What does the chart show?

The chart shows the Atlanta Fed’s Flexible-Price and Sticky-Price Consumer Price Indices (CPI) since 1970. The Flexible-Price CPI (green line) represents goods and services included in the CPI that change price relatively frequently, whereas the Sticky-Price CPI (blue line) represents those changing price relatively slowly. For example, some sticky prices are those for medical care services, alcoholic beverages, household furnishings while things like new vehicles, fuel and gas, or bakery products are part of the flexible price items. The latest readings showed the US headline CPI index at 7.5% year-on-year, once again above analysts’ estimates. The Atlanta Fed’s flexible price component is, as expected, sitting at all-time highs at 17.8% year-on-year, whereas the sticky price component is up 4.2% on a year-on-year basis, its highest since 1991.

Why is this important?

As sticky prices are more gradual to change, when these prices are set, they include expectations about future inflation to a greater degree than flexible prices, which tend to be more responsive to short-term changes in the current economic environment. Last year the debate was on whether the inflation spike was transitory or not and now that the “transitory team” has badly lost the match, we are all gauging when it will come back to lower levels. The sticky price component therefore may provide key insight when trying to gauge where inflation is heading. In January, the flexible measure reduced slightly from 17.9% to 17.8% whereas the sticky metric has reached new highs, this could indicate that the supply chain and pandemic related pressures are improving but inflation expectations are shifting meaningfully higher. When the sticky price items are hitting multi-decade highs, the risks of inflation becoming persistent cannot be dismissed. Markets are in the process of adjusting rapidly to this new reality, and already financial conditions have been tightened significantly by the policy pivot.

What does the chart show?

Last week, Facebook (now known as Meta, reflecting Mark Zuckerberg’s desire to focus on construction of the virtual metaverse) saw its market value drop by $250bn in a single day following its quarterly earnings release that missed expectations and was accompanied with lower future earnings guidance. That $250bn drop was the largest one-day drop (in market value terms) ever recorded in US stock market history. To put this into context, that is the equivalent of an entire Nike disappearing in a day, or a Netflix, or two Goldman Sachs, or three Fords. Each are as staggering as the last!  

Why is this important?

Facebook missed on earnings expectations last week, albeit by only 4% at the headline level, revealed its daily active users (DAUs) fell for the first time in the company’s 18 year history and lowered future earnings guidance, not helped by huge investment expenses associated with building the metaverse. Furthermore, it also warned it might shut down Facebook and Instagram in Europe if new data protection legislation isn’t adopted. No doubt plenty here to challenge the future growth trajectory of this business but we think a key takeaway is that when company valuations become too overstretched it need not take a huge disappointment for Mr Market to punish a stock severely. Companies priced for perfection, despite how popular and glamourous they might be, can suddenly look far from that in share price terms if those once stellar earnings suddenly look a little more challenged. We should disclose Facebook/Meta was an exception this quarter with the other tech giants actually delivering strong earnings updates on the whole but it serves as a handy reminder of the importance of valuation within one’s investment selection.

What does the chart show?

After a volatile start to the year, US equity benchmarks, the S&P 500 and NASDAQ, have ended the month trading well below their highs of the beginning of the month and mid-November respectively. The S&P 500 ended the month down -5.2% and the NASDAQ down -9.0% in local terms. The chart shows the net monthly fund flows of the Invesco QQQ Trust since 1999, one of the most actively traded exchange-traded funds (ETFs) in the world. The fund only invests in non-financial stocks listed on the NASDAQ, which has naturally seen higher weightings to large tech names. It ultimately is trying to track the performance of the NASDAQ 100 Index. In January 2022, the monthly outflows reached levels not seen since the 2000s, reflective of the changing investor sentiment after weeks of turmoil in US large cap companies. $6.2bn was exited during January with the majority of the outflows taking place towards the end of the month, suggesting that investors have been taking profits after a number of very strong years for US equity markets in addition to concerns over inflation and interest rate rises.

Why is this important?

US large cap stocks have suffered a volatile start to 2022, largely attributed to the Fed signalling tighter monetary policy this year in order to combat the highest inflation levels seen in decades. Expectations of rising interest rates have driven investors to reassess the valuations of large cap growth stocks as these are generally more sensitive to interest rate movements. With such a significant shift in the monetary policy landscape coming into view, we expect the best returns are now likely to come from a very different cohort of stocks than those that have led returns over the past decade. We continue to see a lot of opportunities in value stocks, which have generally proved resilient during the sell-off in January. As well as maintaining broad diversification, we believe it is more important than ever to include a significant allocation to value stocks in portfolios, across a broad range of industries and geographies.

What does the chart show?

US equity markets have fallen under strong pressure recently, as expectations build that the Fed will unwind monetary stimulus measures quicker than expected. In fact, markets are now expecting the Fed to increase interest rates as much as four times this year, starting in March, to fight surging inflation. Higher interest rates raise borrowing costs for all businesses as well as making companies’ future earnings worth less in terms of discounted value. The effect is magnified for tech and other growth companies, whose earnings are further out in the future. 

