Investors De-risk As Clouds Emerge

Thoughts

• Markets paused following December’s surge to record highs, as Fed and Omicron fears persist, with the S&P 500^® Index losing 2%. The “democratization” of returns that began later in 2021 returned last week, with value, international and small caps outperforming large-cap technology. Per Bloomberg, the Pure Value factor outperformed the Pure Growth factor by the most on record dating back to 2000 at 4.2%. A near-record 40% of companies in the NASDAQ are 50% below their 52-week high, as the average technology company has been punished.
• Interest rates have surged in the first week of 2022, with the 10-year Treasury yield touching 1.78%, the highest level since before the pandemic, and up from 1.51% at year end. Investors reacted to a perceived hawkish tone from the minutes from the FOMC meeting in December. The Fed Funds futures curve embeds an 80% chance of a hike in March, and an 81% chance of three-or-more this year (up from 36% and 60%, respectively, a month ago). Real yields have risen even faster, as the 10-year breakeven inflation rate has declined this week. Higher interest rates could begin reverberating through the economy, with mortgage rates at the highest level since early in the pandemic, threatening the historic surge in housing prices.
• Despite exaggerated market swings in the first week of trading in 2022, three themes emerged for what to expect in the market for the remainder of the year:

1. Overall investor expectations should be brought down to more realistic levels following an abnormally strong three years of returns
2. The contributions to returns will look significantly different as we see more “democratization” of returns with value, international and small caps outperforming large-cap technology
3. 2022 will be a tough environment for bonds

News

• December payrolls rose a disappointing 199k, well below the 400k consensus estimate and November’s reading of 249k. Despite the weakness, the unemployment rate fell to 3.9% from 4.2% last month. The labor force participation rate remains stubbornly low, while this week’s JOLTS report showed that the number of job openings far outweigh the number of unemployed and the pace of job quits remain at record levels. Wage gains remain strong at 4.7% from a year ago, though that was a deceleration from 5.1% last month. This likely reflects negative real wages, given the estimate for 7.1% consumer price inflation from a year ago in December. The Omicron variant is likely to leave businesses short-handed, as Bank of America estimates 4.2 million workers may be absent this week due to quarantining.
• Economic data have been mixed, with continued strength in consumer demand, housing, and employment, though clouds are developing around Omicron. There has been a sharp decline in occupancy in commercial properties in major cities in the past few weeks, as companies continue to adjust their return-to-work plans. Time outside the home was within 5% of pre-pandemic levels in mid-December but is now 14% below that level. Manufacturing continues to be impacted by supply chain issues, with the December ISM Manufacturing Index falling to an 11-month low, including weak new orders and production. Job openings fell modestly in the most recent month per the JOLTS report, though the number of people quitting remains at record highs at 3% of the workforce and there are far more job openings than unemployed people. The Fed’s Weekly Economic Index continues to reflect an economy growing at roughly 8%.
• Fourth-quarter earnings season will begin in the next few weeks, with current consensus for 25% growth, above the 21% expected as of November. This would mark the fourth-straight quarter with growth above 20% growth, though it marks a notable deceleration from the 37% in the third quarter. Nine of the 11 sectors are expected to see growth, led by Energy, Materials, and Industrials, with Financials and Utilities expected to decline. Management commentary surrounding supply chain and labor issues will be critical, along with margins given producer prices are rising faster than consumer prices.

What to Watch

• Inflation data will be closely watched next week, with CPI scheduled for Wednesday and PPI on Thursday. Other data include NFIB Small Business on Tuesday, hourly earnings on Wednesday, and retail sales, industrial production, and consumer sentiment on Friday. Fed confirmation hearings for Powell are on Tuesday and Brainard on Thursday.