The bond market may fare better in the coming year. The Barclays Aggregate Index unusually fell last year and it has never exhibited two consecutive years of negative returns (warning: n=3).
What does this mean for asset prices? Will 2022 be equity bearish and volatile and become Twenty-Twenty Too?
A bond tantrum
The latest source of market angst was sparked by the release of the December FOMC minutes. Further bad news came with the release of December Jobs Report, which had all the signs of full employment that allowed the Fed to raise rates. Even San Francisco President Mary Daly, who is viewed as a dove, believes the economy is nearing full employment and was in favor of raising rates: “I’m of the mind that we might need to, likely will need to, raise interest rates … in order to keep the economy in balance”.
The Treasury market threw a tantrum last week when both the 10 year Treasury yield broke up through resisance and the 30 year Treasury yield surged above its falling channel. In addition, the 2s10s yield curve steepened, indicating that the market expects better economic growth as the Fed “gently” tightens monetary policy. On the other hand, the 5s30s had the opposite gentle flattening reaction to the FOMC minutes.
A similar minor divergence is appearing between the Economic Surprise Index, which is stalling, and the 10-year Treasury yield, which is rising.
I interpret this to mean that investors should fade the bond market’s rising yields. The combination of a hawkish Fed and a loss of economic momentum is a recipe for slower growth and lower rates.
Defensive stocks take the lead
The stock market’s internals are also telling a similar story of caution. An analysis of the changing leadership of different parts of the stock market was highly revealing.
Starting with the defensive sectors, their relative performance is showing signs of emerging leadership. All are forming saucer-shaped relative bottoms against the S&P 500, indicating that the bears are wrestling control of the tape away from the bulls.
The leadership pattern of value and cyclical sectors looks a little better. In particular, the relative performance of financial stocks is the most correlated to the shape of the yield curve, mainly because banks borrow short and lend long. A steepening yield curve, therefore, enhances banking profitability. The other value and cyclical sectors are all exhibiting sideways basing patterns, though there have been some short-term recoveries, such as the one shown by energy stocks.
A more detailed look at the relative performance of cyclically sensitive industries tells a different story. Most have been trading sideways against the market and show no definitive signs of strong leadership.
From a global perspective, even though commodity prices are holding up well, the relative performance of the equity markets of resource producing countries to the MSCI All-Country World Index (ACWI) are all flat to down. This is additional confirmation that cyclical exposure is to be avoided.
What about growth stocks? They look downright ugly. Growth sectors are either rolling over or in decline on a relative basis.
In short, stock market internals are turning risk-off. This is consistent with a hawkish interpretation of Fed policy. The market is already discounting three quarter-point rate hikes this year and a discussion of quantitative tightening, or a reduction in the size of the Fed’s balance sheet, may not be very far behind.
Here is what this means for investors. Position for slower growth, at least for the first half of 2022. This means:
- A flattening yield curve and long bond duration, or maturity,
- Long USD in response to a hawkish Fed;
- Long defensive sectors of the equity market; and
- Long large-cap growth stocks as duration plays for their interest rate sensitivity.
Equity investors should also brace for greater volatility. The S&P 500 exhibited a drawdown of only -5.2% in 2021, which is well below average. The S&P 500 rose over 10% for the last three consecutive years, which is an unusual condition. Even on those occasions, which saw the market advance in four out of five instances since 1928, the average drawdown in the fourth year was -13.5% and the lowest was -6.8%.
To be sure, a flattening yield curve is a signal of slower economic growth. In all likelihood, COVID-19 fueled inflation pressures will begin to fade about mid-year, which will allow the Fed to reverse course on monetary tightening. Prepare for a dovish and cyclical pivot in the summer or autumn. This scenario is consistent with the historical mid-term election year pattern of a choppy market for the first nine months, followed by a rally into year-end.