The prospect of a faster pace of rate hikes sent US equities to their lowest levels so far this year. Coupled with concerns over the effect that the Omicron variant has had on economic activity as well as rising geopolitical tensions, the S&P 500 experienced its third consecutive weekly decline with tech shares and growth stocks being amongst the worst performing, which drove the NASDAQ and Russell 2000 down 13% and 11% YTD.  

Why is this important?

With the fiscal stimulus measures of the past few years disappearing into the rear-view mirror as we head into a rising rates cycle and a quantitative tightening environment, the backdrop isn’t particularly reassuring. During periods of volatility, markets can swing wildly as investors reduce risk and reposition their portfolios in light of changing news flow. Making rational, informed decisions during periods of heightened uncertainty is not an easy task, and fear can dominate in the short-term. A more prudent approach is to build additional diversification levers, which can reduce volatility and drawdowns, smoothing the investment journey – an approach that we promote and implement.

What does the chart show?

The chart shows the Federal Reserve’s FOMC (Federal Open Market Committee) ‘dot plot’ – essentially each official’s expectations on where interest rates will be at future dates. Each dot represents an individual’s prediction as to what the federal funds rate will be at the end of each year until 2024 and then longer-term views. The median of all dots is then used as a basis to set the official rate forecast. Since its introduction, the Fed dot plot has become one of the most closely watched news releases among investors. The most recent projections from the FOMC meeting dated 15th December (so admittedly now a bit dated) indicated three rate rises before the end of 2022 and another three moves in 2023. Only two members were pointing to four rate rises this year. Looking at the median of the dots from December’s meeting against prior dot plots from September and June shows the shift to a more hawkish stance in response to inflation levels not seen in decades. It is noticeable that the dots show a wide range of predicted outcomes for the long-term, and even as soon as 2023, reflecting a great deal of uncertainty.

Why is this important?

A tightening labour market and inflation at multi-decade highs have pushed the Fed to adopt a more hawkish stance. Minutes from the December FOMC meeting showed officials voted to maintain the current target rate of 0% - 0.25%, but that members were on board with accelerating the tapering of the bond buying programme adopted at the onset of the pandemic. The pace of tapering will be increased from $15bn to $30bn per month beginning this month. This would result in the Fed ending its purchase program (quantitative easing) by March 2022 if there are no further changes, giving greater flexibility to raise interest rates. They have also now pointed towards quantitative tightening soon after commencing rate rises. Interestingly the market is now pricing in four rate rises through 2022, ahead of current Fed projections. You might often hear this referred to as the Fed being ‘behind the curve’. Importantly, with four rises now factored into market/government bond prices, if the Fed doesn’t see these through then positive capital returns could be made in government bonds. However, a faster and sharper move higher would almost certainly be negative.

What does the chart show?

The chart shows the US 10 year government yield (red line) and the share price performance of the MSCI World Financials Index relative to the MSCI World Index (blue line). An upward sloping blue line indicates the MSCI World Financials Index is outperforming the broader MSCI World Index, whereas a downward sloping line means it is underperforming. Since the beginning of the year, the performance of the MSCI World Financials Index has bettered the broader index.  The yield on the benchmark 10-year Treasury bond has climbed for seven consecutive days to 1.77%, now above the highs of last year. Through time there has been a fairly tight relationship between the two. Higher yields have been positive for financial equities whilst lower yields are often associated with underperformance.

Why is this important?

Minutes from December’s US Federal Reserve meeting were released last week which pointed to the central bank potentially raising interest rates and shrinking their balance sheet faster than previously anticipated, in response to consumer prices rising to multi-decade highs and the labour market showing strong signs of recovery. This triggered a sell-off in US government bonds in anticipation of tighter policy from the Fed which coincided with a sharp increase in bond yields. We saw this feed through into the equity market. Higher bond yields have a greater negative impact on growth stocks than value names, as the interest rate used to discount their higher future earnings increases, meaning the present value of those earnings (in theory, the share price) decreases. This has hit tech stocks, whose valuations are better supported in a lower interest rate environment. Financial stocks, on the other hand, can benefit from increasing interest rates through higher net interest income (the difference between income earned and income paid out). Furthermore, banks have started to release loan loss provisions set aside earlier in the pandemic and more of this is expected which should be supportive for earnings. So far this year we have seen financials outperform the broader equity market by over 5%.

What does the chart show?

