Santa Claus had barely hung up his boots after delivering his namesake rally to good little stock-market investors, then all hell broke loose.
The past week saw big market swings as investors rung in the first week of trading in 2022, and market watchers pointed to the prospect of more volatility as they grapple with the Federal Reserve’s ability to fight inflation without tipping the economy into recession.
“I think markets are trying to figure out how aggressive the Fed will be in removing accommodation and tightening and if it possibly will make a policy mistake,” said Ed Keon, chief investment strategist at QMA, in a phone interview.
The release of the minutes of the Federal Reserve’s Dec. 14-15 policy meeting on Wednesday stoked the uncertainty. They revealed that policy makers had discussed being more aggressive in raising rates than previously anticipated and had talked about the possibility of beginning to shrink the size of the Fed’s balance sheet more quickly than they had done when they ended an earlier round of quantitative easing spurred by the financial crisis.
That added fuel to a bond-market selloff that saw the yield on the 10-year Treasury note TMUBMUSD10Y, 1.767% jump by more than 27 basis points, or 0.27 percentage point, over the past week, the largest such rise since September 2019. At 1.769%, the rate is the highest since Jan. 17, 2020.
Ahead of the minutes, the Dow Jones Industrial Average DJIA, -0.01% and had risen 2.4% in the final five trading days of 2021 and the first two of 2022 — the stretch that defines the so-called Santa Claus rally. For the Dow, it was the strongest run for the seasonal phenomenon since 2008-09, when it rose more than 6%. The S&P 500 SPX, -0.41% gained 1.4% courtesy of St. Nick, its strongest such run since 2012-13.
But the jump in yields did no favors to tech and other rate-sensitive growth stocks, which had already began to suffer last month. The tech-heavy Nasdaq Composite COMP, -0.96% had missed out on the Santa rally altogether, falling 0.2%. On Wednesday it tanked more than 3% for its worst one-day performance since February.
Valuations for growth companies are based on expected cash flows far into the future. Higher interest rates mean that cash isn’t as valuable as it was when rates were lower.
The Dow and S&P 500 also suffered, and all three major indexes ended the week with losses, though the Dow and S&P 500 remain just 1.5% and 2.5% off record levels finishes set on Jan. 4 and Jan. 3, respectively. Crypto traders also appeared rattled by the minutes, with bitcoin BTCUSD, +0.02% sliding to a three-month low, leaving the world’s biggest digital asset with its worst start to a calendar year since 2014.
Value stocks beat their growth counterparts in the first week of 2022, extending outperformance seen in December. The Russell 1000 Value index RLV, +0.23% rose 0.8% over the past week, while the Russell 1000 Growth index RLG, -1.09% fell 4.8%, according to FactSet data. In December, the Russell 1000 Value index climbed 6.1%, for its biggest monthly gain since November 2020, to surpass the Russell 1000 Growth’s advance of 2.1%.
At the sector level, tech fell 4.7% in the past week, while deep-value cyclical sectors jumped, noted Brian Levitt, global market strategist at Invesco. Financials jumped 5.6%, while energy soared more than 10%. And the defensive consumer-staples sector managed a rise of around 0.4%.
That doesn’t mean investors should rush off to chase the rotation, he said, in a note.
“Basically, we see the Fed tapping the brakes by guiding interest rates higher and flattening the yield curve to restrain an overheating U.S. economy. In that context, we think it’s too soon to rotate into deep-value cyclicals, which would likely require a steepening yield curve and an economic reacceleration,” Levitt said.
Absent an economic recession, the timing is also likely wrong for investors to load up on defensive stock sectors, he said, as they’re unlikely to outperform meaningfully until the end of the current market cycle.
QMA’s Keon doesn’t expect the Fed to overdo it, but cautions that it’s a non-negligible risk as policy makers grapple with the inflationary aftermath of a $5 trillion fiscal stimulus and the central bank’s own aggressive actions on the monetary-policy front.
The shift from an environment of free-flowing liquidity to one in which policy makers are closing the spigots and draining liquidity doesn’t preclude positive returns for equities and other risky assets, he said, but one doesn’t have to be bold to expect more subdued gains after the S&P 500 posted annual price rises of 28.9% in 2019, 16.3% in 2020 and 26.9% in 2021.
For his part, Keon expects inflation to subside as supply-chain bottlenecks ease. Economic growth may see a first-quarter hiccup due to the omicron variant, improving in the second quarter as investors wait to gauge what’s sustainable for late 2022-2023.
Rising yields aren’t necessarily a negative for stocks — after all, a stronger economy should lead to higher rates — but they are a bigger relative headwind for growth stocks. Keon said he doesn’t expect value to “crush” growth in the year ahead, but the stage may be set for a more “balanced” market, rather than one marked by narrow leadership.
A much weaker-than-expected rise in December nonfarm payrolls on Friday did nothing to quell upward pressure on yields, with investors instead focusing on an unemployment rate that unexpectedly dropped to 3.9% from 4.2%, while average hourly earnings showed a strong rise.
“A 4.7% gain in annual hourly earnings, coupled with a drop in the unemployment rate to a fresh pandemic low of 3.9%, is a clear sign of a tight labor market if ever there was one, and will likely give the Fed a green light for monetary tightening,” said Seemah Shah, chief strategist at Principal Global Investors, in emailed comments.
The December jobs report “is not going to take the steam out of bond yields, nor is the headline payrolls number strong enough to reassure markets of a very strong economy,” Shah wrote. “Equity markets are on the line for a volatile month.”
The week ahead, meanwhile, should provide fodder for volatility, with the economic calendar featuring the December consumer price index reading on Wednesday, the December producer price index on Thursday, and December retail sales and the latest reading of the University of Michigan’s consumer sentiment survey on Friday.