Published January 7, 2022
Markets have kicked off 2022 with a bit of a bang. Interest rates have surged higher as investors bet that the Federal Reserve will act quickly to tamp down nascent inflation and return interest rates to their pre-pandemic levels. The rise is seen most clearly in the near-term part of the yield curve, as near-term rates are most heavily influenced by the Fed’s actions. The 2-year interest rate continues to rise though it remains well below pre-Covid levels. However, the 5 and 10-year rates, shown on the second and third charts, have now fully recovered and just this week burst back to their pre-pandemic level.
This sharp jump in rates has caused a selloff in growth stocks, such as those that populate our favored Nasdaq 100 (QQQ) index. The selling abated late in the week at a key support level as shown here:
However, the S&P 500, while majority influenced by those same high-growth stocks, has held up well, supported by a sharp rise in “value” stocks found in the financial and energy sectors.
To reiterate the key market action from this week, we reprint an overview from Delta that provides a more fundamental view of the market outlook. Note that our models are built on price and volume activity and do not incorporate earnings. Here is their view:
“The S&P 500 attained 70 closing highs during 2021 with the last one on December 29. On January 3, 2022, it reached a new closing high. The market’s sprint-pace record of attaining new market highs will be tested with the Omicron Covid surge, shifting Fed policy and upcoming earnings reports. Sell-offs on Covid and Fed news are likely buying opportunities. Strong earnings reports are an essential factor in potential further market gains and we will have to wait and see through the next several weeks if the market’s anticipation of a positive earnings season comes to pass.
Covid daily cases have surpassed one million new infections in a day. Cases are expected to rise near-term. But, if we follow the path of Covid cases in South Africa, we should expect a steep Covid drop-off in the next couple of months. It appears that for 2022, the stock market may fully “look-through” the daily Covid news to an indeterminate point when Covid is not a significant economic factor.
The chart below shows why the market may be looking-through Covid. Vaccinations are up, cases are way up but deaths trend lower.
Investors interpreted the December Fed minutes release this week as increasingly hawkish. Because of strong GDP growth and a quickly improving labor market, the Fed may start raising the Fed Funds rate sooner than expected and accelerate the reduction of its balance sheet.
The Fed has been buying debt (quantitative easing) for years as a way to prop up debt markets and keep interest rates ultra-low. The Wednesday Fed minutes release suggest the Fed will begin selling some of the debt at a faster pace which normally causes interest rates to rise. This week through Thursday, the 10-year treasury rate climbed 15% from 1.51% to 1.73%.
Fed actions are a good news/bad news market input. The good news is the Fed is relaxing its “emergency” zero rates/quantitative easing because of strong economic growth and a recovering labor market. The bad news is interest rates are a part of how future corporate earnings are discounted back to present value. Higher rates tend to lower present values.
We are starting from zero/ultra-low rates. JPMorgan Asset Management believes the stock market will not be negatively impacted by rising interest rates until the 10-year treasury rate exceeds 3.6%. So far, this has proven to be true. In the past year, the S&P 500 and NASDAQ 100 are up 26% and 24%, respectively. The 10-year treasury rate is up 82% from 0.95% to 1.73%.
In 2021, 47% earnings growth helped lift the S&P 500 by 29% including dividends. The stock market actually became less expensive relative to earnings in 2021 as the P/E multiple contracted by about 7%. Earnings season begins on Monday, January 10. Recent market strength suggests we should expect to see upside to current earnings expectations.
We expect the stock market to clear the Covid and rate hurdles this year although we may see stumbles along the way. We also expect continued upward revisions to earnings estimates for the foreseeable future which will provide fundamental support for recent market gains.”
Stocks opened 2022 with a continuation of their 2021 bullishness. Tech shares led the way to a +0.6% gain, with the Nasdaq rising by double that amount. The Consumer Electronics trade show and substantially strong deliveries of cars by electric car maker Tesla (TSLA) fueled the tech stock rise. But that was the end of the gains for tech. Tuesday saw Apple become the first company with a $3 trillion market valuation. But the tech sector more broadly struggled with the Nasdaq reversing Monday’s gain. The S&P 500 held flat as energy shares rose on an oil supply agreement. Financial shares were the big gainers with interest rates moving notably higher ahead of minutes from the Federal Reserve’s monthly meeting. The release of those meeting minutes Wednesday hammered growth stocks. The Fed sounded a more aggressive tone in reducing their participation in bond market purchases. A -3% drop in the Nasdaq ensued, tumbling over into a -1.9% slide for the broader market. Stocks paused Thursday with financial and energy shares continuing their run higher as interest rates pushed further upward. The week’s trend continued Friday as the monthly jobs report showed a weaker than expected amount of hires. Whereas a report like that only a couple of months ago would have caused interest rates to slip, the sentiment has flipped. Rates pushed higher again and stocks struggled Friday to a -0.4% dip, with growth stocks again bearing the brunt of the selling.
A difficult week for the market’s growth-oriented shares saw the Nasdaq 100 (QQQ) slide -4.52%. To be fair, this decline only puts the index back at the bottom of its trading range over the past six weeks. The S&P 500 fell a relatively light -1.87%. Smallcap stocks slid -2.87%. Of note, the equal-weight S&P 500 closed the week with only a -0.60% dip, showing that many stocks fared just fine in the face of the rise in interest rates.
Warm wishes and until next week.