Investment Strategy

Investors: Have you set your New Year’s resolutions yet?

Here are three tips to consider to help you navigate through the current market environment.

Our Top Market Takeaways for Jan 7, 2022.

Market update

For auld lang syne

 

This week, investors were focused on the Federal Reserve and Omicron. Sound familiar? 

We will start with the more negative market news from the Fed first. The minutes from the Federal Open Market Committee’s meeting in December suggested that less supportive monetary policy is right around the corner. Rate hikes seem likely this year (maybe even as soon as the March meeting, when asset purchases are set to end), and the Fed hinted that it may even let its balance sheet shrink soon after.

Interest rates across the curve rose. Ten-year yields are close to their March 2021 highs, and two-year bond yields are at their highest level since policy rates were cut to zero in response to the initial COVID-19 crisis. In equities, the highest-valuation, fastest-growth stocks were hit the hardest (the NASDAQ Composite lost 3.5%), while stocks levered to cash flows in the here and now (such as energy +9.0% and financials +4.2%) outperformed. 

This chart shows the federal funds target rate from 2017 to early January 2022. It began at 0.75% in early 2017 before jumping to 1% in mid-March 2017. In late June 2017, it jumped to 1.25%. At the end of 2017, it jumped to 1.5%. It then hiked to 1.75% by the end of March 2018. At the end of June 2018, it hiked again to 2%, then 2.25% in early October of that year. By mid-December 2018, it jumped to a peak of 2.5%. From there, it began its descent. The federal funds target rate fell to 2.25% by early August 2019, 2% by late September 2019, 1.75% by mid-January 2019, 1.25% by early March 2020, and 0.25% by late March 2020. It maintained that rate until recently. Meanwhile, the 2-year Treasury yield began at 1.2% in mid-January 2017 and rose to 1.3% by mid-September 2017, 2.6% by the end of May 2018 before peaking at 3.0% in early November 2018. It fell to 2.2% in late March 2019, 1.4% in early October 2019 before dramatically falling to 0.2% in early April 2020. It remained relatively constant until May 2021, when it trended higher. As of recently, it landed at 0.8%—a peak since policy easing.

Now for the more positive news. It has been six weeks since the Omicron variant started to take off in South Africa, and the evidence suggests that the wave will be manageable from an economic and market perspective. New cases in Gauteng (Johannesburg) are down over 80% from the peak in early December. In London, new case growth has slowed without a rise in hospital patients requiring ventilation. In San Francisco and New York, the test positivity rate has plateaued, which has presaged a peak in new case growth. It will be a pain to deal with staff shortages, school closures, testing backlogs and event cancellations, but vaccines and prior immunity seem to be reducing the severity of the disease, and they are providing a path toward a more normal social and economic environment.

While it may be a new year, many of the same issues are facing investors. To help guide you through what is still a hectic investment environment, we are going to try to stick with three New Year’s resolutions.

Spotlight

Three New Year’s resolutions for investors

 
 

1.    Don’t fear the Fed too early. Central banks are a critical input into investment outlooks because they control the cash interest rate on which all other financial assets are priced. They move this rate around to try to impact the economy as a whole. When the economy is overheating and inflation is too high, they move the cash rate up to try to get people to take money out of risky things and into cash. In the past, they have moved the rate too high and caused recessions that were characterized by rising unemployment, credit defaults and equity bear markets. Even though the Fed is getting ready to start raising cash interest rates this year, we think it has a long way to go until it causes problems.

For one, even if cash rates end up at 1% in December, they would still be dwarfed by inflation; 1% is better than 0%, but losing purchasing power by staying in cash isn’t attractive. This will incentivize spending and investment. Next, long-term rates (such as mortgage rates) have to move higher too. The housing market is very important and very interest-sensitive. Right now, most outstanding mortgages have a higher rate than what you could get if you took out a new loan. This should support the housing market.

Bigger picture, the Fed usually starts raising rates because the economy has built up enough momentum to continue growing and creating inflation on its own. As the chart below argues, the start of Fed tightening cycles isn’t the time to worry, the end of Fed hiking cycles is.