For our first chart of 2022, we thought we would reflect on the performance of a number of asset classes in 2021. The strongest performer which we chart here was global equities (blue line) boosted by loose monetary policy for most of the year, government stimulus packages and a recovery from the most severe lockdown restrictions. The MSCI World Index rallied 20% in 2021 in contrast to the MSCI Emerging Markets index which fell 5% over the same period, weighed down by tightened regulations in China which particularly targeted the education and tech sectors, along with default concerns within the country’s real estate market. What was more remarkable was the returns seen in certain commodity markets, including UK natural gas (+294%) and oil (+50%). Government bonds were more challenged as higher inflation and the prospect of tightening monetary policy saw yields continue to rise, ending the year with a -7% total return. Rising cases of Covid-19, stemming from the Omicron wave, and surging inflation threatened investor returns towards the end of the year. However, global equity markets pulled through the increased volatility and these developments failed to ruin the year’s rally.

Why is this important?

The year started on a high after last November’s vaccine success and it has largely been one way for risk assets since then. There was a handful of small drawdowns in global equity markets in 2021, but these proved short lived. Given obvious uncertainties around further mutations of Covid-19, how central banks will tackle surging inflation and geopolitical tensions in Europe and Asia, markets have looked through a lot of the ambiguity of late and whilst they have come a long way since the lows of 2020, there is still much disparity, and thus opportunity, within. 2021 was really a year to stay invested and not try and time the market. Anyone who sat on the sidelines waiting for a better entry point will likely be ruing that decision. Finally, last year proved that bonds are not risk free. They still have a role to play in more defensive portfolios, but investors should look to diversify their diversifiers as the classical ‘60/40’ portfolio will be challenged going forward.

What this chart shows

The US equity market looks set to top the charts again this year amongst the global developed equity markets, with the S&P 500 up 25.1% YTD, compared to returns of 9.7%, 11.6% and 1.3% from Europe, the UK and Japan, respectively (in USD terms). We thought it would be worth diving a little deeper into the world’s largest equity market, now flirting with a 70% weight in the global MSCI World index. The chart shows what we call the US equity value spread (blue line), measured by taking the average valuation, as measured by the price-to-book (P/B) ratio, within the cheapest quintile of companies relative to the average valuation of the entire universe. In other words, the blue line shows the valuation discount between the cheapest quintile and the entire universe average. 

The green line shows the actual average P/B of the cheapest quintile, thus measuring the absolute valuation level. The P/B ratio is used to compare a company’s current market value to the book value of its equity (assets minus liabilities) and a lower P/B ratio can be indicative of an undervalued stock. There are two key takeaways from the chart. Firstly, the absolute valuation level of the cheapest quintile has increased materially and isn’t far off historic highs. However, despite this the value spread remains extreme, near a 65% discount, implying the universe average has been pushed higher by a cohort of very expensive stocks, which we know to be the technology giants, the key beneficiaries of the pandemic.

Why is this important?

These have been challenging times for value stocks, with a difficult post-GFC period compounded with the pandemic-induced sell-off and continued performance divergence between value and growth stocks. The value spread narrowed following ‘Vaccine Monday’ in November 2020 through Q1 this year but it did little to close the discount. The high absolute valuation of even the cheapest quintile today raises further questions around the valuation headwind for US equities; even beneath the household names the opportunity set looks less compelling today, notwithstanding the extreme value spread. We think the better opportunities lay outside the US, where absolute valuations are not as high and the value spread appears just as extreme.

We hope you have enjoyed receiving our weekly charts throughout this year and we look forward to continuing to deliver updates to you next year. For now, we wish you a safe and enjoyable festive period and best wishes into 2022. Might it be the year when value stocks stage a sustained recovery?

What does the chart show?

The chart shows the yield to maturity on Chinese high yield (sometimes referred to as “junk”) bonds over the last 5 years. High yield bonds are rated below investment grade bonds by credit rating agencies due to their higher perceived risk of default. They typically offer higher yields in order to compensate for the increase in credit (and sometimes liquidity) risk. In recent weeks, the yield on this broad index has moved north of 20% indicating the spiralling cost of borrowing for sub-investment grade rated Chinese companies. What began as a confidence crisis around the health of Chinese property developer Evergrande has reverberated to numerous other real estate firms that have either already defaulted or appear close to default. This of course has led to fears of broader market contagion.

Why is this important?

The market has suffered another wave of selling as the latest news on Evergrande suggests that the property developer is very close to default, with some investors claiming that they have not received bond payments after the end of a 30-day grace period on Monday (6th December). The sharp increase in yields (that coincides with a sharp decline in bond prices) shows how regulatory restrictions on borrowing and slowing home sales have pressured the real estate sector in China, which today accounts for approximately 55% of China’s high yield market but would have been higher in the past. Demonstrating the severity of the situation, on Monday the People’s Bank of China (PBOC) said it would reduce financial institutions’ reserve requirements by 0.5% which would free up 1.2tn yuan ($188bn) of liquidity for the banking system, in a move widely seen as intending to reassure investors if the troubled real estate developer collapses. However, there does seem to be an element of the ‘baby being thrown out with the bathwater’ with some less correlated and higher quality credits also impacted amidst a broad market selloff. You hear us say this a lot but it is another good example of the opportunity in active management, taking advantage of market mispricing to selectively identify attractive entry points for long term investments.