This year has already seen some sharp price moves and violent rotations in equities. The rotations were triggered by a large rise in yields, following more hawkish signs from the US Federal Reserve (Fed) and other central banks, in response to persistent inflationary pressures and tight labour markets.
Investors, and central bankers, were further reassured by growing signs that the Omicron variant appears to be less virulent than previous strains of the virus, and less of a threat for economies.
Jump in Treasury yields and inflation spooks investors
US 10-year yields hit 1.87% in mid-January, from 1.33% in early December, and were close to their pre-pandemic level. The market is now pricing in five rate hikes in the next 12 months, starting in March. Bond yields in other areas, including Germany, have also repriced sharply higher. As a result, long-duration assets have been hit hard, catching many by surprise. In equities, there was a powerful rotation to value from growth, and to cyclicals from defensives.
Until we see inflation convincingly peaking, we believe those rotations have more legs, this favours a pro-cyclical stance in portfolios, as well as a value tilt, reiterating the views expressed in our Outlook 2022.
Historically, the main beneficiaries of higher yields and inflation have been financials, energy, industrials, and basic materials. We believe that those sectors remain well positioned in the near term. They are more heavily concentrated in value indices and non-US markets.
In contrast, the sectors that tend to be most negatively correlated with yields and inflation include telecoms, healthcare, utilities, consumer staples, and technology. Despite recent underperformance, we believe that group of companies will remain vulnerable in the near term, as these sectors are more defensive, have longer duration assets, and are more heavily concentrated in growth indices and the US market.
Concerns about over-aggressive policy tightening
One of the main concerns at present is the risk that excessive policy tightening could derail growth, and lead to a market sell-off, or even a bear market. Our view is that a lot of the repricing has already been done on the fixed income side, and that inflation should decline progressively in the second half of the year, as supply constraints ease, and demand shifts to services from manufactured goods.
While the path of policy normalisation currently priced in by the market is faster and more aggressive than we initially anticipated, yields seem unlikely to reach a level that will hurt the economy, or derail markets. Yields remain low by historical standards, and certainly well below the above-trend growth that we expect globally in the next couple of years.
In addition, the equities’ earnings yield still significantly exceeds bond yields, supporting the continued outperformance of stocks versus bonds, and encouraging the “There is no alternative” (Tina) mindset to prevail. Finally, the macro backdrop remains favourable, with global activity supported by large excess savings, accommodative financial conditions, an expected pickup in capital expenditure, and restocking.
Fed hiking cycles - a history
In order to address investors’ concerns that the upcoming hiking cycle could present a major risk for stocks, we look at how equity markets have performed in the four previous hiking cycles, stretching back to 1994.
While there have been nine hiking cycles from the US Federal Reserve (Fed) since the 1970s, our analysis focuses on the last four (February 1994, June 1999, June 2004, and December 2015). Markets were very different back in the 1970s and 1980s, and as a result, offer less useful comparisons for investors today.
The hiking cycles were much steeper, to combat very high inflation, and the Fed did not communicate explicitly on its policy targets. In the last four hiking cycles, the central bank raised policy rates by only 188 basis points, on average, in the first 12 months, from 2.25% to 4.13%.
Sector, style, and regional performance around rate-hiking cycles
The average performance of several MSCI indices in the first two months and 12 months after the first hike, versus price at the time of the first hike, during the four Fed hiking cycles since 1994. All prices in US dollars unless otherwise stated
For all the styles covered, the biggest drawdowns were seen in the first couple of months, varying between -5% for momentum, small caps, and growth, and -2% for minimum volatility, based on monthly readings. By the third month, all indices had resumed their up-trend. Twelve months after the first hike, the best performing indices were momentum and small caps, up 9%, while the main laggards were defensives and minimum volatility, up 4%.
A time to be diversified and nimble
Equities have usually performed relatively well in the run up to and during US rate-hiking cycles in the past thirty years. After an initial blip, equities delivered mid-single digit returns in the year following the start of the hiking cycle. We do not expect this cycle to be any different, especially as aggressive tightening by the Fed is already priced in. That being said, we continue to expect increased volatility in the coming months, requiring investors to be diversified and nimble.