The new year for markets got off to an interesting start with major equity indexes declining on the week after a poor reaction to a major Fed release on Wednesday. The potential forecasting of policy tightening moved interest rates up and sent high-valuation, growth-style stocks down. There were winners on the week as value-style stocks, particularly in the financial and energy sectors, handily outperformed their counterparts. It’s worth breaking down the rotation and causes to determine if this is a potential investment theme for 2022.
Happy New Year! I hope 2022 brings all of you health, wealth, and happiness.
Alas, capital markets are off to a bit of a dour note to start the new year. The S&P 500 is down more than 1.5% as of Friday’s close, but that does not fully speak to the amount of churn and rotation underneath the surface. Monday, the first trading day of the year, was a moderately positive day that saw the index rise 0.6%. Then, from Tuesday through Friday, investors dumped technology, high-flying growth-style stocks, and bond “proxies.” The buy side of the trade was financials, energy, and value-style stocks, but not enough to keep the index from declining. The divergence by sector and style is notable as seen in the chart below.
Another data point to mark the deviation in performance is by stock valuation measures. Using price/earnings, price/book value, and price/sales ratios, stocks in the highest decile by valuations are down 5-8% on average year-to-date, while deciles of stocks with the lowest valuations are up 3-6% year-to-date. Valuation measures also work on a secular level as the price/earnings ratios of the financials and energy sectors are currently in the 55th and 63rd percentile, respectively, compared to the last 10 years, while technology resides in the 92nd percentile.
What is the root cause of the rotation over the past week?
Interest rates. Full stop.
The 10-year U.S. Treasury yield has risen from 1.34% in early December to 1.77% as of Friday’s close. The quick move in rates is putting some pressure on assets that are considered “long duration” and have loftier valuations (e.g., NASDAQ-100, ARK universe, etc.), as well as on assets that are considered “bond proxies,” such as utilities and real estate due to their yields. We saw very similar dynamics play out at the beginning of 2021 during the economic recovery from the initial Covid pandemic shutdowns, and a smaller cycle at the end of 2021.
That 1.77% mark on the 10-year is a new post-COVID high, eclipsing the prior high from March 15, 2021. Another small move up and the 10-year yield will be above the pre-COVID 2020 level of 1.84%.
What is driving the move in interest rates?
There may be some cautious optimism around the Covid Omicron wave if hospitalizations and deaths remain decoupled from case counts. The dips and recoveries in the 10-year chart above coincide with the initial wave, Delta wave, and Omicron wave of Covid cases.
However, market data supports that the Fed was the main driver of last week’s move. On Wednesday, the Federal Open Market Committee released the minutes from their December meeting. The S&P 500 declined by almost 2% after the release, which was the fourth-worst reaction to Fed minutes by the S&P 500 since at least 2007.
The minutes were consistent with a moderately hawkish stance that the Fed has maintained since the fall. However, there was a new wrinkle around the potential “run-off” of the Fed balance sheet. At some point during policy normalization, the Fed may decide to let some of their bond purchases mature without replacing them, and effectively reduce the size of their balance sheet – aka Quantitative Tightening. There was a discussion around commencing balance sheet reduction while raising rates and at a faster pace than previously mentioned.
“Participants judged that the appropriate timing of balance sheet runoff would likely be closer to that of policy rate liftoff than in the Committee’s previous experience. They noted that current conditions included a stronger economic outlook, higher inflation, and a larger balance sheet and thus could warrant a potentially faster pace of policy rate normalization. They emphasized that the decision to initiate runoff would be data dependent.”
The potential of monetary policy tightening by two methods spooked equity markets on Wednesday and moved the 10-year upwards. However, there should be some moderation in reaction. CNBC contributor Peter Boockvar made a few good points on it.
– Practically, it’s too early to even have the discussion about shrinking the Fed’s balance sheet while they are still growing it into March.
– The minutes said “some” talked about this, not “several.”
– The Fed should be doubtful to repeat one of the same mistakes that they made at the end of 2018, when Jerome Powell was also Chair.
Have a great Sunday!
Timothy W. Ellis, Jr., CPA/PFS, CFP®
Senior Investment Strategist, Wealth Strategist