January was a turbulent month for most asset classes, with peak bearishness reached at the beginning of the week of January 24th. Consequently, we chose to write a market and portfolio update for our investors the following day.
The key influence on financial markets in January has been inflation. Particularly, the US central bank, aka the Federal Reserve Bank (Fed), chaired by Jerome Powell, and its acknowledgement of stronger economic growth and crucially, inflation.
Added volatility came from the prospect of hostilities from Russia towards Ukraine. The winding down of quantitative easing (QE) and the question of how many interest rate hikes the Fed would be likely to impose in 2022 unsettled all asset classes with the exception of commodities. Indeed, monetary policy mania was highlighted by the word-by-word analysis of the Fed’s statement on the evening of the 26th of January. Could the Fed raise the Fed Funds rate by 0.50% in March? They might. Short-termism was in vogue: investing is a longer-term proposition. The ‘growth’ to ‘value’ rotation in equities that ended 2021, continued into the start of 2022 before turning into a sell-off in all equities and other risk assets such as high yield debt. The prospect of a more aggressive central bank in the US, and in the UK via the Bank of England, caused a significant rise in government bond yields in January with a knock-on effect on credit markets.
Exceptions and Labels
The one major exception to the sell-off in equities and bonds was the FTSE 100 index which managed a positive outcome in January. That index is heavily tilted towards financials, miners and oil companies and it was the performance of the latter that edged the FTSE 100 index into positive territory. This was largely a consequence of a firmer oil price which rose over 10% during the month.
The previously mentioned ‘growth’ to ‘value’ rotation started with a sell-off in businesses yet to make a profit or ‘cashburners’ as one of our research providers refers to them.
A higher discount rate (higher bond yields) made those ‘cashburner’ valuations unsustainable. That selling created a contagion into equities with a growth label attached to them – even profitable companies with a low reliance on debt. The initial beneficiaries were cheaper companies, often identifiable by a cheap price/earnings ratio and a ‘value’ label.
Price/earnings is a poor valuation metric on its own and many companies are cheap for a reason; their businesses/industries challenged by thin margins and leverage.
The better businesses will be price-makers not price-takers with the former being the better growth prospects for the future. In truth, the defining feature for a number of good companies hit by the ‘growth’ sell-off, will be their earnings. Early signs from those that have been reported is encouraging, with the odd exception.
Most equities, irrespective of their label, endured a poor month. The technology heavy Nasdaq index in the US fell by 10% in January having been down over 15% until a rally in the final week of the month, reduced losses. The broader US S&P 500 index was down 4.3% in January. In the UK, the FTSE All Share performed relatively well, falling just 0.3% in January.
What’s Priced In?
While the outcome of Russia’s intentions with Ukraine is up in the air and tensions simmering, quite a lot of interest rate expectation is priced into the rates market, five rate hikes in the US and UK, as can be seen from the following two charts.
Source: The Daily Shot
What is the bond market saying?
The US Treasury yield curve flattened since January 26th’s Fed guide on rate increases:
Source: The Daily Shot
While January was a poor month for bond holders, from governments to high yield, the prospect of interest rate hikes meant two-year US Treasury yields rose more than their ten-year counterparts, flattening the yield curve. Longer-term interest rates would appear to be more sanguine about inflation, expecting it to subside. Real interest rates remain in negative territory.
Was 2021 all about inventory build in the face of supply shortages? Much of the reported strong growth in 2021 was from the build-up of inventories of goods. With supply shortages abundant, it would appear that there has been a build-up of inventories as a result of over-ordering to avoid running out of supplies. That demand was another contributory factor in higher inflation. As the following graph from Alpine Macro suggests, supply disruptions are abating and with that, history would suggest personal consumption expenditure (PCE) inflation should follow the same downward path.
As mentioned earlier, the oil price was strong in January as were energy prices in general. High and rising energy costs have had a material impact on inflation, but they are, in effect, a tax on consumers – reducing their disposable income – businesses and economies, as a whole. Hopefully, central bankers have learned from past mistakes, not to tighten monetary policy as a result of higher energy costs and hit consumers twice in a double-whammy.
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