Week Ended January 7th 2022
Last week was not a good start to the year for investors, with bonds and stocks tanking because of a confluence of weaker sentiment and sufficiently strong economic data to support a view that the Fed might accelerate its path towards monetary policy tightening, having dropped its “inflation is transitory” rhetoric a few weeks back.
As I have written now for several months, risk assets were approaching – if not already in – bubble territory, at least when considering historical valuation metrics. Fiscal and monetary policy had primed the risk pumps beyond imagination, and as omicron faded into a “more transmittable but considerably less lethal” strain, markets got another push forward as 2021 drew to a close. However, the new year seems to be bringing fresh perspective, especially as far as the trajectory of Fed tightening. Investors interpreted the FOMC minutes from the December 14-15 (2021) meeting, released Wednesday (see here), as showing a potentially more hawkish tilt. US Treasuries tanked following the mid-week release as yields soared. The spike in yields filtered quickly into equities, especially tech / “high-flyers”, which also got hammered. Weaker-than-expected payroll additions for December seemed to reinvigorate the ongoing economic tug-of-war between inflation and growth that the Fed is attempting to navigate. The BLS report (here) released on Friday showed that unemployment fell to 3.9% in December, its lowest level since February 2020 just before the pandemic. This data makes it more likely that the Fed will stay on its hawkish course to address inflation through a series of monetary tightening measures. Eurozone inflation also moved higher in December, reaching 5% Y-o-Y for the currency bloc according to the first release of December data from Eurostat (here). Not surprisingly, yields in the core Eurozone have risen along with yields on US Treasuries, with the 10-year Bund closing Friday at -0.04% (+12bps W-o-W). If the Bund continues to sell off and yields creep above 0%, it would be the first time that the 10-year Bund has been in positive territory in nearly three years (since early April 2019).
The realisation of tighter central bank policy and stretched valuations hit most major equity markets in the first week of 2022, with laggard (and arguably the most attractive value) UK equities being the only market to start the year with a gain.
As bad as it felt by the end of the week, it is interesting to remember that the first day of 2022 was actually a good start for US equities, although this proved to be short-lived. The S&P 500 was mixed albeit slightly weaker on Tuesday following Monday’s gains, but the hammer-blow came on Wednesday when the Fed’s mid-December FOMC minutes were released. The benchmark index never recovered from this, and sentiment across the large cap / defensive names (proxy DJIA), the value names (proxy Russell 2000) and tech/healthcare (proxy NASDAQ Comp) also sold off. Especially vulnerable were the higher volatility technology names, many of which dominate the NASDAQ, the poorest performing index for the week as you can see below. More defensive names and perceived value sectors (financials, energy) performed the best, relatively speaking.
There is a lot of discussion about the effect of higher yields disproportionately on technology names, since a higher rate used in discounting (high growth) future cash flows lowers the present values of such companies. As true as this might be, I am not sure the newest generation of investors – a technical lot living off the mantra of “buy the dip” – really gives two cents about this. However, what cannot be ignored is that higher yields on Treasuries (and corporate bonds) makes these assets more attractive vis-à-vis equities, especially high vol equities. I suppose that time will tell if this was just one more opportunity to dive into equities with impunity, buying the dip at “attractive prices”, or to run for cover.
I have alluded to the effect of the Fed FOMC minutes on UST yields across the curve, and here’s how it looked last week as far as US Treasuries, which gapped out on Monday and continued to steadily widen the entire week.
As bad of a start to the year it was for equity investors, investors in US Treasuries also did poorly as yields moved wider across the curve all week. Not even mixed payroll data on Friday could soothe bond investors, with most pundits and investors saying that the economic data will only accelerate the Fed’s resolve to cool inflation. The yield curve also steepened during the week, indicating a nod towards economic growth and its dangerous sidekick at the moment, inflation. Personally, I remain less concerned about inflation, because I think price pressures will ease (so inflation will prove to be transitory even though the Fed has retired the word). As I have written before, I am more concerned about the Fed moving too abruptly and deflating the various asset bubbles so fast that they lead to a sudden (negative) wealth effect, which in turn blunts demand and tips the economy into recession. Any way you slice it, the Fed remains between a rock and a hard place, as navigating this complex situation will take enormous skill and undoubtedly some luck. Let’s see.
Aside from US Treasuries, other safe haven assets had a mixed week. Gold was down on the week (what’s new?), whilst the US Dollar continued its steady ascent undoubtedly aided by higher US Treasury yields. The Yen, on the other hand, continues to move in the exact opposite direction, continuing its steady downward trajectory. As far as other assets, oil prices continued their recovery off the lows experienced in early December, reflecting a more robust global economic outlook ahead whilst OPEC+ held to its modest January supply increases. Somewhat out of character, Bitcoin and its cryptocurrency breathern were down sharply on the week, as Bitcoin continues to flirt with the lows last reached in late September.
In corporate credit, corporate bonds got hit hard across the credit spectrum. Investment grade spreads came in a few basis points, but this was not nearly enough to prevent a sharp widening in BBB corporate bond yields as prices fell. It was worse for high yield bonds, which experienced both wider credit spreads and higher underlying yields, pushing prices down sharply in BB, B and CCC. Marching to its own beat though, EUR-denominated high yield bonds experienced tighter spreads and lower yields last week, as you can see in the tables below.
This was not the start to the year that investors were hoping, but as I wrote last week, I expect 2022 to be much choppier than 2019, 2020 and 2021, in spite of the pandemic and its aftermath. Tread carefully!