Pondering the Punch Bowl

The Markit Services business activity PMI for January printed at 50.9, weaker than consensus expectations at 55.0 and down from the December level of 57.6. The January Manufacturing PMI came in at 55.0, a little lower than consensus expectations at 56.8 and the December reading of 57.7. While these weaker headline PMIs may spark fears of an economic slowdown, we think that the surveys are more likely reflecting a temporary downturn related to the post-holiday Omicron surge than a dramatic shift in underlying demand. The Services survey’s new business component supports this theory as it remained steady and did not indicate that general demand has decreased significantly. As Omicron cases fall, the surveys will likely rebound quickly.

Fourth quarter earnings continued to be released with many financial companies having already reported. For the full quarter, the consensus is expecting S&P 500 earnings-per-share to rise by about 21,6%. However, that rate of growth is expected to normalize heading into 2022 with S&P 500 EPS expected to rise by 7.9%. With CEO confidence hitting a record high in December, we believe there is a very good chance that earnings will continue to beat expectations. Especially for companies that have shown strong pricing power.

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Fed Chairs Jerome Powell, Janet Yellen, Ben Bernanke, and Alan Greenspan are household names for investors. However, William Martin was the longest-serving Fed Chair in U.S. history, having served as Chair from 1951 to 1970 and for five different U.S. Presidents. It is his famous words, that the Fed’s job is to “take away the punch bowl just as the party gets going,” which may be the most relevant to how investors feel right now.

It is hard to argue that the party was just getting started with the S&P 500 having rallied an impressive 92% since bottoming on March 23, 2020, but now is the first time that investors have seriously considered imminent rate hikes from the Federal Reserve since the start of global pandemic. As recently as June 2021, the Federal Reserve was projecting just over two rate hikes in 2023. Now, seven months later, investors are pricing in a 100% probability of a rate hike as soon as March 16th – a full year prior (see figure 1).

This line chart shows the number of fed rate hikes expected by the end of March 2022

Investors also need to consider the Fed’s balance sheet intentions. Following the Global Financial Crisis, the Fed raised interest rates for the first time in December 2015 but waited until the end of 2017 to reduce its balance sheet. This time around, the Fed is telling markets that it may start to unwind its balance sheet shortly after the first rate hike. That means that the Fed is currently planning to normalize policy much faster this time around to combat inflation. However, Fed Chair Powell has already stated that it may take another two to three meetings to firm up its balance sheet plans. It also remains an open question as to how much the Fed can influence inflation that has been caused by supply bottlenecks, the Fed is clearly communicating a renewed focus on its price stability mandate. 

On January 26th, the Fed will hold its January Federal Open Market Committee meeting and release its press statement at 2PM EST. It is possible that the Fed will signal its intent to raise interest rates by saying something like, “an upward adjustment to policy rates will be appropriate at an upcoming meeting.” We doubt that the Fed will discuss whether it views a 25 basis point or 50 basis point rate hike as appropriate. Most likely the Fed Chair will simply acknowledge that most Fed officials still see three rate hikes in 2022 as the base case. As far as the balance sheet, the Fed Chair may simply suggest that it will happen later this year, but there is a reasonable chance that he may clarify that it could be begin after just one or two rate hikes. Citi Research’s economists believe that bond purchases will end by March and that the runoff of balance sheet assets will likely begin in July. 

Unsurprisingly, this focus on “dual tightening” through both rate hikes and balance sheet reduction has weighed on interest rate sensitive technology shares with the NASDAQ down about 14.5% year-to-date, which pushes the index well into correction territory. As we have mentioned before, in a rising rate environment, a dollar today is worth more than a dollar in the future. This can weigh stocks of growth companies whose earnings potential are often considered to be further down the road. Until bond markets stabilize, technology shares may continue to underperform the broader market (see figure 2). Since the start of December, the divergence between value and growth performance has been notable with the S&P 500 Value index up 6.6% while the S&P 500 Growth index is down by 16.3% - an outperformance of almost 23% (see figure 3).

This line chart highlights the NASDAQ Relative Performance vs. S&P 500 and Real 10-Year U.S. Treasury Yield from April 20th 2020 to 2022 Year-to-Date

This line chart shows the S&P 500 Value vs. Growth Indices’ Returns Since December 2021 (%) from November 30th 2021 to January 24th 2022.

While we see exposure to value sectors like Energy and Financials as decent inflation hedges, we do not see these sectors as long-term market leaders. Instead, we favor going up in quality as monetary policy uncertainty rises. The Consumer Staples sector is a good example with the sector consistently generating return on equity and dividend growth. Since the start of December, the S&P 500 dividend aristocrats index is up about 2.7% while the S&P 500 is down 5.5% (see figure 4). We also believe that Global Healthcare stocks provide an opportunity to gain exposure to long-term growth while reducing portfolio volatility.

This line chart shows the S&P 500 Dividend Aristocrats vs. S&P 500 Returns Since December 2021 from December 1st 2021 to January 24th 2022.

Conclusion: Intra-Year Corrections Tell Investors Little About Annual Performance

Now seems like a good time to remind investors that intra-year corrections are a normal part of investing and often tell us very little about annual performance. As figure 5 shows, since 1980 the S&P 500 has experienced intra-year corrections of over 10% in 22 separate years but has only finished the year with a negative annual return in just 8 of those years (or 36 percent of the time). Nearly all of those years were associated with U.S. recessions (1981, 1990, 2000, 2001, 2002, and 2008). With financial conditions still extremely accommodative and the economic backdrop solid, we think that the odds of a deep annual decline remain low. The hawkish pivot from the Federal Reserve, rising geopolitical tensions between the U.S., Ukraine, and Russia, and valuation headwinds may be testing investors’ resolve, but history suggests that U.S. equity markets likely have further room to run (see figure 6).

This chart shows the Intra-Year Declines vs. S&P 500 Annual Returns (%) from 1980 to 2020. Intra-year declines are common and tell investors very little about annual returns.

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