The new trading year is only a few weeks old, but we have already seen major setbacks on global equity markets. The US stock market has lost more than 10% from its all-time high and hence is in correction territory. The main reason for the very volatile start into 2022 is the Federal Reserve’s ”hawkish“ communication in recent weeks. Although the Fed tightened its rhetoric already in the final quarter of 2021, it was only with the publication of the FOMC December minutes that investors became aware that things are now getting serious and that three major changes are on the horizon: an even faster reduction of quantitative monetary easing, several rate hikes this year and the reduction of the central bank balance sheet (Quantitative Tightening). However, there are huge return differences in equities, both on a regional and sectoral level. This divergence is also reflected in the policies of other central banks, as both the European Central Bank (ECB) and the Bank of Japan have not yet announced any changes in their expansionary monetary policy in the foreseeable future.
The Fed’s communication in recent months has been successful in avoiding a ”taper tantrum“ like the one we experienced in 2013. At that time, ten-year US Treasury bond yields quickly rose from 1.7% to as high as 3%, triggered by the reduction of the quantitative easing. The current situation, on the other hand, is more comparable to the constellation in the fourth quarter of 2018. At that time, turbulences hit capital markets because the Fed raised interest rates and simultaneously reduced its balance sheet. Markets were thus provided with less liquidity. The US stock market has always struggled when liquidity has been reduced quickly and massively. Uncertainty among market participants is likely to remain high until the Fed’s initial interest rate hike, which is expected on March 16, 2022.
There have been nine interest rate hike cycles in the United States over the past fifty years. It is noticeable that risky assets such as equities and commodities performed positively during these periods – however, the dispersion was huge. This means that, nevertheless, caution is required when investing in risky assets in a rate hike cycle.
In the last two weeks, uncertainty on financial markets has once again increased. On the one hand, the Ukraine conflict quickly escalated in the second half of January, and on the other hand US President Joe Biden’s poll ratings have plummeted following the latest inflation figures. The Democratic party could face a Waterloo in the upcoming elections in fall, meaning there is a potential risk of losing both chambers in congress.
The first few weeks of trading could be a harbinger for the asset allocation in the months ahead, as the two most important asset classes, equities, and bonds, have come under pressure at the same time. For example, ten-year government yields have risen not only in the US (+27 basis points), but also in the eurozone (+11 bps), the UK (+20 bps), and even Switzerland (+12 bps). The development reflects market participants’ expectations of receiving less liquidity from global central banks in the future. So far, only commodities and gold have been able to escape this trend and actively contributed to diversification.
For several quarters now, we have been focusing on quality in all asset classes. This has not changed after the recent correction. In a market environment characterized by liquidity withdrawal, quality is more in demand than ever. This has prompted us to take slightly less risk in our investment strategy and to keep our powder, or liquidity, dry. In the course of the month, we therefore downgraded US equities to ”neutral“ and reduced the technology sector to ”underweight“. With the Fed’s monetary policy creating headwinds, US companies are feeling the effects disproportionately. Caution is warranted for companies that are barely earning a profit and the stock has lost 50% or more of their value in recent months. Until we have more visibility, we recommend to suspend the ”buy-the-dip“ strategy. In the short-term, we advise to stay on the sidelines and to increase liquidity. As a consequence, we are re-setting the liquidity ratio to ”overweight“ and the equity ratio to ”neutral“.
The start of the year signals that return differentials in equity markets will be enormous over the course of 2022, not only at sector and industry level, but also between regions and countries. Therefore, in our view, the most important success factor in equities remains selection, especially when it comes to relative performance. We continue to favor non-cyclical consumer goods, the commodities sector, and European financials.
The rise in long-term interest rates has been considerable. We expect this rise to continue at a slower pace and the upward pressure to remain. The only exception we see is if investors flee into government bonds due to further harsh losses on equity markets. This remains our risk scenario. Within the fixed income quota, we are focusing on short duration and continue to consider hybrid bonds and Asian high yield bonds attractive.
Publisher: LGT Bank (Switzerland) Ltd., Glärnischstrasse 36, CH-8027 Zurich
Author: Thomas Wille, Head Research & Strategy, Email: email@example.com
Editor: Alessandro Fezzi, E-Mail: firstname.lastname@example.org
Source: LGT Bank (Switzerland) Ltd.
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