New Year Jitters
Q1 2022 – JANUARY
For many people, the start of a new year is a time for reflection, refocusing and resolutions. For those prioritizing stress management in 2022, the volatile ride in financial markets to start the year has likely not helped with blood pressure regulation. While we lack formal cardiology training, hopefully our global financial market assessment can provide some remediation.
As investors rapidly priced in additional US interest rate hikes (alongside a progressively more hawkish sounding Federal Reserve), global equity markets took a nosedive in January with the MSCI All-Country World Index falling 4.6% in Canadian dollar terms. US “big tech” and growth stocks were hit particularly hard, as the NASDAQ 100 Index fell 7.9%. Of course the escalating situation on the Ukrainian border only added to market skittishness.
Major central bank rate hiking cycles need to be taken extremely seriously, as they are the most common cause of modern recessions. Beyond the direct economic implications of higher corporate borrowing costs, rising rates also have a contractionary effect on equity valuation multiples, as future earnings and cash flows get discounted at a higher rate. This is particularly acute for growth stocks, which tend to trade on higher multiples to account for their superior future earnings potential.
So why are we taking these developments in stride? For starters, we find the probability of a recession to be very low. Fiscal stimulus has been engaged in numerous major global economies, debt levels are manageable, household wealth (particularly in the US) has soared and pent-up demand still exists for a wide variety of goods and services. The bond market appears to agree with us. Instead of inverting, per the chart below the US treasury yield curve actually steepened in January. As noted in our most recent Ask Forstrong publication, major equity bear markets outside of recessions are exceedingly rare.
From a global perspective, there is little evidence of coordinated monetary tightening. The European Central Bank is scaling back asset purchases, but continues to advocate a transitory inflation view and defer rate hikes. The Bank of Japan is showing no signs of wavering from its ultra-loose policy positioning. China is actually easing monetary conditions after tightening throughout 2021 and most other major emerging market central banks are nearing the end of their rate hiking cycles.
We believe that investors are likely overestimating the speed and magnitude of impending US rate hikes. Part of the communication strategy of the Federal Reserve has been to keep inflation expectations anchored, as soaring expectations can become self-fulfilling in nature. Accordingly, in this case hawkish rhetoric actually helps maintain stability and buys the central bank time to gauge the incoming data. With high base effects and the gradual resolution of supply chain bottlenecks, US inflation is likely at or near its peak.
Our view remains that central bank tightening will not derail the global equity bull market (at least not in the near future). As with all bull markets, corrections will occur at various stages and provide a healthy cooling off period to remove market froth. With the path of least resistance for interest rates likely to be higher, we continue to avoid growth stocks in favour of more attractively valued segments of the market (generally found outside of the US) and remain overweight sectors such as financials which thrive on a steeper yield curve.
CASH AND CURRENCIES
The US dollar has reversed course in recent months, moving from weakness to strength as investors brought forward their expectations of Federal Reserve tightening. We continue to see downside risk emanating from long-term overvaluation, counter-cyclicality and the possibility that the Bank of Canada may be more aggressive than the Fed in tackling inflation. We have elected to maintain our partial hedge on US dollar exposure this quarter.
We maintain our view that the yields offered on longer-term developed market bonds are completely insufficient to compensate for their high degree of interest rate risk. While we do not view a sudden spike in longer-term yields to be a highly likely scenario in the near term, risk is nonetheless significantly skewed to the upside. We have added investment grade floating rate note exposure to further portfolio shorten duration this quarter.
We continue to view equities as the best option in a reflationary environment, as economic growth should be supportive of earnings and corporations are able to “pass-through” a portion of their rising input costs to consumers. Policymakers in major economies are likely to maintain a gradualist approach to tightening that should not be forceful enough to derail the recovery. Equity exposure in client portfolios remains overweight and has been increased this quarter.
Hong Kong equities struggled in 2021 as concerns about exposure to the Chinese property sector, continued political risk and weak consumption (in part due to relatively onerous travel restrictions) all weighed on performance. The asset class trades at deeply depressed valuation multiples and the financial sector-heavy index should benefit from bellwether Chinese companies moving their primary listings from the US to Hong Kong. We have initiated a position in Hong Kong equities in balanced and growth-oriented strategies this quarter.