Markets Weekly podcast – 7 February 2022

Henk Potts (HP): Hello. It’s Monday, 7^th February and welcome to the Barclays Private Bank Markets Weekly podcast, the recording that will guide you through the turmoil of the global economy and financial markets.

My name is Henk Potts, Market Strategist for Barclays Private Bank, and each week I’ll be joined by guests to discuss both risks and opportunities for investors.

Firstly, I’ll analyse the events that moved the markets and grabbed the headlines over the course of the past week. We’ll then discuss the recent sell-off that we’ve seen in equity markets, and consider whether now would be a good time to allocate some of your risk budget to small caps. And finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.

After a turbulent January, there were signs at the start of last week that investors were prepared to peek over the macro wall of worry that’s been created by hawkish central banks, geopolitical tensions, and virus disruptions to refocus on the corporate fundamentals. This is as a raft of influential companies delivered their fourth-quarter earnings.

However, volatility spiked as the week progressed, as policymakers from the Bank of England and the European Central Bank projected more persistent inflation.

US labour data put pressure on the Fed to frontload hikes, and some of the shine was taken off the earnings season by the mega miss from Meta. A 10-day average of the value of all stocks traded in the US stands at $820 billion, which is 46% above 2021’s average, to give you some idea about the volatility that we’ve been seeing in markets over the course of the past few weeks.

Despite the wild swings, US equities did manage to register positive gains over the course of the week. The S&P 500 was up 1.6%. The STOXX 600 in Europe, however, was down seven-tenths of 1% over the course of the week.

The real action, as we know, was in bond markets, where yields have been surging. UK 10-year yields rose to 1.37%, that’s the highest level in more than three years. Ten-year Treasury yields settled at 1.93%, the highest close since December 2019. And we’ve seen yields rise in Europe as well. Italy’s 10-year yield topped 1.75%. That compares to just 1.25% at the start of the week.

As expected, the Bank of England felt compelled to back up its 15 basis point hike in December with a further 25 basis points last week, the first back-to-back hike since June 2004. The minutes highlighted the rationale for the increase, which included a tight labour market. Remember, UK unemployment fell to 4.1% in November. There’s also been concerns over the shortage of labour and a mismatching of skills, and continuing signs of greater persistence in domestic costs and price pressures.

The Bank of England is now forecasting that annual inflation will peak at 7.25% in April. This is after Ofgem increased energy price caps by more than 50%, although inflation is still projected to be back below 2% at the end of the forecast horizon.

The minutes from the meeting also provided a surprise hawkish twist, this is after four out of nine policymakers voted for a 50 basis point hike. The Bank of England stated it would embark upon passive quantitative tightening by not reinvesting maturing government bonds in March, and conclude the sale of the corporate bonds by the end of 2023.

In terms of the rate outlook, we now expect the Bank of England to hike rates by a further 25 basis points in both March and May, putting the base rate at 1% by mid-year.

By mid-year, the UK economy will inevitably face up to the impact of monetary tightening, that’s higher rates, fiscal timing, that’s of course higher taxes, along with the cost of living squeeze, all of which the Bank of England said will amount to the biggest annual reduction in spending power since 1990. Therefore, we would expect some of the wind to be taken out of the Bank of England’s tightening sails after May.

We anticipated that in comparison with the Bank of England, the European Central Bank meeting would have proved to be uneventful. The central bank was expected to maintain its patient approach and wait for new economic projections in March. However, the incoming data appears to have tested the Governing Council’s resolve to maintain its ultra-accommodative stance.

Euro area inflation surprisingly accelerated to a record high in January. Consumer prices rose to 5.1% year on year last month. That’s well ahead of the consensus, which was at 4.4%.

Energy continued to be the major driver. Food inflation continued its gradual acceleration. There were few signs that reduced demand, due to Omicron, eased any of the price pressures.

Meanwhile, eurozone unemployment fell to a euro-era low of 7% in January.

At a hawkish press conference, Christine Lagarde appeared to leave the door open for a rate hike this year, as she pivoted away from the previous guidance that an interest rise this year was unlikely to now focus on the incoming data. She also signalled a recalibration of quantitative easing would come at the March meeting.

