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Monetary policy turnaround prompts major equity market rotation

The minutes of the Federal Open Market Committee’s December meeting show that the Federal Reserve (Fed) is willing to take swift action. One of the focal points is the reduction of the bank’s balance sheet in the near future. Yields on US Treasuries surged in response to this news. But to what extent are expectations of rising interest rates being reflected in the stock markets?

Both the equity and bond markets started 2022 with a bang. In the market for US government bonds, yields on two-year Treasuries rose by 13 basis points (bp) compared with the end of December, reaching 0.86 per cent – their highest level since early March 2020. Yields on ten-year US Treasuries climbed by 25bp to 1.76 per cent (figures as at close of trading on 7 January). Once the minutes of the Fed’s December meeting had been published, the market began to price in an increased likelihood (around 85 per cent) of an interest-rate hike in March.

Yield curves are shifting

Yields on US and German government bonds

Yield curves are shifting
Sources: Bloomberg, Union Investment, as at 7 January 2021.

This also had repercussions in the equity markets, which showed signs of a pronounced factor rotation: growth and momentum stocks weakened significantly, while value stocks and cyclical stocks advanced. The growth factor had the toughest start to the year since 1995. The Russell 1000 Growth index plunged by around 5.5 per cent (closing price on 7 January). By contrast, the Russell Value index rose by 0.6 per cent. This further reinforced a trend that had been observable in the US for some time. The growth and momentum factors are gradually losing their long-held edge over value stocks, i.e. shares in companies with a favourable valuation or strong intrinsic value based on relatively moderate but stable profit growth.

Growth factor under pressure since the start of 2022

Performance (%)

Growth factor under pressure since the start of 2022
Sources: Bloomberg, Union Investment, as at 7 January 2021.

The three most prominent and closely-watched US share indices followed similar patterns. Since the start of 2022, the tech-heavy Nasdaq Composite index has fallen by 5.6 per cent and the broader S&P 500 index by 2.5 per cent. Meanwhile, the Dow Jones Industrial index, which is skewed more heavily towards the manufacturing sector and contains more cyclical stocks, has only lost 0.9 per cent. Unprofitable US tech stocks were hit particularly hard by the recent sell-off.

Hedge funds adjust their position

The strong rotation was prompted by a variety of influences. Firstly, US and UK hedge funds adjusted their position. A survey by US investment bank Goldman Sachs, for example, found that the net weighting of the value factor in the surveyed hedge funds had risen to a five-year high. Moreover, equities from the technology, media and telecommunications sector were relatively strongly underweighted in net terms, while cyclical stocks were overweighted.

This shift can be attributed in part to new risk budgets for 2022, but probably also to monetary policy expectations in the US and persistently high inflation expectations. These expectations are rooted in the robust outlook for economic growth in the US. Unlike in Europe, the US economy has managed to close the overall output gap and is already pushing beyond maximum production capacity levels. In addition, it seems that the risks to growth associated with the Omicron variant of coronavirus are currently tolerable and the US labour market is recovering rapidly. Observations made in South Africa, where the Omicron variant was first identified, and in the UK suggest that the threat posed by Omicron, i.e. the risk of severe illness and need for hospital treatment, may be lower than initially feared. As a result, consumers and companies will probably be spared another round of broad-scale lockdowns. Union Investment’s experts also anticipate continued robust economic growth.

 

As at: 7 January 2022