As long as policy uncertainty remains, markets will be in flux

The speed of equity market moves in January have been violent. At one point in the month, global value stocks were outperforming growth stocks by over 10%. But shifts are happening throughout the financial markets.

Inflation rates are at multi-decade highs in developed countries, bond yields are rising, the US dollar is strengthening, and commodity markets are climbing. While these trends started last year, the difference now is that all the major central banks are signalling a switch to quantitative tightening.

But there is still considerable policy uncertainty. For example, we don’t know the pattern of interest rate rises or how balance sheet run off will be conducted.

While central banks keep their options open, the chances of a policy mistake are high given the level of inflation to cool versus the mountain of debt that could be tipped into bankruptcy. That’s why real rates are a key metric to track; as they approach positive territory, risk rises sharply. In that context, the six interest rates hikes that bond markets expect from the Fed this year seem excessive.

As the paths of central banks unravel, volatility will likely remain higher than normal. For equity investors, the onus should be on earnings growth. Companies that can protect their margins in an inflationary environment will be in demand. We expect a respectable 6% earnings growth this year, but with wide dispersion between companies, and that should deliver reasonable returns. A deeper assessment of the drivers of earnings this year can be found here.

Toby Gibb

Global Head of Investment Directing, Equities

The Equities Outlook provides an overview of our investment team’s views and positioning in each of the key markets. Each of our portfolio managers has discretion over the positioning and holdings of their portfolios, and, as a result, there may at times be differences between strategies applied within a fund and the views shared in this document.

TRADING DESK UPDATE

A month of extremes

January was characterised by some extreme rotations, but it was ultimately a risk off month for equities, with most developed markets down 2-10%. The VIX spiked more than 65% higher, value beat growth, large caps outperformed small caps, emerging markets pipped developed markets, and the US dollar strengthened. Market leadership was dominated by value sectors such as energy and banks, which dramatically outperformed the more expensive technology and industrials sectors.

Market sells off as yields rise

Source: Bloomberg, 2 February 2022.

The S&P 500 started the year with a new all-time high only to pullback 5.9% and close the month down 5.3%. The Nasdaq returned -8.5%; its worst month since Q4 2018, and the Russell 2000 posted -9.8%.

Volatility driven by a mix of technical and fundamental factors

High inflation, rising rates, and slowing growth dragged markets down and triggered stark rotations. During the month, the move out of growth and into value names registered a performance differential of +15.4%, expensive growth/technology companies fell 19.4%, and energy and commodity sensitive equities climbed 19% and 7.8% respectively, which were supported by oil prices rising 17% year-to-date.

The volatility was driven by hedging flows (ETF flows reached 40% of overall US flows - a level similar to March 2020), a lack of liquidity (liquidity in the highly liquid S&P 500 e-mini futures instrument ranks in the lowest percentile compared to the past 10 years), and a geographical shift out of the US and into emerging markets via ETFs and futures products.

Wide dispersion indicates rotation underway

Source: Refinitiv, MSCI, January 2022.

While markets are increasingly expecting more than four interest rate hikes this year, posing a headwind to stocks, corporate earnings were generally better than expected, providing some support. At month-end, 52% of the 169 companies in the S&P 500 that reported results beat estimates by more than one standard deviation, compared to 46% historically.

Some mega mergers grabbed headlines in the capital markets, but deal flow is slowing. European M&A activity was 66% lower in January compared to last year. IPOs are also cooling reflecting uncertain investor risk appetite.

Hong Kong stands out; China growth positively surprises

Asia broadly took its cues from the prevailing global sentiment. Key markets were down significantly including Korea’s KOSPI (-10.5%), China’s CSI 300 (-8%), Japan’s Nikkei (-6%) and Australia’s ASX 200 (-5%). Hong Kong managed to swim against the tide and the Hang Seng eked out almost 2% in gains. The rotation into value supported the banking-heavy index, with HSBC, Hang Seng Bank, Standard Chartered and Bank of China all up 7-20%.

Macau stocks were in demand as investors appreciated the greater regulatory and policy certainty for the sector. In the onshore China market, sentiment was briefly lifted by a 10bps cut to the one-year medium-term lending facility (MLF); markets had expected only 5bps.

China’s Q4 GDP growth of 4% yoy surprised to the upside but failed to buoy onshore markets through to the end of the month. Net flows into China via Northbound connect were CNY 16.8 billion (US$ 2.7 billion) and on Southbound connect into Hong Kong were HK$ 44 billion (US$ 5.6 billion) in January.

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