The final week of January saw considerable ructions in financial markets with some unusually strong intraday shifts in valuations. For example, on 24 January, we saw a swing in the US S&P 500 equity index of a magnitude that has only occurred eight times in the last century. Over the past week, the tech-heavy Nasdaq 100 and the broad S&P 500 have put in a bottom and started to recover.
Investors have viewed the fall in valuations – before the recovery began on 24 January, the Nasdaq 100 was down by as much as 16.58%, with the S&P 500 off by 11.97% year-to-date – as a buying opportunity.
Monetary policy, real yields and earnings
We see the turmoil in equity markets as the result of markets wrestling with the question of how the two main drivers of asset returns – discount rates and cash flows – will fare amid the known unknowns represented by the prospect of tighter monetary policy and the next stage of the reopening of many economies.
Real yields have barely recovered from their COVID-policy driven 2020 plunge: if they were to rise by 90bp from here, it would only get us back to the levels over the decade of secular stagnation after the Great Financial Crisis. The rise so far in real yields, although modest since the beginning of 2022, does boost the importance of the growth outlook in determining the performance of risky assets.
As central banks tighten monetary policy against a backdrop of rising inflationary pressure, bond yields (or discount rates) are likely to rise further. For this reasons, we hold underweight positions with regard to interest rate risk in our bond and multi-asset portfolios.
Company earnings may fall if economic growth falters. The pace of upward earnings revisions slowed in the fourth quarter of 2021, while the ISM manufacturing index has declined, but remains elevated at above 50. We expect economic activity to be resilient in 2022, supporting earnings.
Relative to the rest of the world, we see scope for stronger earnings in Europe, Japan and emerging markets. Equities in these markets could also benefit from currently attractive valuations and supportive domestic policies.
We continue to expect that the European Central Bank (ECB) will tighten monetary policy much later than markets are now pricing. We also anticipate broader policy easing in China.
Pace of upward earnings revisions slowing
On the fourth quarter of 2021, of the 33% of S&P 500 companies that have so far reported results, 77% have posted a positive earnings-per-share surprise and 75% a positive revenue surprise relative to market expectations.
The blended net profit margin combining actual and estimated results that have yet to be reported for the S&P 500 for Q4 2021 is 12.0%. This is above the year-ago margin of 11.0% but marks a slowdown relative to the previous two quarters. That said, this is the fourth-highest net profit margin since 2008.
Nonetheless, the slower pace of earnings revisions in the US does leave equities more vulnerable should the Federal Reserve turn even more hawkish. In this respect, even a weak non-farm payrolls report on 4 February (the consensus forecast is for a 175 000 gain, down from December's 199 000) is unlikely to change the Fed’s intention to start raising the federal funds rate in March.
Fed Chair Powell sounded bullish on the strength of the US labour market at the January FOMC press conference and noted that Omicron will likely depress data in the first quarter, but the effects should prove temporary.
Recent signs that the pandemic may start to evolve into an endemic should provide further support for risk assets. Our equity portfolios have been selectively adding to positions in information technology, communication and financial stocks. Companies in these sectors have been punished significantly in price terms recently for relatively modest earnings or revenue misses.
Higher eurozone inflation
Data released this week showed consumer price inflation (harmonised indices of consumer prices or HICP) in the eurozone rose by a record 5.1% in January (see Exhibit 1), putting pressure on the ECB to respond with tighter monetary policy.
The latest figure surprised markets, which were reckoning with a fall in inflation. Significant increases in the prices of energy and food were offset only partially by slower growth in manufactured goods prices. As a result, annual inflation rose from its previous record of 5% in December. This is an awkward situation with the rising cost of living a major point of discussion across the eurozone.
Over the last week, markets have pulled forward expectations of a tightening in eurozone monetary policy. A rise in the ECB’s deposit rate to minus 0.25% — from its current level of minus 0.5% — has now been priced in by December 2022, based on pricing in short-term debt markets.
We not expect a rate rise from the ECB in 2022 as we think there is sufficient slack in eurozone labour markets to allay the risk of a wage-price spiral. The fall in core eurozone inflation we saw this week and the deceleration in goods prices suggest an absence so far of widespread second-round effects (i.e. to date, higher prices are not leading to sharp increases in wages, as appears to be the case in the US).
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. The views expressed in this podcast do not in any way constitute investment advice.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.