Dry January!

The year 2022 has just begun, but already it looks very different from 2021. At $88 per barrel, the WTI continues on its uptrend; the US 10-year rate has risen from 1.50% to 1.80%; the Nasdaq is down 8.50%; the SPACs (Special Purpose Acquisition Companies) are down 12%; Bitcoin is down close to 20%, and recent IPOs (Initial Public Offerings) are down 20%.

Fund Commentary
8 Feb 2022

The year 2022 has just begun, but already it looks very different from 2021. At $88 per barrel, the WTI continues on its uptrend; the US 10-year rate has risen from 1.50% to 1.80%; the Nasdaq is down 8.50%; the SPACs (Special Purpose Acquisition Companies) are down 12%; Bitcoin is down close to 20%, and recent IPOs (Initial Public Offerings) are down 20%.

How to read these events?

The first key to understanding this situation is inflation fears. With the consumer price index reaching 7.0% in the US, the subject is becoming politically sensitive, especially in an election year. In the short term, there are a few arguments for an easing of inflationary pressures: the commodity base effects should smooth out but not before H2 2022, wage growth should be sustained by labour shortages in some sectors and the disruptions caused by COVID should also play a role.

In this environment, the Fed has no other option than to affirm its “hawkish” stance: After the Tapering acceleration, questions are now raised centred around the number of rate hikes to expect in 2022 (up to 5?), as well a possible quantitative tightening, aka a potential reduction of the Fed balance sheet… Time will tell whether the Fed will have the opportunity to be as drastic and as hawkish as market participants expect.

The second message to consider to decrypt the situation is that of long-term rates and their impact. By rising by a mere 30 basis points, the US 10-year is barely back to its February 2020 yield level – just before the COVID crisis – and is flirting with levels from March last year.

While long term rates could continue to adjust towards a higher level of inflation, we believe that it should nevertheless be limited, as the additional debt resulting from the COVID crisis is incompatible with a sharp rise in long-term rates. Albeit modest, the increase is enough to trigger violent repricing in many asset classes. More than the tightening of financial conditions represented by the rise, this repricing is more of a cause of concern.

_____
After the “growth only” years of the post-2008 period, portfolios should now reflect a greater disparity of styles, an exercise made difficult by the high proportion of growth stocks in global indices and portfolios after nearly 15 years of domination.

The now positive correlation between equity and bond markets (see graph 1) highlights the limits of traditional asset allocation models. While higher long-term interest rates are not necessarily a cause for concern for large-cap growth companies with low- or no-debt and highly cash generative, it does translate into a higher discount rate, which is more problematic for non-profitable stocks valued solely on their future prospects. This also serves as a reminder that the recent rise in some stocks is more the result of an increase in valuation multiples than of earnings growth.

As we mentioned in our previous letter, after the “growth only” years of the post-2008 period, portfolios must now reflect a greater disparity in styles, an exercise made difficult by the high proportion of growth stocks in global indices and portfolios after nearly 15 years of domination. The year 2022 should therefore fully prioritize active management.

Graph 1: Correlation Rolling 52wk – Nasdaq 100 / Bloomberg US Treasuries Index

GRAPH 1: CORRELATION ROLLING – 52WK NASDAQ 100 / BLOOMBERG US TREASURIES INDEX

Source: Bloomberg, Banque Eric Sturdza. 01/2000 – 01/2022.

The month of January also confirms our belief that China is following its own path. By lowering the rate at the margin for REPO operations, the PBoC has shown itself to be accommodative and at odds with the Fed, a position justified by its desire to steer the real estate sector to a soft landing.

Another sector under pressure last year is China’s internet champions, which may enjoy some respite this year. It is not surprising to see Chinese assets decoupled from the rest of the world: Chinese onshore bond markets up at a time when most major fixed income markets are in red, Chinese stocks listed in Hong Kong almost flat for the year. China should remain a must-have in any portfolio.

The first few weeks of 2022 confirm the trend that we have been sensing, namely a more volatile and open environment in terms of geographic leadership, but also in terms of styles and sectors. While the macro framework should remain supportive, we will have to learn to be more selective and cautious in 2022, as the shaky start of the year and the resurgence of geopolitical risk in Ukraine remind us.

Fixed-Income Markets – Chinese Doves and American Hawks

 

Indigestible minutes and 7% headline inflation

The December FOMC minutes revealed that the Fed was planning to start reducing its balance sheet size (Quantitative Tightening) once the tapering was completed at the end of March. The interest rate market reacted badly but we remain convinced that significantly higher long-term rates are difficult to imagine as they would be hard to bear.

To give just two examples of many: growth stocks and real estate (rising mortgage rates). US long rates are nevertheless particularly resistant. If they have slipped by about 30 basis points since the end of December, it is only because the Fed’s December minutes envisaged quantitative tightening.

The CPI inflation index came in at 7%, a record high, yet the markets hardly moved at all. We reduced our spread risk in January, only to return to it at the first significant deviation.

