investment insights
Managing 2022’s market volatility
Lombard Odier Private Bank
Key takeaways
- The Fed is striking a more aggressive tone to reduce four-decade-high inflation, with unemployment close to pre-pandemic lows
- We expect four rate hikes in the US this year plus the Fed’s balance sheet to start shrinking; inflation should decline
- Markets are pricing the change in monetary policy with heightened volatility
- We keep our pro-risk positioning with an overweight in equities, underweight fixed income and remain agile and opportunistic.
In December, US consumer prices rose 7% compared with a year earlier. The last time American inflation was that high Ronald Reagan was into his second year as US President and it cost less than three dollars to buy a ticket to watch the biggest box-office hit of 1982, Steven Spielberg’s ‘E.T.’ Driven by this historic level of inflation, a shift in US monetary policy has triggered a market sell-off that signals a volatile 2022.
The US Federal Reserve has a dual mandate: achieve full employment and ensure price stability. The strength of the US economy means that unemployment of 3.9% is close to its pre-Covid, half-century low of 3.5%, however, inflation is at four-decade highs.
Shelter, for example, is a large component in consumer price index calculations. Nationwide, four-fifths of US housing markets recorded double-digit price increases last year. The pandemic pushed many employees out of city centres to work remotely and then as people returned to work, demand rose further. Last year competition for properties also translated into rental price rises as landlords looked to pass-on their higher property taxes. The US median rent for a one-bedroom apartment, for example, increased 19% in the year through December, to USD 1,651 according to Realtor.com, a real estate website. By another measure, the Case-Schiller US National Home Price Index, housing nationally increased 22% between February 2020 and November 2021.
Mr Powell repeated last week that the central bank’s quantitative easing, in the form of asset purchases, would end in early March, followed by a first increase in the world’s most closely-watched benchmark interest rate. This time round, Mr Powell reminded investors, the Fed is beginning to raise rates with unemployment lower, and inflation much higher, than at the start of previous rate cycles.
Although the Fed made no substantive change to its outlook last week, it did underline that there is still room to step-up the pace of monetary policy normalisation. So what level of inflation does the central bank think is appropriate? Mr Powell’s use of the word “humble” to describe the Fed’s uncertainty suggests that it does not yet know the answer.
The Fed’s focus on fighting inflation means that the end of abundant liquidity is near. That makes investors understandably more concerned about asset valuation and price volatility. After a statement by Fed Chair Jerome Powell, markets priced four rate hikes this year, and another three in 2023. Assets fell further, taking this year’s declines on the S&P500 and NASDAQ to 10% and 16% respectively, while ten-year US treasury yields rose 30 basis points to 1.83%. At this point in time, we believe that the Fed will deliver four rate hikes this year and begin to let its balance sheet shrink. This is based on our expectation that inflation will start to decline over the course of this year.
Nevertheless, we expect the pressures that have pushed prices higher to begin to normalise as logistical bottlenecks and supply levels return to their pre-Covid trends. This is especially visible in metrics such as the cost of shipping, which, measured by the Baltic Exchange Dry Index, for example, has fallen five-fold from a peak in the third quarter of 2021 or in car production, that is recovering from its shortage of semiconductors over the first nine months of last year. Still, the combination of higher rents and wage growth through full employment should leave core inflation between 2.5% and 3% for 2022, which remains higher than the Fed’s long-term average target of 2%. These pressures are typical of every maturing economic cycle, and should not undermine the broadly favourable monetary conditions for growth.
While the Fed is focused on inflation, volatility also brings complications for consumers. The price of lumber to build Americans’ houses, for example, recorded a 12% variation in monthly prices over 2020 and 2021. That is 40 times more volatile than the month-to-month price change seen over the previous 70 years, according to MarketWatch data.
Catalysts and market selectivity
This new phase in the economic cycle signals the start to a volatile 2022. Beyond the US, the Omicron variant and the West’s tensions with Russia, higher oil prices and weaker manufacturing data have all contributed to market uncertainties. In addition, the corporate earnings season follows a string of exceptional results and reporting so far has failed to excite investors more used to double-digit growth in recent quarters. The sell-off at the start of this year has concentrated on equities and especially on some high-valuation, low-earnings areas of the market that were hit hardest.
We anticipated a more volatile environment in late 2021 and responded by first raising cash in order to allow us a more active portfolio management. In addition, we reduced the portfolio sensitivity to equities by selling call options as markets approached our year-end targets.
Volatility should continue to offer opportunities to adjust portfolio positioning. For example, whenever the Cboe Volatility Index or VIX, the most widely used measure of S&P500 volatility, is around 15-17 we believe that buying put options or put spreads can be appropriate. In turn, when volatility is higher than 25, selling covered put options can help us generate income. These strategies let us manage exposure since equities represent the largest share of our active risk in portfolios. Current VIX levels of around 28, while higher than the average reading of 19 over the past 15 years, remain well below its historic peaks (see chart).
Taking a step back, we note that historically equities have been volatile in the early phase of monetary policy normalisation, but then tend to stabilise and rally, rather than signal an end to a bull market. This tendency for equities to rally through a hiking cycle is logical since it reflects a robust economy.
After strong equity performance and low volatility in 2021, we are moving toward more normal market functioning, corrections included. Since 1980, the average peak-to-trough market decline within any given year was 14% on the S&P 500 index. Nevertheless, the index finished the year higher in 32 of those 42 years. Last year’s peak-to-trough however reached just 5%. We see two major risks with portfolio implications: a more aggressive Fed tightening cycle, or even more persistent inflation; both of which would choke-off growth.
With liquidity in shorter supply than through the pandemic, investors will have to be much more selective in choosing assets. Our equity focus remains monitoring and reviewing portfolios with a preference for quality and profitability, both of which will become more prized as interest rates rise and financing becomes more difficult. In addition, we believe that investors should balance portfolio exposure to technology companies with other sectors linked to the real economy, such as industrials, materials, financials, and energy firms.
For now, trading data shows that large institutional investors continue to buy on weakness, and all indications are that corporate earnings will, overall, remain solid as the global economy continues its growth path.
Year-to-date, fixed income and particularly credit and high-yield markets have moved far less. High yield spreads have widened by 62 bps in the US and 35 bps for euro-denominated credit, as companies refinance aggressively in anticipation of higher borrowing costs.
With interest rates rising, equity investors will concentrate on earnings results over the next two weeks and use opportunities to add quality, oversold and undervalued names to their portfolios. For now, we maintain our moderate pro-risk stance: overweight equities, with a focus on stocks and companies better able to stand higher rates and with the capacity to defend their margins. We remain underweight fixed income, with a preference for Chinese sovereign debt, high yield and emerging market dollar-denominated debt. Overall, we favour remaining agile, opportunistic, and diversified.
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