Week ended February 18th 2022
“He will win who knows when to fight and when not to fight” – The Art of War, Sun Tzu
Similar to the week before, the themes that mattered this week were inflation (including recent FOMC minutes), earnings and the Russia-Ukraine situation. Concerns regarding the potential invasion of Ukraine by Russia far over-shadowed most other news this week, leading to an increasingly “risk off” sentiment that favoured safe haven assets. I will touch on this further below but let me first summarise the week’s key events as far as markets:
We were reminded once again Tuesday morning with the release of January PPI data that inflation is running hot in the US, very hot in fact. January PPI increased 1.0% in January (vs December), and core PPI (ex-food, energy and trade) increased 0.9%, both sharply higher than anticipated. Y-o-Y (vs Jan 2021), PPI and core PPI increased 9.7% and 6.9%, respectively. Increases in the prices of goods continue to be the most influential as far as PPI, increasing 1.3% in January, versus a 0.7% increase in the prices of services. The Bureau of Labor Statistics press release is hereshould you wish to dig deeper.
Awaiting PPI data on Tuesday morning, all eyes were on St Louis Fed president Bullard who was interviewed that morning on CNBC before the open (and before PPI data was released). It was arguably an opportunity for Mr Bullard to walk back his hawkish comments that had wrecked markets the week before, but instead, he doubled-down and reiterated the aggressive approach he felt the Fed needed to take to quell persistent inflation. FOMC minutes for January 25-26 were also released on Tuesday, which you can find here. I believe that expectations regarding future inflation and the pending Fed tightening is priced into the risk markets now, and for this reason, markets did not over-react to Mr Bullard’s comments or the FOMC minutes from January.
Markets, including the price of oil, gyrated all week with rumours as to the Russia-Ukraine situation, causing heightened anxiety and uncertainty throughout the entire week. Ramped-up geopolitical uncertainty is never good for investors who are trying to make informed decisions. As mentioned above, Ukraine is dominating news and has become the most influential factor as far as risk sentiment. Given this context, it is not surprising that the VIX was in the high 20s most of the week, reflecting heightened volatility in equities.
Earnings remain reasonably good although time and time again, we see that the bias is heavily skewed towards the downside, particularly involving earnings of technology companies, with the most vulnerable being the so-called “high flyers”. Even meeting consensus expectations and providing realistic and positive guidance provides little shelter for companies that are richly valued but disappoint investors in any way. It is clear that the good times are over for the high flyers, and this is weighing heavily on the tech-heavy NASDAQ. Should you want to review the week’s earnings for the S&P 500 companies, check out the weekly update from Refinitiv here. Valuations continue to get more sensible according to Refinitiv data, with the current forward P/E ratio of the S&P 500 index now at 19.4x.
Market data and tables
Geopolitical risks outweighed economic news this week across global markets, with safe haven assets like government bonds, gold and haven currencies rallying, while risk assets like equities, corporate bonds and cryptocurrencies floundered.
The Shanghai Comp Index served up the only positive return week-over-week for the global indices that I track. The SSE also has the best performance MtD in February, albeit trailing the 2022 YtD return of the FTSE 100, the only index that I track which is in the black for the year. Granted, valuations are more attractive in China (probably deservedly given uncertainty around government actions), and the Chinese central bank is becoming slightly more dovish just as the Fed (US) and BoE (UK) head in the other direction, tightening monetary policy to address rising inflation. Perhaps it is time for Chinese equities to outperform. Certainly, for investors with the stomach, Chinese equities look compelling, especially remembering that the Chinese economy is the world’s 2nd largest economy (having just passed the EU in terms of GDP). If you are wondering why the FTSE 100 has done so well this year, keep in mind that the benchmark UK index is both cheap vis-à-vis the US market and its components are skewed towards energy and financial services companies. Both of these sectors have performed well YtD and are likely to continue to do so given the direction of travel of the BoE as far as monetary policy and ongoing issues on the supply-side with oil.
In the US equity markets, it was the tech names that really took it on the chin again this past week, although to be fair, there was virtually nowhere to hide. The NASDAQ Comp is down 13.4% YtD, reflecting this index’s heavy weight of tech names. The S&P 500 – the benchmark US index that returned 26.9% in 2021 – is now down 8.8%YtD, as you can see in the table below.
In addition to equities suffering from investors tilting towards a more risk-off attitude, corporate credit is also continuing to slowly weaken as you can see in the table below. The figures indicate that around
71% of the yield widening suffered in investment grade corporate bonds year-to-date has been attributable to higher underlying US Treasury yields as government bonds have sold off, with the remaining 29% (22bps) attributable to a shift in risk appetite. For USD high yield, around 47% of the increase in yields on such bonds year-to-date is a result of higher yields on US Treasuries, with the remaining 53% (64bps) representing a change in what investors seem to believe is the “right” price of high yield bonds. The spread widening it not really surprising for an asset class that is reasonably well correlated with equities, since equities have been under pressure all year. This does not appear related to concerns over future defaults per se, at least not yet, since the US economy remains reasonably strong. However, the spread widening does reflect – as with equities – concerns about the future effects of higher interest rates and slowing US economic growth.
As investors moved out of equities and corporate bonds, they moved into safe haven assets like US Treasuries. The UST market remains highly volatile and sensitive to inflationary pressures, but the fact is that as geopolitical risk over Ukraine-Russia rachets up, investors are moving into safety. As a result, USTs were slightly better bid at the short end of the curve and flat W-o-W at intermediate and longer maturities in spite of near-record PPI data for January.
US Treasuries weren’t the only government bonds to find a stronger bid during the week due to flows into safe haven assets. Bucking recent trends, prices of 10-year government bonds of the UK, Germany (Eurozone proxy) and Japan also rose this past week, meaning that their yields declined.
Another beneficiary of a growing risk-off attitude is gold. Gold has undeniably been a laggard, but the precious metal has gained stream as geopolitical risk has taken the spotlight, arguably also buoyed by rising inflation. Yen also strengthened this past week, a rare occurrence but reflective of the Yen’s status as a safe haven currency in times of uncertainty.
As far as other assets, WTI crude remained elevated as concerns continue over the effects of a Russian invasion of Ukraine on global oil supplies, principally in the form of what would likely be harsh sanctions on Russian energy exports. Bitcoin also weakened as the week wore on, moving for once in the opposite direction of gold and perhaps – like equities – showing some cracks in what has otherwise been a fairly resilient performance for cryptocurrencies.
Monday is a holiday in the US so equity and bond markets will be closed. I expect next week to bring more of the same as this past week, with continued focus on the Russia-Ukraine situation. Should this situation de-escalate as it hopefully will, this will likely cause a recalibration of investors’ risk attitudes perhaps leading to flows back into risk assets. However, as long as the situation remains in flux with an uncertain outcome, it will weigh heavily on the performance of risk assets like equities.