Fynsa
There are two concepts that dominate the baseline scenarios for 2022: a return to “normality,” assuming the pandemic is behind us, and a “more volatile” year as a result of monetary policy normalization.
In our last newsletter of 2021, we noted that we believe 2022 will be the year of a full global recovery and the end of the global pandemic, thanks to widespread population immunity and new therapies, and that this would translate into a strong cyclical recovery, a return to global mobility, and the release of pent-up demand from consumers (e.g., travel, services) and corporations (inventory restocking, capital investments, and buybacks), in a context where monetary policy will remain accommodative.
For this reason, we remain bullish on stocks, commodities, and emerging markets, and bearish on bonds.
But some risks have begun to emerge… The Fed is shifting toward a “tougher” stance
The December FOMC minutes paint a picture of “a Committee moving toward the withdrawal of monetary accommodation,” which comes as no surprise to anyone. However, regarding the expected path of policy rates, the minutes note that participants see rate hikes “sooner or at a faster pace” than previously expected.
The minutes also indicated that participants continued to view mid-March as an appropriate end date for net asset purchases and, therefore, consistent with a first rate hike at the meeting that same month.
However, what was new in the minutes—and was also unexpectedly “hawkish”—were the clues provided regarding the pace of balance sheet normalization.While some believe that balance sheet assets will be phased out after the first rate hike, the general consensus was that asset sales would occur earlier than in the 2014–17 episode. Furthermore, it was generally believed that the pace of asset sales would be faster than in the previous cycle: as a reminder, the last time around, two years passed between the first rate hike and the start of balance sheet contraction, so the Fed is now hinting that it could shorten this to less than nine months so that balance sheet reduction begins in 2022.
On the economic front, the assessment of growth “remained strong, albeit with some caveats,” reflecting increases in COVID-19 cases and a “more gradual” resolution of supply chain disruptions. “Many participants noted that the new variants of the virus pose ‘downside risks to economic activity and upside risks to inflation.’”
Furthermore, “most” participants believed that the economy could reach maximum employment “relatively soon if the recent pace of improvement in the labor market continued,” and “several” participants noted that “they viewed labor market conditions as already largely consistent with maximum employment.” “Some”participants noted that it might be appropriate to raise the federal funds rate “before full employment is fully achieved,” for example, “if inflationary pressures and inflation expectations were to rise materially and persistently.” These comments again appear consistent with a rate hike in March.
In particular, we believe that the risks to growth are limited, but the same cannot be said for the risks to inflation, given that pressure on supply chains remains at peak levels.
Against this backdrop, we believe that markets will be vulnerable to a faster rise in sovereign bond yields at the start of the year.
In fact, 10-year U.S. Treasury yields are already trading at 1.75%, a key level given that it served as the pivot point throughout 2021.From there, yields have room to easily rise to 2.2%.
It’s not that a rate at those levels is particularly problematic in terms of equity valuations—since our estimates for the S&P 500 this year, at 5,000 points, already factor in a 10-year Treasury yield closer to 2.0%— but we are concerned about the speed of this potential move. In other words, more than the level of interest rates, the market is stressed by rapid movements over short periods of time— which may well end up being the case, given the Fed’s tougher stance, inflationary risks, and a tight labor market.
What about the actual rates?
Something remarkable has happened at the start of this year: while real Treasury yields had been trading at multi-month lows on the last day of 2021, hitting a low of -1.13%—an indication that markets viewed the economy’s future prospects as bleak and discouraging, reflecting chronic skepticism about the Fed’s ability to raise rates decisively— in the first week of 2022, real rates have surged to -0.8%, the highest level since June.
The result has been a sharp rise in nominal rates, which, as we mentioned, are currently at 1.75%, surpassing last year’s high in March 2021 and the highest level since before the pandemic, because the decline in breakeven rates has been more than offset by the rise in real rates.
Clearly, this upward movement (less negative) in real terms is a response to market confidence that U.S. economic growth can withstand a faster process of monetary normalization, but it could also begin to put pressure on market valuations (compression of multiples), especially considering that, compared to the post-financial crisis normalization cycle, real rates remain at extremely low levels.
We believe that the risk of corrections has been increasing, which could, in any case, provide better entry points for 2022, given that from current levels, the upside for equities appears limited and valuations are somewhat stretched— a situation that is particularly true for the U.S. market and even more so in the large technology sector.
Our recommendation? Stay away from growth sectors, at least for the first part of the year; prioritize short-duration value investments (which are therefore less sensitive to interest rate hikes) and positions that benefit from a steeper yield curve (financials, energy), diversify outside the U.S. into developed markets where valuations are more attractive (Europe and Japan), and maintain a very conservative strategy in terms of duration in international fixed income.
Finally, consider keeping some cash on hand (to look for better entry points) for the rest of the year.
Humberto Mora, Strategy and Investments
