As we go to press, U.S. equities have officially entered correction territory for the first time since the onset of the pandemic. Market volatility has spiked, with the CBOE Volatility Index (better known as the VIX) up more than +35% intra-day, and more than doubling year to date to a recent 36 (we started the year at 17.2). Angst over a plethora of issues is currently plaguing the market including higher interest rates, inflation, domestic politics, and geopolitics on the Eastern Front in Europe with Russia and Ukraine, amongst others. Which of these risk factors is precisely the culprit is hard to pinpoint, given the Federal Reserve signaled higher interest rates to come back on November 22. Investors may simply fear the Fed is further behind the curve than they admit, which may ultimately result in more aggressive, or more hawkish, monetary policy in months to come.
The fixed income markets have moved quickly over the past few months as the Federal Reserve has become less tolerant of high inflation readings and more comfortable with the employment rate. The Fed no longer views inflation as “transitory,” which means that instead of waiting for it to resolve itself, they are preparing to confront it head-on. This will be done by removing or lessening monetary stimuli, such as zero interest rate policy (ZIRP) and Quantitative Easing (QE).
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In addition, we continue to experience pandemic-fueled supply chain disruptions, goods shortages, too few workers, and headline inflation hit an unattractive 7% in the most recent release. Some countries have again resorted to lockdowns during the recent Omicron wave, which will present an impediment to the speedy resolution of many of these issues.
Given the significant concern over policy changes, it becomes understandable that we may experience some market indigestion. There is even some anxiety that the first-rate increase will be larger than typical, a full half-percentage point instead of a quarter-point.
As of today, a non-telegraphed half percentage point rate increase is not a high probability. Unexpected policy changes are not well received and increase price volatility in the markets, as was experienced during the infamous “taper tantrum” in 2013. Chair Bernanke was less successful at clearly communicating his intentions to the market than our current Chairperson. Powell has learned from living through the impact of the 2013 miscommunication with the markets and has been very intentional about avoiding a replay of it.
While it’s painful to see a sea of red in global equity markets, it’s important to put the recent volatility into perspective. Year to date, it’s the most speculative area of the market that has been most vulnerable to selling pressure.
Companies with no earnings, pipe dreams for revenue and profits, and those that just got plain expensive have all seen their share prices fall. Bitcoin has fallen more than -50% from its all-time high of $67,734. Not only has Bitcoin been cut in half, but it’s also been cut in half again, having lost more than -50% of its value, albeit from lower prices, on multiple occasions. Other areas of speculation, namely initial public offerings (IPOs) and special purpose acquisition vehicles (SPACs,) have taken a beating, down -24.6% and -26.1%, respectively, this year.
Technology has come under pressure, most notably from “innovation” names with sky-high valuations. Cathie Wood’s ARK Innovation ETF, up +152.8% in 2020, fell -23.4% in 2021, and is down another -25.7% YTD, highlighting the impact that discounting future cash flows at a higher interest rate has on equity prices. The NASDAQ 100, by comparison, is down -14.0% YTD.
From a fundamental standpoint, earnings season has thus far been robust, with 82% of companies reporting better than expected results. This week nearly 20% of the S&P 500 will report Q4 results, led by Apple, Microsoft, and Tesla. Visa and Mastercard report on Thursday which should be telling for consumer spending given recent choppiness in retail sales data.
Taken together, the recent correction in U.S. equities is probably overdue since March 2020, given cumulative gains of +52.4% from 2020-2021 inclusive of the pandemic induced drawdown. Perhaps investors waited for the calendar to turn the page before taking gains, or perhaps the market’s crystal ball sees higher interest rates and a Russia/Ukraine conflict more clearly than the rest of us. In the meantime, S&P 500 earnings are expected to be $220 in 2022 and $242 in 2023, meaning at a recent 4,300 on the S&P 500, Large-Caps trade for 19.5x this year’s expected earnings, and 17.8x next year’s estimates.
Looking ahead, all eyes will be on Fed Chair Powell on Wednesday afternoon. Any change to the Chair’s expected plan of action will be delineated as the Fed wraps up their January meeting. The market will be looking for Powell to provide clarity on the speed and magnitude of future hikes, all while digesting a slew of earnings releases over the coming weeks from the world’s largest companies. As geopolitics continues to take center stage, volatility may remain elevated, and we’ll be keeping our eyes open for opportunities as the dust settles.
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