The decision to put cash into markets this year depends on when investors think the interest rate cycle is properly priced. Getting there might be tricky. Higher bond yields and some growth uncertainties have provided a stuttering start to equity markets. A reduced gap between equity and bond returns is certainly one outcome for the year. In the short term, we need to watch the inflation and COVID-19 numbers and markets could be more volatile. Patience is the hardest virtue sometimes. Beware the sirens’ call.
Welcome to 2022 and a Happy New Year. I hope everyone was able to have some rest and peace over the holiday season. As we get back to work, markets have quickly shown us that there is much to be concerned about this year. I suggested in my last note that a key risk would be that we have all mis-priced the monetary policy cycle, meaning rates will go higher more quickly than was thought. The minutes from the last Federal Reserve Open Market Committee, which were released on January 5th, underlined that risk. They more than hinted that rate hikes could start sooner and that the central bank’s balance sheet could be reduced more aggressively. While this says nothing about the end-game of the coming monetary policy cycle – the Fed’s terminal interest rate forecast is still 2.5% – the journey there could be bumpier.
Real yields on the move
The big reaction to the minutes was a 30 basis points (bps) jump in real yields at the 10-year maturity of the curve. I have discussed real yields extensively in the past from both a secular and cyclical point of view. The focus now is very much on the cyclical. Previous recent monetary tightening cycles in the US have seen real yields rise. This has not been on a one-for-one basis but has been enough to push nominal yields higher. It looks as though this process is happening again and both earlier Fed rate hikes and a more aggressive reduction in the balance sheet will potentially force real yields higher. It tends to a view at the moment that bond returns will struggle until the markets have settled on a new consensus for the path of rates. Of course, the Fed is not all the story.
There are growth risks as well
If 2022 was characterised by continued economic recovery in the face of a receding pandemic and easing of supply disruptions and labour shortages, then confidence in the path of interest rates would be higher. However, we are in the midst of a fourth wave of the pandemic. While hospitalisation and death rates are lower than in previous waves – thanks to vaccination programmes – there is still disruption being done. Note the widespread cancellation of airline flights over the holidays and the shortages of public sector and other workers being reported in many economies. This is bound to create some downside growth risks in the short-term. In addition, there is no let-up in the global surge in energy prices. This tax on incomes will add to the growth uncertainties. So even though bond markets are super-sensitive to central bank messaging and have priced in more in terms of rate hikes than was the case a few weeks ago, there has to be a scenario in which the normalisation of policy is delayed.
All of this creates uncertainty. Bond yields have risen to their 2021 highs. For those investors concerned about growth and the ability of equity markets to sustain the performance of the last two years, these yield levels offer some defensive protection. On the equity side earnings momentum and revisions data suggest a 5%-10% total return expectation is reasonable this year. The most recent data from analysts is more negative in terms of EPS growth for Europe relative to the US but it remains the case that the US market is more highly valued. I would remind readers again that the rise in bond yields may force some re-ratings of equities – this is perhaps already happening at the index and sector levels.
Mean reversion anyone?
Globally, equity returns have massively outperformed. Using the MSCI world total return index and the ICE global bond market index, stocks beat bonds by 26% in the year to December 2021. In the initial COVID-19 recovery period between March 2020 and March 2021 the outperformance was 40%. My hunch is that we won’t see such an outcome this year. Some mean reversion is likely. In the US the gap between the earnings yield on the S&P500 and the 10-year US Treasury yield is 2.88%. This is lower than for any other market and lower than it has been for most of the QE period. If bond yields do spike higher the risk of an equity correction moves correspondingly.
Wealth growth stalling?
If equity-bond relative returns are less in 2022, it is more likely to be because of falling equity markets than a significant jump higher in bond returns. It would be because of a surge in risk-off behaviour brought about by the uncertain economic and policy outlook. I think investors should be prepared that total wealth doesn’t grow as much as it has in the last couple of years. For now, I stick with the view that short-duration high yielding fixed income and inflation linked-bonds remain attractive, as do income generating floating rate instruments. So far there has been no evidence of any deteriorating in credit quality. On the equity side, it may be a case of waiting for better valuations or sticking with a long-term view. There are many mega-trends that will drive equity returns over the coming years, mostly centred around de-carbonisation, further digitalisation and social considerations (healthcare, leisure, new trends in life-work balance). As always with investing, it depends on your time horizon and your risk tolerance.