Markets get excited for the start of earnings season as stocks take another battering
When the Fed is embarking on a rate hiking cycle you sell rallies; that seems to be the advice that the majority of market participants are taking on the second week of trading in 2022. Calls for the end of the tech market sell off look premature at this stage, after the Nasdaq snapped a 3-day winning streak to post another 2.5% loss on Thursday. The S&P 500 and the Dow followed suit with losses of 1.4% and 0.5%, respectively, which suggests that the rotation out of growth stocks and into value stocks, which has been a big investment theme for the last two months, is not over yet. The sell-off in stocks comes as we wait for the start of the US corporate earnings season, Treasury yields have fallen, and the dollar is also under pressure.
Why US yields are receding, temporarily
The decline in Treasury yields is worth watching in our view. The moderation in the 10-year US yield from 1.74% on Wednesday to 1.7% on Thursday was attributed to a weaker than expected US producer price report for December, which showed a 0.2% increase vs. a 0.4% increase expected. However, the annual rate was still a whopping 9.7%, the highest level for 10 years. This report followed Wednesday’s CPI reading for December, where the annual CPI rate reached 7%, the highest level in nearly 40 years. Although inflation has surged, there are signs, such as the weaker gain in PPI, that inflation may have peaked. Added to this, the annual comparisons in inflation should start to bring the YoY inflation rate down in the second half of this year. We think that this is currently being priced into the Treasury market and is the reason why yields are falling. This should be good news for stocks, however, there is a risk that inflation does not fall back to the Fed’s target rate of 2% inflation growth per year in the coming months. The risk is that inflation stays sticky around 3-4% per year for the long term. This is when things could get tricky for stock investors, as it would support a prolonged hiking cycle from the Fed, and a higher terminal Fed funds rate than the 2% that is currently expected. If inflation doesn’t fall back as quickly as some expect, and it is increasingly likely that goods price inflation could be experiencing a multi-year adjustment due to the shrinking of global supply chains, then stock traders looking for bounce backs after a quick market sell-off could be see their hopes dashed. Stubborn inflation is one reason why we expect the 10-year US Treasury yield to rise to 2% this quarter, as the market digests a more hawkish Fed in the coming weeks.
Choose airlines over tech
The markets are different in 2022, as we are finding out. The bulls can’t expect to fall into the supportive arms of the Fed anymore, which is why stocks are continuing to sell off. While the 4-basis point drop in the 10-year Treasury yield seems like a large decline, we doubt that this will ease the pain for tech bulls anytime soon. Some analysts had started to talk about the end of the rotation from growth stocks into value stocks, we think it is far too early to do this, and we continue to see more pain for tech in the short to medium term. Big tech names such as Amazon and Microsoft fell on Thursday, they were down some 2% and 4% respectively, however, Tesla was down some 6% and Snap was down more than 10%, Virgin Galactic fell nearly 20% after it announced it was selling debt. There is no mercy for tech stocks, and especially not for tech stocks without profits. We continue to see relative value in the tech trade, with Microsoft and some of the other bigger players outperforming the ‘super growth’ stocks like Snap and, to a lesser extent, Tesla. However, although the markets are falling overall, there are still pockets of strength. For example, in an environment where there is a hawkish Fed and lots of inflation in the economy, then you want to own companies that can withstand these forces and can continue earning profits in this hostile environment. After suffering for most of the last two years, airlines could be having their moment. Delta Airlines in the US announced that it had beat earnings expectations in Q4, and also reaffirmed its full year earnings guidance on Thursday. This upbeat earnings report sent Delta’s share price surging by more than 2%. Airlines in the UK are also in demand. IAG, the parent group of British Airways, was up nearly 3% on Thursday. Airlines could do well this quarter, as holiday-starved westerners book holidays and pay large sums for trips abroad later this year. For example, after France removed its ban on leisure travel from the UK, bookings for ski holidays surged more than 300%. It will be a busy half term on the Alps! We think that the shifting political stance in the UK and elsewhere around coronavirus to an endemic disease from pandemic, is also good news for the global travel and tourism sector. The world is taking steps to return to ‘normal’, even in the face of future waves of covid. This is already being priced into the airline sector, for example IAG’s share price is up more than 30% so far this year.
What to expect from US banks
Looking ahead to the end of the week, the start of the US earnings season is focused heavily on value stocks, before tech stocks get a chance to report results later this month. On Friday, US banks including JP Morgan, Wells Fargo and Citi will report Q4 earnings. JPM will be watched closely, its earnings are expected to be just below $3 per share. While banks have led the ‘value over growth’ theme in stock markets in Q4, and the US banking sector outperformed the S&P 500 by 6% last quarter, we expect banks that generate most of their cash from investment banking to outperform the retail banks. This is because the yield curve flattened to the tune of 40 basis points last quarter, which is bad news for banks’ lending books. While JPM may be able to beat forecasts, it could be harder for the smaller retail-focused banks including Citi and Wells Fargo. While we think that there is only a small chance of a major earnings miss for Q4, any company that does disappoint market expectations for Q4 earnings could be punished.
The dollar’s decline continues
In the FX space, the dollar continues its decline. We have spoken about the reasons why the dollar is under broad pressure in the G10 FX space before, however, as a re-cap we believe that it is because positioning had been stretched after a strong run for the buck in Q4, Fed hawkishness is already priced in and the Fed Funds terminal rate for this hiking cycle has not shifted much. As mentioned above, the terminal rate is around 2%, while the market expects the Fed to hike sooner than expected, they are not expected to raise rates above 2%, which is also limiting USD upside. We continue to like GBP/USD, which continues its march higher in 2022. It is above $1.37 as we move to the end of the week, and the next key resistance level is the 20th October high above $1.3820. If we clear this level, then $1.40 comes back into view.
Aside from bank earnings, we are also watching the FTSE 100 closely, as its negative correlation with the pound seems to have broken down. European shares also continue to outperform their US counterparts, and we think that this trend could continue. In the short term we like both the pound and the FTSE 100, we like the latter because of its large number of ‘value’ names, including banks, airlines and energy companies, which we think will continue to do well this quarter.
Ahead on Friday, the UK will report GDP for November, which is expected to be strong and could see the UK economy formally return to its pre-pandemic size. Added to this, UK manufacturing output is also reported. In the US all eyes will be on retail sales for December, which are expected to be flat last month as Omicron fears took hold. The preliminary University of Michigan Consumer Confidence survey for January is also released. I will be watching this closely to see how consumers’ expectations for future prices have changed. If we get stagnant retail sales for December, along with rising inflation expectations then we could see another dip in risk appetite as the market starts to worry about stagflation.