This chart shows the federal funds target rate from October 1982 to November 2021. The first data point came in at 9.6% by October 1982. From there, it declined to 8.6% before it rose to a peak of 11.4% by September 1984. Here, it sharply declined to 5.9% by December 1986. It then rose to another relative peak of 9.3% by July 1989. From there, it declined once more to a trough of 3% by November 1992. It then maintained rangebound until January 1994, when it rose to 5.8% by July 1995. Here, it slowly declined until it reached 5% in July 1999. It then rose to 6% by January 2001. Here, it declined to 1% by May 2004 before it rose to another relative peak of 5% by September 2007. From there, it declined to 0.125% by March 2009, where it maintained rangebound until November 2015. Here, it rose once more to 2.125% by August 2019 before it declined to 1.625% by February 2020, and then to 0.125% by May 2020. From there until recently, it stayed at 0.125%. The table below shows the yield change, in basis points (bps), during the six hiking cycles: May 1983 to July 1984, March 1988 to February 1989, February 1994 to February 1995, June 1999 to May 2000, June 2004 to June 2006, and December 2015 to January 2019. For each cycle we have: The federal funds rate: 313 bps from May 1983 to July 1984, 325 bps from March 1988 to February 1989, 300 bps from February 1994 to February 1995, 175 bps from June 1999 to May 2000, 425 bps from June 2004 to June 2006, 213 bps from December 2015 to January 2019, with an average of 292 bps. The 2-year Treasury rate: 311 bps from May 1983 to July 1984, 227 bps from March 1988 to February 1989, 305 bps from February 1994 to February 1995, 121 bps from June 1999 to May 2000, 238 bps from June 2004 to June 2006, 141 bps from December 2015 to January 2019, with an average of 224 bps. The 10-year Treasury rate: 274 bps from May 1983 to July 1984, 91 bps from March 1988 to February 1989, 185 bps from February 1994 to February 1995, 50 bps from June 1999 to May 2000, 52 bps from June 2004 to June 2006, 36 bps from December 2015 to January 2019, with an average of 115 bps. The S&P 500 return: -2.2% from May 1983 to July 1984, 15.4% from March 1988 to February 1989, 7.4% from February 1994 to February 1995, 4.7% from June 1999 to May 2000, 15.5% from June 2004 to June 2006, 40.8% from December 2015 to January 2019, with an average of 13.6%. The U.S. dollar: 14.1% from May 1983 to July 1984, 7.4% from March 1988 to February 1989, -9.1% from February 1994 to February 1995, 5.7% from June 1999 to May 2000, -5.8% from June 2004 to June 2006, -4.1% from December 2015 to January 2019, with an average of 1.4%.

2.    Focus on earnings expectations. Last year, the bears nailed inflation (hottest CPI prints in decades), COVID variants that dented vaccine efficacy (Delta and Omicron), and the speculative retail bubble (down 40%–80% from peaks). The issue for the bears is that earnings also grew by over 45% year-over-year, which took investors by surprise and drove a 30% return in the S&P 500.

We think corporate earnings are probably still being underestimated. Right now, consensus expects S&P 500 earnings per share to grow by 9%, which isn’t too shabby. The problem is that 9% earnings growth is probably inconsistent with our outlook for the nominal growth environment, which should be closer to 5%–7%. In other recent years where nominal GDP grew by 5%–7%, earnings grew by 15%–20%. We think earnings will continue to drive stock markets to new highs.

3.    Find the new trends. Many of the hottest market trends of the pandemic era are now passé. The stay-at-home beneficiaries, such as Teladoc, Peloton and Zoom, are 60%–80% below their early 2021 peaks. SPACs and solar companies are doing a little better, but not by much. Meme stocks are already down almost 9% this year. Gold, which rallied 80% from March to August 2020, has barely been treading water for the better part of the last year.

This year, new trends are starting to emerge. The most notable one, at least so far, is in the electric vehicle space. Ford broke out of a 20-year trading range after announcing it was doubling production capacity of its new electric F-150 Lightning. Volkswagen and Toyota are likewise gearing up to spend billions and take on Tesla. While we won’t offer our take on who will end up winning the EV wars, we will note that investing in companies that enable EVs (such as semiconductors and industrials, which are critical for charging infrastructure) could be an attractive opportunity.

Another sector that could do well as the expansion continues, as the Fed raises rates and as long-term rates continue to rise? Banks. U.S. bank stocks closed at an all-time high on Thursday. But now we are just rooting for the home team.

For more on how these dynamics might impact your plan and portfolio, please get in touch with your J.P. Morgan team.

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All market and economic data as of January 2022 and sourced from Bloomberg and FactSet unless otherwise stated.

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