Peak Fed Hawkishness – and Beyond
- 09 mins 23 secs
Portfolio Manager Jack Janasiewicz discusses the December Fed meeting, living with Omicron, the power of earnings, and the new market highs at year end.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 are 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 US Investment Committee.
December. The final month of the year, and it’s been quite a year. The common theme? All-time highs. We made 70 of them in 2021. Four in December alone and three of those coming in the final six trading days of year.
So what happened in December? The start of the month saw strength in equites with value outperforming growth and large caps lagging the broad market. But after the first week or so, a buyer’s strike ensued with the rally taking a pause in the run up to the December Federal Reserve meeting. This buyer’s strike had several issues at play, much having to do more so with technicals rather than fundamentals but this led to some chop and sideways action in the market.
First of all, the December 15th Fed meeting had some seriously hawkish expectations already discounted by markets. Rates markets were already pricing in three hikes for 2022 and it was widely expected that the Fed would announce a quicker pace of tapering of its bond buying program. And the Fed did not disappoint with Chair Jay Powell announcing that the pace of bond buying would be reduced by $30 billion a month from its current pace of $15 billion. And the Summary of Economic Projections – also known as the infamous Fed dot plots which depict the anonymous forecasts of both regional bank presidents and the board of governors for where the fed funds rate will fall over the coming years – that suggested that the median forecast called for three interest rate increases in 2022, matching what the rates market had been pricing for some time now.
Also of note, while the Fed has pushed in previous press conferences to retire the term transitory from its language, the text of the Fed communique still made references to it – and I’ll quote here - “Supply and demand imbalances related to the pandemic and the reopening of the economy have continued to contribute to elevated levels of inflation.” So while they’ve opted to retire the term transitory, they still are basically referencing transitory without directly using the word.
But our take? The Fed has been sounding tough on inflation for some time. And they have to. But the market going into this Fed meeting was set up for some pretty hawkish expectations. And given that three rate hikes were already discounted, as well as an increased pace of tapering, how much more hawkish could the Fed get? Which is why we’ve been calling the Dec 15th FOMC Fed meeting peak hawkishness. Yup. Peak Fed Hawkishness.
Going forward we expect a few things to play out regarding the Fed. We think that Jay Powell and company will continue to rely on the balance sheet reduction for now as the primary policy tool lever while at the same time relying on forward guidance. And by that we mean jawboning the market with hawkish rhetoric in an attempt to continue to let the mkt do his dirty work. And this has worked so far. The market priced in three hikes already and we’ve seen a modest tightening in financial conditions as well. This in turn buys some time before having to begin hiking rates while giving the inflation backdrop more time to normalize with the prospects of a fading pandemic helping to improve supply chains and loosen up labor issues. All of these could very well help ease the near term inflationary pressures at the time when rate hikes might just be about to kick off.
So given that we’ve had such hawkish expectations in the run up to this meeting, it’s no wonder that the market was a bit apprehensive to hold any significant risk going into this December meeting. And we think this had a lot to do the market chop and that buyer’s strike.
But there were several other things at play here too. If we then add in the fact that it was option expiration week which tends to see volatility increase and often times some additional price weakness, this didn’t help sentiment. And tack on some tax loss related selling, which we noted with some peculiar price action in small caps for example, as well as some rebalancing going on – and I would highlight a few days there where we some of this year’s winners underperforming the market while the losers were showing some interesting strength over a few days. All of this on top of Fed week and it’s not surprising that we saw many players opting to stand aside and sit on their hands.
But the bigger issue was the price action that we saw at the start of the following week. The weekend news began to accelerate about the new Covid variant strain that was detected in South Africa. The Omicron variant. With case counts already on the rise here in the United States and the headlines certainly not helping as numerous sporting events across the NFL, the NBA and the NCAA as well as Broadway productions – to name a few - were canceled, postponed or moved, and this set the stage for further market angst as investors stepped back to assess the news. The market now had to assume that this variant was already present here in the United States with case counts on the rise. But with initial results pointing to a significantly higher contagion rate and the market in a sell first ask questions later mode given that we were nearing the end of the fiscal year for many and precious gains were ready to be defended – it’s no surprise that investors had no problem hitting the eject button and liquidating risk.
But as more data and more information became available on the Omicron variant over the subsequent days, it started to become clear that this variant would be very different than previous strains. Several important characteristics were common to Omicron: first of all, the strain was certainly more contagious. But more importantly, the severity associated with Omicron was much less when compared to Delta. Yes, case counts in South Africa were much higher than the peak wave for Delta. But the severity of this variant was very different: ICU hospitalization rates were significantly lower and ventilator use was a fraction of what we saw during Delta. More contagious but less virulent. This will likely prove to be very important for the markets. And we’ll come back to this in a bit.
At the same time, we’ve started to see a shift in the framework from policymakers and the White House where it seems that case counts are no longer the relevant metric but rather severity is now the focus. This is very important because the policy response triggered by this shift moves the reaction function away from quarantine and lockdowns to learning to live with the virus.
Sentiment had certainly flipped decisively bearish during this time and the buyers strike had turned into a sell first ask question later mode. But as markets continued to digest the latest batch of news and began discounting the policy response function, buyers began to step back into the market and equities began to see a lift into the end of the year. And yes Virginia, there is a Santa Claus. While some began to question the old adage – the one where the last week of the year typically sees market strength – dubbed the Santa Claus rally – equities came back with a vengeance and certainly did not disappoint the bulls.
So where do we stand? Still bullish as we head into the start of 2022. Sentiment is still sour from the previous events that left many investors sitting out the markets as the Santa Claus rally left them on the sidelines. The market appears to be just fine with the Omicron variant. Case counts are no longer the metric that can move prices significantly. And as we’ve been harping on for months now – it’s all about severity. While Omicron has proven to be more contagious, the severity had proven to be much more mild. And the fact that vaccination rates are up, medical treatments are more robust – and think about things like Pfizer’s oral antiviral treatment here for example, and more people have antibodies from previous infections, all of this may very well make this recent variant the final piece to the endemic. Omicron becomes the dominant strain, forces out Delta, more people get infected but the side effects are less severe and more manageable. More people, in one form or another, have antibodies and this finally fizzles out. Fingers crossed!
The other note worth highlighting. Earnings. And we all know that earnings are what drive stock prices. We had two very important bellweathers provide us with some early color for the upcoming season. Both Micron and Nike reported above consensus earnings growth with strong gross margins. One of our base case themes for 2022 remains that many still are underappreciating corporate America’s resiliency and flexibility and that earnings and the operating leverage accrued over the last 12 months will once again surprise to the upside.
So what did we do this month? Well. Nothing. Stayed the course and let our current positioning work for us. We remain risk-on into the start of 2022, overweight equities versus fixed income and favoring US equities, small caps and the cyclical portion of the market. Our homebuilders tilt continues to pay some handsome dividends and we expect this trend to remain intact for much of 2022. On the bond side, we continue to underweight investment grade corporates, instead favoring a barbell approach utilizing intermediate US Treasuries and Floating Rate and High Yield exposure. As we’ve been stating for some time, we see little value in up-in-quality fixed income aside from an equity risk offset. As a result, we continue to underweight US treasuries but are taking that exposure with the longer duration portion of that market. As we are overweight equities, the negative correlation of treasuries to equities should provide some cushion in a risk-off environment.
With that, hoping that everyone had a great holiday and here’s to a healthy and prosperous 2022. Thanks for your interest and support throughout 2021 and I hope this podcast provides you with some meaningful insights.