In terms of market reaction, the euro had its best week since March 2020. Investors increased bets of rate hikes during the course of this year.

In terms of the policy outlook, however, we still do not believe that we’ll see a rate hike in 2022 from the European Central Bank, but an expected upward revision to the 2023/2024 inflation forecast in March, now leads us to forecast a 25 basis point hike in March 2023 and a further quarter of 1% increase in September 2023.

Moving on to the US, where the nonfarm payroll report delivered an historic overshoot relative to estimates. Headline numbers, well, the US economy created 467,000 jobs in January. Remember, the estimate was closer to 125,000, and that was accompanied by 709,000 of upward revisions over the course of the past two months. Average hourly earnings jumped as well. They were up seven-tenths of 1% month on month.

However, we do have to be, I think, careful not to read too much into these numbers. The report appears to have been impacted by statistical factors, revisions to the benchmark, seasonal features, and compositional effects as well.

Putting that to one side, the headline number added to market jitters that the policy tightening timetable will be more aggressive than previously forecast. Markets, if you look at their pricing now, well, investors are now pricing in five hikes during the course of this year, and a chance of a 50 basis point increase in March, as we know, has been rising as well.

If you look at overnight index swaps, they now indicate an even chance of a half of 1% increase coming through at that March meeting. However, if you look at the recent commentary from Fed officials, it still points to a more gradual removal of policy. We still believe a 25 basis point increase in March is more likely, but it’s looking like it could, indeed, be a very close call.

So that was the global economy and financial markets over the course of the past week. In order to discuss the outlook for equity markets, and, in particular, small caps, I’m pleased by joined by Dorothée Deck, Cross Asset Class Strategist with Barclays Private Bank.

Dorothee, great to have you with us today. So, let’s start off. What are your views on the market pullback that we’ve seen since the start of the year? Do you see it as buying opportunity, or as a reason to reduce exposure to the equity market, and perhaps risk assets in general?

Dorothée Deck (DD):  Thanks a lot, Henk. Good to be here. So, yes, markets have certainly been very volatile in recent weeks. The sell-off in equities has been broad based, but the long-duration sectors have suffered the most, and we’ve seen powerful rotations out of growth into value. These rotations were triggered by a reassessment of the path of policy normalisation and a sharp rise in real yields.

There has also been increasing concerns about the risk of excessive policy tightening, which could derail growth and lead to a major market sell-off or even a bear market. But our view is that it’s more likely to be a correction within a bull market, rather than the start of a bear market, and we feel investors should use this pullback as an opportunity to invest selectively, as opposed to a reason to reduce exposure to the equity market, and I’ll give you a few reasons why we feel this way.

First, a lot of bad news has already been priced in and sentiment is quite depressed. Second, historically it’s been extremely rare to see a bear market outside of a recession, and we do not expect one. Actually, it’s happened only once in the past 50 years, and that was in 1987. Third, equities have generally performed well in previous hiking cycles.

They have tended to digest the increasing rates relatively well after a 5% drawdown, on average, in the first couple of months, and that’s based on the four previous cycles going back to 1994. And finally, the macro backdrop remains favourable, with global activity supported by large excess savings, accommodative financial conditions, and expected pick-up in capex and restocking.

So, as long as growth remains above trend and yields do not move into restrictive territory, then stocks should continue to beat bonds and risk assets should continue to outperform.

HP: So, you mentioned investors should be looking at this pullback as a buying opportunity. Which sectors or styles should they be focusing on? Is there one particular area of the market that appears dislocated at the moment?

DD: So, over the long term, we continue to favour quality companies with a strong balance sheet and cash flow generation. However, in the near term, we believe the equity performance will be driven primarily by changes in inflation expectations and rates, and we think the recent rotations have more legs.

Until we see inflation convincingly peaking, we encourage investors to maintain a pro-cyclical stance in portfolios, a value tilt, and a preference for non-US equities. And our view on inflation is that risks are skewed to the upside in the first half of the year, but that it should decline progressively in the second half as supply-bottlenecks decline and demand rotates from goods to services.

