Some believe that how stocks start a year off is how they will end it. After the first four days of 2022, this may suggest that we are in for negative returns following a solid year in 2021. That may, in fact, turn out to be the case; however, the gyration in equities this week is more a reflection of the fact that the market has transitioned from reflecting on Covid-19 to how monetary policy is going to shape up this year. In effect, bulls are running a relay race where they are passing focal points like batons.  The problem is that sometimes that baton can be a little hot and that’s when we get stumbles.

If we only watched the regular news stations, we would think that there is no way that market participants can shift focus at all from the virus.  Daily cases, driven by the new Omicron variant, are escalating and economic restrictions are being put back in place in some regions. The seriousness of the situation is real, although the market is looking beneath the headlines to studies that suggest this latest wave is going to prove shorter and less lethal and prior ones. In other words, the market has moved on to the next big play – figuring out where interest rates are going.

Given that we have been talking about an inflection point in monetary policy for quite a long time, you might have gotten the impression that stocks were as immune to talk about higher rates as they have been to the virus. Immune is the wrong term to use here though. I would say they just became more comfortable with that talk – provided that central banks would not rush into tightening policy and would initiate a significant round of rate hikes. That view vanished somewhat this week with the release of minutes from the December FOMC meeting, where officials discussed the potential need for a move on rates sooner than say the middle of this year.

 

The response was seen acutely in the bond market, where 2yr US treasury yields jumped 0.1% this week to 0.87%, which is the highest we’ve seen since March 2020. The absolute level of this yield may seem very small, but it is the rate of change that gets the attention of traders. Now, it’s not unusual for the 2yr yield to start reacting before the Fed even begins to lift rates. In fact, this is rational pricing. We saw it years after the Great Recession, when the 2yr had risen to 0.9% by the time the Fed raised rates for the first time in December 2015. A similar thing happened after the recession following the tech bubble implosion of 2000, when the 2yr started rising from its low just above 1% to almost 3% before the Fed made its first move. Back in 1998, the 2yr started to push higher even before the Fed stopped cutting rates.

Right into December of last year, the consensus was that the Fed would start raising rates around the middle of 2022. That would give the front end of the yield curve a little time to drift up before then. What happened this week is that the timeline was compressed by a couple of months. Whether or not the Fed does raise rates in March or May doesn’t matter. What does is that the bond market adjusted its pricing. And that is important for stocks, especially high growth ones, because a company’s share price is calculated as the discounted value of future earnings. The higher the interest rate we use in that calculation, the lower the stock price. Which is why growth stocks were more heavily hit this week than other sectors. Where the Dow was down this week by only 0.3% at the time of writing, the NASDAQ was off 3.6%.

Let’s go back to the reference of what happens this week is a guide for the year. Like most seasonal indicators, this one is far from perfect.  This looks to be the worst start of the week for the major US stock aggregates since the beginning of 2016. In the first four sessions of that week, the S&P500 lost more than 3% and went on to a loss of almost11% by February 12^th. This was also a US election year, so as markets slid, pessimism grew with many analysts anticipating a negative year as a whole. As it turned out, the S&P ended 2016 with a net gain of over 8%. This year is a mid-term election year, but I would argue the more relevant comparison between now and then is what is happening on the monetary policy front.

The US jobs report for December was released this morning and it was a mixed bag on the surface. Non-farm payrolls rose by only 199,000 on the month which was way below street expectations. True, there were upward revisions to the prior two months but it is clear that the momentum in jobs growth slowed into year-end. On the flipside, more people entered the labour force and there was a sharp jump in household employment. This sent the unemployment rate down to 3.9% and this is the lowest since February 2020. Average hourly earnings also rose by 0.6%, also more than anticipated. The market’s read on these numbers is that the Federal Reserve is on track to raise rates and potentially in March.

 

 

I have talked before about how the Fed spent years after the Great Recession before raising rates.  Well, that starting point was back in December 2015 and that is why I believe the comparison between the start of this year for equities and 2016 is pure and simply based on the story of interest rates. The other interesting takeaway is what unemployment was doing prior to the Fed’s first move back then. As the chart shows, the US unemployment rate had fallen to 5% just before the December 2015 rate hike. That was just over a half a percent above the pre-recession low of 4.4%. Well, today’s 3.9% rate is also about half a percent below where we were just before the pandemic.

I would argue that the facts on the ground do support a March Fed hike and if that’s what the Fed wants to do, then we should get definitive guidance at the January 26^th meeting.  There are things that could change that stance, including the virus, but there are other nuances as well. For example, the Fed has spent more time in the last year discussing how the economy has to benefit all segments of the employment spectrum and that involves diversity. 

 

 

From an investor perspective, the important question from this week’s data and policy views is what happens to my portfolio if the Fed starts to tighten? First, it doesn’t necessarily mean we need to run for the caves. In the chart above, I have highlighted the last four major Fed tightening cycles against the S&P500 going back to 1994. In all four experiences, the S&P saw a net improvement over the course of the Fed tightening period. The worst performance was the paltry 0.1% rise in 1994-95, while the strongest showing was the 20.9% lift from end of 2015 to the end of 2018. This has been the guidance that Ally, and I have been giving clients through the past year – that it’s not the near-term outlook that worries us, even as rates move higher.  It is what happens if rates reach a point that is too tight for the economy. The last two tightening cycles lasted for a couple of years before major turbulence/recession transpired. It’s possible that the same holds true this time around. For now, I wouldn’t get too excited about the business news this weekend.