Volatility returns as investors adjust to policy outlook
Equities, and asset prices in general, have seen a return of volatility during January, following over a year of very subdued volatility and strong returns. Why, especially in a historically favorable seasonal period? In our view, markets are adjusting to the indications of moderately tighter monetary and fiscal policy following a period of extraordinary support from both US macro policy drivers. Investors are debating whether policy makers will be able to reduce stimulus and inflation pressures without provoking excessive economic weakness, and this debate is showing up as volatility in markets.
Macro uncertainty is provoking volatility
Rate policy diverging among global central banks
Central bank policy remains a key focus for investors as rates are set to rise in the US this year, with debate about the pace of the rate hikes and balance sheet adjustment ongoing. However, this is not true everywhere, as there have been growing divergences in expected rate policies among the major developed market central banks.
As shown in the chart below of two-year sovereign bond yields for the US, UK, Japan, and Germany (Eurozone), investors are pricing in multiple rate hikes over the next year or two from the US Fed and the Bank of England (BoE): US and UK two-year yields are at or near 1% now, up from around zero for most of the time since early 2020.
Does Tech reliably lag when yields rise? No
We often hear the narrative that rising long-term bond yields are harmful to valuations of “long duration” Growth stocks, especially the Technology sector that dominates the Growth style. This has been evident in day-to-day swings in the market recently.
While we understand the concept embedded in discounted cash flow models that higher discount rates depress current equity values more when capitalizing earnings that occur further in the future, we have been skeptical that the discount rate effect in most cases is sufficiently large to dominate changes in growth expectations or investor risk tolerances, at least for the Tech sector. In other words, our view has been that an investor’s bigger concerns when evaluating higher-Growth Technology stocks are the future earnings growth rate and the risk involved, not whether Treasury bonds yield 1.5% versus 2%. Changes in growth expectations and investor risk perceptions will typically have much larger effects on stock prices than moderate changes in Treasury yields, especially when interest rates (and real rates in particular) are at such a historically low level.
Earnings expectations for 2022
With 2021 now in the history books, earnings reporting season for Q4 and the full year is set to begin soon. Below we update the current consensus earnings outlook for Q4 as well as the coming year for the S&P 500. We also drill into expectations for sector earnings growth for this year.
The bottom line, so to speak, is that analysts expect solid but more moderate growth in earnings of about 9%, led by gains in the Industrials and Energy sectors, with Financials and Real Estate the only sectors expected to show declines in earnings this year.
That’s a BIG Apple
There have been a number of headlines recently highlighting the extraordinary market capitalization being awarded to Apple Inc. (AAPL), which has retaken the title as the world’s most valuable publicly-traded company.
The company’s value is now approaching $3 trillion, a level that places it not only as the largest individual company ever on public markets, but would rank it among the largest stock markets.
Energy sector supported by recovering output and elevated prices
We remain overweight the Energy sector, as analysts continue to raise earnings estimates and the sector is very favorably valued, though the picture has become somewhat more mixed as crude oil prices have been volatile recently. News of the new Omicron variant of COVID-19 and corresponding constraints on international travel have renewed concerns about fuel demand, while OPEC’s decision to go ahead with output increases has reduced the earlier concerns about insufficient supply.
Powell testimony adjusts timing of taper, not long-term rate outlook
Fed Chair Jerome Powell testified before Congress on Tuesday alongside Treasury Secretary Janet Yellen, and markets were listening. While many topics were discussed, the markets responded most to Powell’s indication that the Fed may speed up the recently announced tapering plan for the huge bond buying program (“QE”) that has been in place since March of last year. The initial plan for $15 billion/month reductions in bond buying would have brought the process to a close by June of next year, while a faster pace could do so by March. Markets also focused on Powell’s comment that the word “transitory” may no longer be applicable with regard to inflation: “it might be time to retire that word (‘transitory’) and try to explain more clearly what we mean.”
Inflation expectations: markets showing more worry now, less worry later
Inflation remains a hot topic among investors, policy makers, and voters. While there is not a great deal that policy makers (fiscal or monetary) can do in the short term to control inflation (today’s announcements of coordinated releases from strategic oil reserves are mostly a signaling action), there are steps that can be taken on a longer horizon. Monetary policy has historically been the primary lever used to try to manage inflation, though it has arguably been less effective in recent years as it has run into the “zero lower bound” (ZLB) with short-term interest rates. Fiscal policy is likely a more potent lever but historically has not been used as such.
Tilting toward Growth over Value
One of the themes in our sector/style work recently has been to tilt somewhat more toward Growth over Value and Cyclical areas within the US market.
Why? Three key factors support Growth over Value, while one remains a concern.
Our bottom-up aggregated earnings estimate revisions trends continue to favor Growth
The relative performance trend has been shifting back to Growth over Value
However . . . relative valuation of Growth versus Value remains stretched versus historical norms, though the interest rate backdrop is arguably a structural reason for that
Also, the relative risk (volatility) differential of Growth vs Value has moved back in favor of Growth (i.e., Growth is now less volatile than Value on a rolling six-month basis).
Do Emerging Markets really have higher growth?
As emerging market (EM) equities continue to lag those of developed markets (DM), a question we sometimes get is “why have the stock markets for ‘higher growth’ emerging markets lagged developed markets so much in the last decade?”. A key reason is that higher GDP growth has not translated into corresponding corporate earnings growth for emerging markets.