Now, on the tactical side, we see an attractive opportunity to invest in small caps at present, as they provide an overweight exposure to the more cyclical sectors as well as a value tilt, in line with our sector preferences for the first half of this year, and this opportunity is present in the US, in Europe, including the UK, and developed markets more broadly.

So, relative to large caps and using MSCI World indices as an example, small caps are overweight industrials and materials primarily, but also financials and energy. We believe those sectors remain well positioned in the near term to benefit from a broadening of the recovery, as well as higher yields and inflation. And in contrast, they’re heavily underweight tech and communications services, but also consumer staples and healthcare. And those sectors are more defensive or have long-duration cash flows, which are more vulnerable in times of rising yields.

HP: So why do small caps look particularly attractive now?

DD: So, the reason why we think it’s a good time to invest in small caps now is because they have underperformed a lot in the past year, especially in the US, and they’re now discounting an overly pessimistic macro outlook, with an ISM manufacturing in contraction territory, significantly below 50, and the last reading was 57.6 for the month of January.

So, historically, it’s been very unusual for small caps to underperform large caps when the macro environment was strong, with an ISM above 50, and when cyclicals outperformed defensives. Those relationships have been strongly correlated in the past, but a large disconnect has opened up in recent months.

And to give you some numbers, cyclicals in developed markets have outperformed defensives by 8% in the past 12 months, while small caps have underperformed large caps by 12%.

Similarly, small caps also tend to outperform in carries of rising yields, and they have failed to track US yields higher in recent months, so we could see a bit of a catch-up on that front as well.

Now, this call is very much supported by valuations as well. Valuations are usually not a good timing tool, but they’re useful at extremes. So, using the Russell 2000 versus 1000 indices, small caps are now trading at 2.3 standard deviations below their 20-year average, based on forward PEs.

To be more specific, US small caps are now trading at a 14% PE premium to large cap, a historical low, while historically they have traded at a 40% premium on average, and that premium reflects higher earnings growth over the years.

And finally, momentum in earnings revisions is also supportive. So, in the past five months it’s been more negative for large caps versus small caps.

HP: OK. My final question. Dorothee, are there any particular risks in owning small caps that investors should bear in mind?

DD: Yes, absolutely. So, small-cap returns tend to be more volatile, and to illustrate that point I’ll give you some numbers on long-term returns and drawdown profile. So, if we look at performance over the past 20 years, small caps have been the second best-performing strategy, with annualised returns of 10%, just behind momentum and in line with quality. And that compares with annualised returns of 8% for the MSCI World Index over the same period.

However, it’s important to bear in mind that those returns have been delivered with a high degree of volatility, as small caps have a beta of about 1.2. So, in times of market stress, small caps have tended to see larger drawdowns compared to large caps.

But it hasn’t always been the case, as, for example, in 2001/2002. And at present, based on MSCI World indices, small caps are 12% below their recent peak, while large caps are only 6% below their recent peak. That’s a spread of 6%. That spread has been as wide as 10% in the past 20 years, and the last time was actually in March 2020, when small caps were 40% drawdown compared to a 30% drawdown for large caps.

HP: Well, thank you, Dorothee, for putting the recent drawdown in some perspective, and sharing your views on why small caps may offer a good tactical opportunity for investors in the current environment.

Let’s move on to the week ahead. This week’s US inflation report, on Thursday, will do very little to dampen the hiking rhetoric, one would suspect. We look for CPI to have risen four-tenths of 1% month on month, and come in at 7.2%, year on year, in January, driven by higher energy prices, a pick-up in demand for hospitality services, strengthening goods and shelter is expected to drive core inflation up to 5.9%, year on year, over the course of the past month.

In the UK, on Friday we expect December GDP to have contracted by 1% month on month, driven by a 1.4% decline in services, as the Omicron wave and related restrictions likely hampered activity, as suggested by the high frequency indicators.

We think that production and construction, each, may contribute positively because of easing international supply-chain disruption. Even if Omicron proves to be a deeper hit than we forecast, this would likely not be material to the medium-term outlook if the temporary nature of the way means we would still expect much of this activity to be made up over the course of the coming months.

And with that, I’d like to thank you once again for joining us. We will, of course, be back next week with our latest instalment, but for now may I wish you every success in the trading week ahead.