China against the tide

The Chinese slowdown expected at the end of 2021 is becoming clearer and the central bank (PBoC) is cutting rates. This is the first step, as the growth outlook remains mixed, with falling demand and continuing problems in the property sector. Symbolically, this move is strong as it is the first-rate cut since March 2020.

_____
The PBoC cut rates. Symbolically, this is a strong move as it is the first-rate cut since March 2020.

Secondly, this attitude is in contrast to the attitude of other central banks, the Fed foremost, who are taking a resolutely opposing turn to break inflation. We consider central bank policies on a global scale: the more restrictive policies implemented around the world will be “offset” by China’s ultra-accommodative attitude.

The Fed at a crossroads

The Fed’s first meeting on Wednesday, January 26 was a major event, as the US central bank was expected to take a turn. Too lax since the summer of 2021, perhaps too aggressive today, it has confused many.

Jerome Powell has once again disappointed with his poor communication. We would have liked a clearer and less aggressive speech, opening the door to the first-rate hike of 50bp (instead of 25) on March 16th with a communication adopting a “wait and see” mode for a few months.

With the possible normalization of inflation in the second half of the year, growth and the general state of the economy will once again become the focal point of the chessboard. The Fed’s attitude is becoming a large risk and could, moreover, force the Chinese to do too much in the opposite direction.

Equities – Remember the January Effect?

After a treacherous month for equities globally, the “January Effect”, the well-known market anomaly resulting in above-average returns during the first month of the year, seems oh so distant. Indeed, equity markets are down significantly since December 31st, 2021, as investors’ expectations quickly evolved from benign policy adjustment to a heavy-handed hiking cycle by the Federal Reserve.

What started as a contained adjustment of equity prices to a rising yield curve (1.5% to 1.87% on the 10Y yield around mid-month), eventually evolved into a broader risk-off correction confirmed by typical safe-haven flows, including a small initial reversal in yields.

Without surprise, the correction was especially difficult for the highly valued growth stocks, and outright vicious for some of the so-called “concept stocks”. In a twist for the crypto enthusiasts, expectations of receding liquidity and higher rates impacted crypto assets with force, while gold held surprisingly well.

With significant price volatility including an impressive -3.9%, +4.4% intraday move on January 24th, the price discovery for this post-COVID, higher baseline inflation world is so far taking place in a rather dramatic fashion.

A vanishing Fed Put?

Against this backdrop, Chairman Powell’s press conference on January 26th was more akin to a cold shoulder than a comforting embrace. Underscoring a tight labour market, strong economic momentum and ongoing inflation, the Chairman seemingly went out of his way to differentiate the current rate cycle from the previous one, opening up the door to “proceeding sooner, and perhaps faster”, while also distancing himself from the gyrations of the market by reiterating a focus on “the real economy” and the anticipatory nature of financial conditions which he hinted as being “adequate”.

_____
As of now, the market remains in flux, looking to understand at what valuation all of it will be “priced-in”.

For reference, in 2018, a hawkish Jerome Powell was forced into submission by collapsing asset markets and decreasing economic momentum, setting up a policy reversal accompanied by a strong 2019 equity rally. And of course, his willingness to decisively intervene in March 2020 further burnished his credentials among equity bulls.

Now, however, his December hawkish pivot coupled with additional conviction this month is pushing investors to question the “Fed Put”, and underscores the focus placed on responding to current inflation readings. As of now, the market remains in flux, looking to understand at what valuation all of it will be “priced-in”.

Looking forward constructively, it seems to us that if the Fed looks to differentiate the current and the past rate cycles, equity investors should consider doing the same. Indeed, strong GDP growth remains an engine of revenue growth potential not seen in years, which should help fight off some of the cost pressures impacting margins.

And while some of the past years’ winning trades might come under pressure, the current phase can offer opportunities such as a value recovery benefiting financials, Energy, Industrials and increasingly Healthcare, while even maybe supporting outperformance from the old continent!

Amid the prospect of tighter monetary policy, the key in our view will be selectivity and valuation discipline. As the first earnings reports demonstrate, certain companies continue to deliver tremendous value and remain key enablers of our increasingly digital ways of life.

While acute nervousness brutally punishes the under-delivering high flyers – as Netflix’s -20% down day can attest – others such as Microsoft continue to arguably earn their high value through profitable and sustained growth, while also seizing opportunities to invest and opportunistically acquire unique assets like Activision when possible. More than ever, fundamentals will matter for returns and active management could get a day in the sun in what increasingly looks like a potentially volatile 2022 for equity markets.

As always, we invite investors and prospective investors, to contact us should they wish to understand our views on the current situation and the positions held in the portfolios.

Adam TurbervilleAdam Turberville
Director
+44 1481 742380
a.turberville@ericsturdza.com

The views and statements contained herein are those of Banque Eric Sturdza SA as of 02/02/2022 and are based on internal research and modelling. Please click on Disclaimer Page to view full disclaimers.