Bedrock’s Newsletter for Friday 4th February, 2022

Posted by Honey Soleymani on 4th February 2022

Friday 4th February, 2022

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We highlighted in our last newsletter that 2022 had started with quite the bang as fears over inflation and expectations of accelerated tightening cycles from global central banks – most notably the Federal Reserve (Fed) – had driven up interest rates and triggered an aggressive sell-off in both bond and equity markets. You might be forgiven for thinking that things had settled down somewhat in the interim if you had just looked at the weekly returns of equity indices since then. For example, the NASDAQ Composite finished last week up a near record-breaking +0.01% (near record-breaking in the sense that it was the 5th smallest weekly move in the index’s 40-year history, as highlighted by Deutsche Bank’s Jim Reid) and it was up a modest +0.79% this week as of yesterday’s close. However, you would be sorely mistaken. The last two weeks have instead been characterised by drastic inter and intra-day price swings across regions, sectors, and individual stocks, which can perhaps best be exemplified by looking at how the NASDAQ behaved on Monday 24th January: it opened down -2.0%, bottomed out at around -5.0% (when we were closing up shop in Europe), and then staged a late rally to finish the day up a respectable, if not jaw-dropping, +0.6%. 

It is little surprise that some of the key drivers of these movements have continued to be central banks and shifting interest rate expectations (which we will get into in depth below), but the earnings season has also provided us with a sharp reminder that company fundamentals do indeed matter as well. This is something that has seemed all too easy to forget given the fondness of market participants, ourselves included, to place companies into certain buckets (e.g., growth/value, cyclical/defensive) and then use these buckets to explain, and even forecast, share price movements in the context of macro factors. We are not saying that this is not a useful tool – indeed, we would argue that it is a crucial tool in making asset allocation decisions – but it is far from the full picture when assessing what makes a company a good investment. We need look no further than the performance of the individual FAANG stocks, often viewed as a fairly homogenous collection of high-growth large cap US tech stocks, this year to see this. While all of these stocks have come under pressure from higher interest rates and concerns about valuations, Netflix and Meta Platforms (formerly Facebook) have both recorded over 30% declines YTD as the former reported a slowdown in subscriber growth, confirming fears that the pandemic-induced growth rate could not be sustained, and the latter reported its first ever decrease in active users. Meta Platforms actually fell -26% in one day after releasing results, which wiped $237bn off its market value and represented the largest single daily loss for a company in absolute terms in history. On the other hand, Google (-1.6% YTD), Apple (-3.2% YTD), and Amazon (-6.6% YTD) have proved significantly more resilient. Amazon even popped +12% yesterday after announcing strong earnings and an increase in the cost of Prime membership. All of this is just to say that a company’s ability to grow its earnings over the long-run is still the key determinant in its long-term share price performance, even if macro factors such as interest rate movements can cause significant short-term fluctuations. Active selection still matters. Indeed, it is going to be even more important in the coming months and years as global monetary policy tightens and the tide that seems to have lifted most (if not quite all) ‘boats’ finally recedes. And with that, on to the central banks.

Starting with the Fed’s meeting last week, there has been no change to the Federal Funds Rate itself. However, the Fed also made it abundantly clear that there was going to be no backing down from the hawkish pivot that had started towards the end of Q4 2021. Chair Powell stressed that the US economy is in a much stronger position than it was during the last hiking cycle in 2015-2018 – inflation has now exceeded the Fed’s 2% target for some time and has proved to be more broad-based than initially thought, while the labour market is tight by historical standards and is closing in on the Fed’s definition of “maximum employment”. The implication of this was, of course, that the hiking cycle itself will also be different (i.e., faster) and little was said to the contrary… When pressed on what this means for the actual path of monetary policy, Powell did not rule out the potential for faster rate hikes, nor the potential for hikes in increments larger than 25bps. The net result was another significant shift upwards in interest rate expectations, which have only been further spurred by strong economic data in the US this week. While the ISM Manufacturing PMI for January (57.6) was more-or-less in line with expectations, the survey’s measure of prices paid to suppliers was significantly higher than anticipated, reminding everyone that inflation is still a pressing issue. At the same time, the recently released US payrolls data smashed expectations by reporting that 467,000 jobs were added to the US economy in January (compared to c. 150,000 expected). These results were collected during the peak of the Omicron wave in the US and the White House itself had warned about the potential for the report to disappoint just earlier this week given this fact. Quite the beat! All of this has effectively cleared the run-way for the Fed to proceed with its tightening and, as of writing, markets are pricing in over 5 full hikes for 2022, which corresponds to an implied policy rate of 1.30% by year-end. Just for context on how quickly expectations for rate hikes in 2022 have shifted, 4 hikes were priced two weeks ago, 3 hikes were priced at the start of the year, and just 1 hike was priced in September last year. It is also worth highlighting that nearly 1.4 hikes are now priced in for March, meaning markets see a significant chance of a 50bp raise. In terms of bond yields, the moves have been most acute in the shorter end of the curve and we have seen the US 2Y rise to 1.27% from 1.00% two weeks ago and 0.73% at the start of the year. The 10Y has also moved upwards, though to a much lesser extent and we have seen a meaningful flattening of the curve overall, suggesting that a rate-induced slowdown in the US is on the cards.

Then there were the BoE and ECB meetings yesterday. As expected, the BoE voted to hike the policy rate by 25bps, following on from another 25bp hike in December. While the hike itself was expected, 4 out of the 9 committee members voting for a 50bp increment was not. Now, this could be seen as the BoE talking tough in an attempt to get markets to tighten monetary conditions for them, similar to how Governor Bailey’s surprisingly hawkish comments in early Q4 last year drove rates up well ahead of the actual hike in December. However, given the BoE’s inflation forecast sees inflation peaking at 7.25% in April (the first time it has crossed 7% for 30 years), we would not recommend taking them lightly and the 5 hikes being priced in for this year seem like a very distinct possibility. That said, it was the ECB that possibly provided the biggest surprise in a rare turn of events. In the post-meeting press conference yesterday, Lagarde pointed out that “risks to the inflation outlook are tilted to the upside, particularly in the near term” and she did not reiterate her comments from just a few weeks ago that rate hikes this year were unlikely. This resulted in a rapid repricing of expectations – lift-off is now expected to be in either June or July and 5 hikes are being priced in for the full year – and we saw significant moves across European sovereign curves. Just to cherry pick some of the most notable changes, the German 10Y yield has risen nearly 20bps this month to 0.20% (its highest level since March 2019), while the German 2Y yield has risen c.27bps to -0.25% (its highest level since 2015). 

While we have spent a good number of words discussing interest rate expectations, we would also like to add that the market has a remarkably poor track record of actually predicting future interest rates and we avoid putting too much stock in these figures. This is simply because the path that interest rates take is dependent on what happens in the real world, not economic models, and no-one has a crystal ball. That said, we do believe that further volatility in interest rates, and markets more broadly, is inevitable this year and we suggest that everyone keeps a close eye on the CPI, and other inflation indicators, in the coming months, as they will play a crucial role in deciding how far and how fast rates rise. In the meantime, we can only recommend that you stay diversified!