With a challenging first month of the year now behind us, subscribers to the old stock market saying, ‘As goes January, so goes the year’ are likely to be packing their bags and heading off in search of a more hospitable environment. Last year’s steadily rising markets, which saw the S&P500 index of the largest US companies deliver an extraordinary gain of 28%, have given way to rising uncertainty, volatility and falling share prices. By late January the S&P500 was 9% lower on the year, with the tech-heavy Nasdaq Composite index falling harder still, losing almost 15%. Warnings of more volatility to come abound, while the FT diligently points out that, while the headline numbers look poor, the real horrors lie beneath: the average stock in the Nasdaq Composite Index is down by an eye-watering 45% from its 2021 peak. This note considers what has changed, and how we propose to respond.
For an explanation of 2022’s volatility, one need look no further than the Federal Reserve (the Fed), the US central bank. The Fed’s stance on inflation in recent months has shifted from benign neglect to a seemingly obsessive focus. Only six months ago, Fed chairman Jerome Powell argued that inflation was a by-product of the supply chain disruption resulting from virus-related lockdowns and the subsequent re-opening of economies. As such, it would prove transitory. In an abrupt volte-face, he and his colleagues on the US rate-setting committee now appear to be on a mission to talk tough in the face of a spike that saw inflation hit 7.0% in December, the highest reading in 40 years. In response, investment banks and other forecasters are competing to quantify just how aggressive the Fed’s interest rate response will be – with the latest being Bank of America’s expectation of seven rate hikes this year alone.
The consensus, then, is that suddenly we have a serious inflation issue. One which will necessitate interest rates rising again and again and again. We find ourselves entirely at odds with this view. Below we offer three pieces of evidence to support our case.
Firstly, the Fed knows that inflation will ease as 2022 progresses. This will be driven by the simple arithmetic of CPI calculations. For example, the December inflation data show that the price of ‘Used cars and Trucks’ rose 37.3% in the prior 12 months. In order for inflation to stay at current levels there will need to be further increases of this magnitude. This does not seem at all likely; as the world economy works its way through supply issues and full-scale production comes back online, price increases will slow or stop. An even more compelling example is the ‘Gasoline’ component of CPI. This is 49.6% higher over 12 months. Again, for inflation not to drop back, there needs to be another c50% increase in the gasoline prices. If such were to occur, we suspect that Mr Powell would be considering interest rate cuts as prohibitively high transport and energy costs dent economic growth, rather than further increases. Thus, even if the price of some components of CPI prove to be more persistent, inflation is likely to fall away.
Secondly, in our view, the Fed must already sense that, strong as the bounce back in economic activity has been, we are now at, or perhaps even past, peak expansion. Survey data such as Purchasing Managers’ Indices, together with retail sales, consumer confidence and other snapshots of the economic picture are, for the most part, beginning to gently disappoint. This is not wholly surprising given that last year’s highly accommodative fiscal policy is not recurring this year. Strongly rising inflation, and aggressive interest rate hikes to deal with it, therefore appear misplaced.
Thirdly, bond yields, having moved higher early in January, have stalled. The world’s most important fixed interest instrument, the US 10-year treasury bond, is yielding 1.78%, up from 1.52% at the start of the year. If bond investors really believed that there will be seven rate hikes this year, that yield figure would have moved much, much higher – perhaps to 2.75% or more. Bond investors, like ourselves, are unconvinced that the economy can withstand sharply higher rates, or that the Fed will have the need, or opportunity, to implement them.
So, what on earth is the Fed up to? In our view, the answer is that it is bowing to its political masters by talking a tough game on inflation. Perhaps there is also an element of barking very loudly now – at consumers, companies and indeed investors – to give them a firm message that the Fed will do what is necessary to bring inflation down. And of course, if
it barks loudly enough, there is every likelihood that it won’t need to bite very hard, if at all, later.
This brings us to equity markets. Early in January the oven- ready explanation was that share prices, and in particular those of high growth companies such as tech businesses, were falling in response to rapidly rising bond yields. This makes sense – the further into the future a company’s forecast profits are, the greater its sensitivity to interest rates and bond yields. Put simply, if it costs me nothing to borrow, I can afford to wait a long time for an investment to pay off, but as borrowing gets more expensive the waiting becomes ever more costly. However, as mentioned above, bond yields rose early in the year but have since plateaued, and at a far lower level than commentators expected, leaving share prices falling for some other reason.
In our view, what we are now witnessing is a long overdue blowing away of the speculative froth that accumulated through the long period of near zero interest rates and super- accommodative fiscal policy. Evidence for this view includes the fact that the biggest falls have been seen in the areas of most obvious excess: the meme stocks, cryptocurrencies, cannabis stocks and blank cheque companies, as one weekend press article put it. This is not wholly unexpected, and also not wholly unwelcome. It goes some way to explaining the 45% fall from peak statistic mentioned above; some shares were pumped up by a great deal of hope and optimism, that is now leaking away. What remains should be something closer to genuine value.
Finally, what do we propose to do in response? Clients will be aware that we de-risked portfolios to some degree in December. This leaves us slightly more defensively positioned, with some dry powder to take advantage of opportunities. For now, however, we intend to press on with the day job. This means we will, much like the Fed, watch the data closely. We believe bond markets in particular are the key to understanding what is likely to happen next and we continue to tap into fixed income managers, strategists and economists to gain greater insight here. Additionally, we continue to interrogate the equity managers of both our recommended funds and others, to build up a picture of how company revenue and profit growth is evolving and how stock market valuations are developing. Should we conclude that changes to portfolios are required, we will of course be in touch.
