Strategy
A New Tightening Cycle
It has been a tumultuous start to the year for both global bond and equity markets. The primary cause has been higher than expected inflation which has forced central banks to respond by signaling their intention to tighten monetary policy and raise interest rates. US headline CPI inflation soared to a 40-year high of 7.5% year-over-year in January, above expectations of an acceleration to 7.3% from December’s 7.0%. Other key inflation measures offered no relief as Core CPI (inflation excluding the more volatile food and energy components) surged from 5.5% to 6.0%.
We have written a lot about inflation over the past year. The debate raged over whether inflationary pressures were transitory and would fade away as the world reopened or whether the pressures were more persistent and would build on the back of excessive government spending to support economies through the pandemic. What complicates matters is the fact the pandemic has lasted a lot longer than many had originally thought. In the US nearly 9 million people missed work in late December and early January as the Omicron variant hit the labour market and stressed global supply chains were put under increasing strain. However, since late summer last year, it has become clear that inflation is broader than just pandemic-related distortions. It is therefore understandable that central banks have decided to act decisively.
Historically, markets tend to be volatile around the time of the first rise in interest rates as it takes some time to digest the impact of the turn of the monetary cycle. However, equities are often higher a year after the first rate rise. The challenge is that this cycle is very different to a usual business cycle. Typically, when interest rates start to rise, unemployment remains relatively high and economies have a lot of spare capacity to grow without inflation. While growth has been very strong, this time the unemployment rate is low and inflationary pressures are the primary reason for the hawkish change in direction from the central banks. Investors therefore need to be careful when using historical playbooks. This uncertainty has added to the volatility, with central banks themselves saying there is a need to be “humble, but a bit nimble”.
An old adage in investing is “stock markets take the escalator up and the elevator down”. The theory is that confidence builds gradually whereas panic and fear happen quickly - selling can trigger further selling. Looking back to the turn of the century an obvious exception is the period after the dot-com bubble. This turned into a protracted bear market for approximately three years before equities finally bottomed out around 2003. However, since then the saying has been a more accurate reflection of market moves. Markets have generally grinded higher but have been subject to rapid drawdowns: the Global Financial Crisis in 2008/2009, the fourth quarter of 2018 sell-off due to concerns that the Federal Reserve would raise interest rates too far, too fast and more recently the COVID-19 panic, which saw the market fall around 25% in a matter of weeks before recovering rapidly. Between these sharp drawdowns, markets have seen small sell-offs of around 5-7%, which are a natural part of volatility inherent in investing. This dynamic has seen a ‘buy the dip’ mentality become ingrained in many investors; when markets have wobbled, there has been a sense of unease but before long, buyers stepped in and markets recovered.
Part of the reason for this has been that the policy environment has been very supportive and low interest rates have been an important pillar of this policy support, so a turn in the monetary cycle is an important development. Equity multiples are high by historic standards and multiples usually fall when interest rates rise, so earnings growth becomes of paramount importance. The earnings outlook typically hinges on the economic growth outlook but inflation pressuring profit margins is an added complication. The reopening of the global economy as the pandemic recedes should support growth this year but the outlook for consumers has darkened as inflation erodes real incomes and interest rates are now on the rise. We remain optimistic that growth will remain resilient. Given all the headwinds however, we have recently become more defensive in corporate credit exposure and cyclical consumer exposure within equities.
Equities
Pricing Power in Focus
Equity markets had a rough start to 2022 as increasing concerns about inflation fueled a surge in interest rates, triggering revaluations in many previously high-flying growth stocks. After generating a 22% return in 2021, the MSCI World Index declined near -10% in January, before partly recovering near the end of the month to finish down -5%. The downturn in the equity markets started early in January, coinciding with the release of the December Fed meeting minutes which highlighted an increasing probability that imminent monetary tightening could be paired with multiple interest rate hikes. Above-target inflation, above-trend growth and a rapidly improving labour market suggest market turbulence is unlikely to dissuade the Fed from starting to hike rates. As long as tightening financial conditions are not expected to impede above-trend US economic growth, the Fed will tend to focus on fighting high inflation, not on supporting asset prices.
The bounce in the equity markets late in the month was aided by strong quarterly reports from market heavyweights Apple and Microsoft, both of which delivered continued strong profitability and positive outlooks. Apple’s earnings shone despite global chip shortages and supply chain disruptions, while Microsoft provided investors with reassurance by maintaining solid projections for its high margin cloud-computing business. The bounce back in these mega-cap stocks masked much heavier price declines in many smaller and less profitable market constituents (some of which declined -40-50% from their peaks) as the technology heavy NASDAQ index finished the month down -9%.
The US equity market fell -5.7%, lagging the rest of the developed world which declined -4.4%. The sectors which sold off most were Consumer Discretionary and Information Technology (despite Apple holding up better than the market at -1.6%), with Tesla and Amazon finishing the month down >-10%. Emerging Market exposures provided diversification, finishing -1.9% with China -2.5%. The only two sectors which generated positive returns in the month were Energy and Financials. The Energy sector soared +15.6%, with some stocks including Exxon Mobil and ConocoPhillips >+20% on higher energy prices. Banks gained +2.8%, with Wells Fargo and HSBC up >+10% on the expectation that rising interest rates will boost income.
A key question at this point is which companies and sectors will be able to weather the inflationary pressures. This means that pricing power has become an important question posed by analysts when companies have reported their fourth quarter earnings results. The extent to which companies can pass on higher input costs (raw materials, transportation, labour) is a function of pricing power - if prices rise what happens to the volume sold? Chipotle Mexican Grill, for example, hasn’t shied away from increasing the price of its burritos and tacos whereas The Clorox Company has struggled to pass on higher costs to customers. These diverging circumstances have been reflected in the relative share prices, with Chipotle up almost 10% after reporting results and flagging further price increases, while Clorox fell around 14% after highlighting the challenge of passing on higher costs. With the overall market challenged by higher interest rates, company specific factors are now very important as company fortunes diverge. This presents opportunities for active managers.