A Bout of Market Indigestion

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  • 10 mins 47 secs
Portfolio Manager Jack Janasiewicz provides context around January’s market swoon, the Fed’s anticipated rate hikes and the start of earnings season.
Channel: Natixis Investment Managers

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Welcome to our podcast, “The Tactical Take,” where we discuss our thoughts on the markets, highlighting the opportunities and risks that we see in the current environment and how we’re positioned in the tactical sleeves of the Natixis models to reflect this backdrop. My name is Jack Janasiewicz, portfolio manager and lead portfolio strategist with Natixis Investment Managers Solutions, and I lead the Natixis Investment Managers Solutions Investment Committee.


We are certainly starting off 2022 with fireworks. The NASDAQ composite index saw a 15 plus percent correction from peak to trough during the month while the benchmark S&P 500 fell just shy of the proverbial 10% correction yardstick – dropping some 9.8% from peak to trough.  From a style tilt, Growth and Cyclicals took some lumps while energy bucked the trend with West Texas Intermediate Crude oil rallying some 17% during the month. And accompanying these returns were some extremely choppy and volatile markets that saw some massive intraday swings. So what gives?  


First of all, let’s take a step back and highlight a few things.  We all know this, but it might be a good time to refresh these truths. Markets tend to see a 5% drawdown 2-3 times each year.  And we often get one 10% correction each year as well.  Last year spoiled us a bit as we saw only one 5% drawdown and it barely cracked the 5% threshold. Let’s also remember that markets tend to correct roughly 3 months before the Fed’s first rate hike. And seeing that the market is currently pricing in the odds for a March hike at more than 100%, the current indigestion is right on schedule.  And while we were anticipating such turmoil, we expected additional strength through January and volatility to kick in at the start of February. As I like to say – it’s tough to get both the direction and the timing right for market moves.  And if you do get them both right, you probably got very lucky. So what happens once the market digests that first hike? We tend to resume course and grind higher.  And it’s not until well into the rate hiking cycle that markets begin to fade.  Can this time be different?  Of course.  Plenty of uncertainty out there. And the withdrawal of monetary policy accommodation certainly has everyone on edge.


But let’s talk a little about the recent Federal Reserve Open Market Committee meeting. This seems to have validated the recent market consternation with pundits casting favor for the camp of increased Fed hawkishness. Markets have been increasingly concerned about inflation and the accompanying wage spiral theme and this has caused the rates markets to increase their expectations for a more aggressive Fed policy path. Rate hikes have been pulled forward with the market now expecting 5 hikes in 2022, taking one of the hikes expected in 2023 and bringing to forward to this year. The March Fed meeting certainly is a done deal as the odds for a hike are now exceeding 100%, which implies that rates traders are placing a non-zero probability for a 50bp move in March as well.  Expectations are certainly running high for rate hikes with plenty of strategists trying to out-hawk each other with more and more rate hike calls hitting the tapes it seems. 


So what did Powell actually say at his press conference a few weeks ago? No hike obviously.  But tapering would be accelerated to finish Quantitative Easing by the beginning of March. He also signaled that rate hikes would likely commence at the March meeting. Balance sheet runoff would be commencing soon after hikes begin. Our key takeaways from this meeting? Powell emphasized that the best way to promote a long expansion that fosters an inclusive recovery – and think broad and full employment here – was to ensure price stability – which is code for keeping inflation anchored. As such, the inflation side of the mandate now supersedes the labor market objectives as this is now a greater threat to the economy.  Powell clearly stated the need for flexibility and optionality as he has always done and continues to do – if the data says to hike faster, they will.  If the data softens and warrants patience, they will take things slower.  But in the end they want financial conditions to tighten.  We continue to believe that nothing has really changed.  The Fed will continue to respond to the data.  And this is somewhat of a change relative to previous Fed reaction functions. They are no longer going to be proactive based on forecasts. The Fed will simply respond to the data.  Because the Fed’s track record at forecasting inflation has been spotty at best.  And the market’s has been, well, even worse. But more importantly, Powell continues to follow the script that we’ve been arguing all along.  Continuing to stress flexibility and optionality. Talk tough. Hike rates in March and June. Continue to talk tough in the meantime. Let the balance sheet impacts begin to take hold. And let the data continue to evolve. Nothing is off the table in either direction.  They might not be saying transitory anymore, but they’re still expecting inflation to normalize meaningfully even without tightening policy. Upside risks to inflation are certainly higher, and that opens up the distribution from the market’s perspective that the Fed will have to move more aggressively.  And markets have reacted accordingly – back to aggressive flattening as the short end of the US Treasury curve sells off at a faster pace than the longer end.  Was this really any different than what we’ve been saying all along? Is this just what aggressive jawboning sounds like?  And after all, if they were so concerned about price stability and inflation, why didn’t they already hike, especially at this meeting?


