, clearing the way for a full-scale reopening and a return to more normal economic conditions. From a macroeconomic perspective, the concern is therefore not growth, but inflation.
The recent, weak Purchasing Manager Index readings from China highlight the economic impact of the country’s tough strategy on Covid, which could drag on activity and exacerbate inflationary pressures by prolonging supply bottlenecks.
After January’s financial market gyrations over rising real yields in the context of stretched valuations in many equity indices and sectors, investor positioning indicators signalled caution and pointed to imbalances. Market-technical factors are now indicating a continued rebound in February. Also being mindful of geopolitical risks, we continue to rebuild positions very selectively.