So back to the rate hike road map I outlined earlier. 3 months before the first hike, the market tends to go through a bout of indigestion. And once we get through that period, the equity market tends to find its footing and subsequently resumes its uptrend. Could this 10% correction lead into something more drawn out and severe?  Of course. But deeper and more prolonged corrections tend to be the product of an impending recession. And we just don’t see those catalysts currently. We’ve talked about the tailwinds for growth and how these may be underappreciated for the markets. So let’s review them once again.  As goes housing, so goes the economy. The US housing market and its ancillary components account for roughly 20% of US GDP. A shortage of homes, a backlog of inventory and millennials reaching peak household formation are just some of the ingredients that will continue to fuel that boom. And the associated non-residential construction will also be a benefactor.  Think of all these new developments popping up and the infrastructure as well as the retail development that will go along in support of this.  Lotsa money to be spent here. Our Capex indicators remain as robust as ever.  And one man's Capex is another man's earning per share growth. We are likely to see a proper Capex cycle continue as companies understand the need to evolve and adapt on top of the fact that they are sitting on piles of cash waiting to be utilized.  The inventory rebuild has just begun. The COVID blueprint was the same as a recession blueprint: cut back production, lay off workers and draw down inventory. It’s now time to restock the shelves. Think of some of the major industries that will be ramping up production:  Boeing for example stands to be a beneficiary here as it returns to pre-COVID production.  And the auto industry alone should boost GDP by over 2% should they normalize their inventory levels back to pre-COVID trends. And yes, the fiscal side of the GDP growth equation is set to slow. But the fiscal side may very well prove to be less severe than many predict. State and local governments are flush with cash as tax revenues from strong consumer spending and appreciating home prices have more than replenished the coffers. Add in head count reductions and expense management operations taken on during the midst of COVID and state and local governments have plenty to spend.


So yes we the expect rate increase to commence.  Our call remains the same as always.  A few hikes.  A lot of tough talk on inflation.  Balance sheet reduction.  COVID becomes an endemic and the labor market and supply chains begin to normalize.  Talk tough some more.  Hike maybe another time.  All of this buys time to let the data adjust and we very well could see growth slow, but slow to a still solid rate. All while inflation continues to drift back down to a sub 3% figure by the end of the year. 


So where do we stand?  The level of bearishness that we are seeing across a number of our indicators is quite astonishing. Several of our key indicators have dropped to levels not seen since the depths of the COVID crisis back in March of 2020. I find it hard to believe that today’s backdrop has any resemblance to the backdrop we saw during the first quarter back in 2020. And while sentiment may not be quite as effective in signaling market tops, it does a pretty good job at acting as a contrarian indicator for calling market bottoms. Sure there are risks, but the upside skew relative to the downside at current levels seems to provide a good incentive for a sharp bounce from these lower levels that we are seeing to close out January.  


The other note worth highlighting.  Earnings. And while it’s early in the earnings reporting season for fourth quarter 2021, the overall backdrop thus far has been what I would consider pretty good. With roughly a quarter of the S&P 500 having reported at the time of this recording, earnings are still coming in above forecast.  Taking note however is the fact that the relative returns of these beats is not eliciting much of a price reaction. Our point, companies are still seeing robust demand and are still reflecting guidance that this demand should persist.  And while the typical headwinds are still a challenge – supply chain related issues as well as labor and input costs – margins have remained firm, and in some cases, even expanded.  So while we are certainly seeing a buyers strike today’s markets, earning have held up quite well and this gives us reason to suspect that this pullback is your typical garden variety correction that likely has been long overdue. 


So what did we do this month?  Well.  Nothing. We’re on hold.  We expect the market to bounce from these levels and still see some room left in the near term for cyclicals to continue to perform. We certainly have expected some market choppiness through the first half of the year, but expect the second half to have much better clarity on several key concerns.  Remember, what’s discounted at current prices is very important.  And there is a lot of hawkishness already reflected in a number of areas of the market.  It’s easy to get uncomfortable with volatility and the negative headlines coming out of the media, but simply take a step back and absolve yourself from a lot of these noises can make a huge difference.  Yes, the Fed will be hiking rates and withdrawing accommodation. But keep in mind that we have never had accommodation this loose in decades. There is a continuum between dovish and hawkishness and the market loves to see things as binary. The US economy still has plenty of tailwinds. Consumer balance sheets have never been better.  Real rates are still negative.  The pandemic is morphing into an endemic. And oh yeah – corporate earnings are, well, still pretty good.    


To wrap up our podcast, “The Tactical Take,” this is Jack Janasiewicz. Hope you enjoyed the commentary and thanks for listening.


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