The Fed policy put is further from the money, and financial conditions are tightening. The period of US equity exceptionalism may be coming to a close and emerging markets are in position to benefit.
Last week was the worst week for US equities since March 2020. The S&P fell by 5.7%, a 2.7 weekly stdev move and broke the 200 day moving average for the first time since the COVID crisis, and for only the third time in the last five years. Losses were broad based with the Nasdaq and Financials falling by 6.9% and 7.4% respectively (EU Financials also had a 1.4 weekly stdev move lower). Following weaker than expected results Netflix fell by 23% on Friday and Bitcoin fell 15% between Friday’s open and Sunday mid-day while the Bitcoin - Nasdaq realised 30 day correlation reached 70%. Volumes were large and the break of key technical levels has resulted in additional CTA selling in key indices.
So what happened? The week began with weak results from investment banks, part of which is tied to the inflation in compensation costs, which undermined the financial sector, a well subscribed long in Long/short equity and directional portfolios. Furthermore with many of the high multiple, high growth stocks down 30-50% from their highs (85% in the case of Peloton), there simply isn't the same type of retail support for equities that characterised the bull market of 2020 and 2021. Indeed, we have seen a broad based derisking of “long-liquidity” proxies, as evidenced by the rise in correlation in meme stocks, tech and crypto in the last month.
Fundamentally, however, this week’s selloff reflects the rise in real and nominal rates, which made a local high at the start of this week. The market is coming to terms that the Fed is removing accommodation, and quickly, and this is likely to be much less supportive for US equities moving forward. However, while it is clear that the Powell Fed is not going to drive equity valuations in the way it did previously, the key question as we head into the Fed meeting this week is where is the strike of the Powell put?
The 2018 December selloff, where the S&P fell by 10%, resulted in a swift turn in communication and policy by the FOMC making 2019 a strong year for stocks. The difference between then and now was that a) the hiking cycle had happened b) inflation had begun to fall and was below target and c) the political pressure was intense from Pres.Trump to focus on the falling stock market. Today, the Fed has not even begun to raise rates, inflation is 7% and the no.1 political issue and pressure is to address the inflation dynamic as evidenced by Pres.Biden stating his support for the Fed expected plan to “recalibrate” their policy.
Given this, while we remain in this type of inflation environment, the clear risk is that the Powell put is much further from the money than we have seen in recent years. Taken together with higher rates, this means that both multiples have to come down and the left tail of the distribution is fatter. With that as a backdrop, the US equity risk premium should rise.
Paradoxically, the opposite may now be happening in emerging markets.
Last year was an annus horribilis for many EM equity and bond markets. Inflation brought sharp hiking cycles across EM, domestic political risk and fiscal slippage in Brazil and Chile compounded the moves by central banks and China combined a tight policy mix with a regulatory crackdown on the tech and property sectors. While S&P finished the year +29%, MSCI EM finished -5% and the year saw sustained outflows bringing valuations to historically low levels vs DM.
In many ways the tightening, re-rating and risk premium build that is happening in DM has already happened in EM and now we are beginning to see signs of incremental positive developments. Chinese policy easing has broadened and accelerated. In the last 10 days the PBOC has lowered the 7 day repo rate, the 1 year MLF rate (the first policy cut since April 2020), the banks loan prime rate and the 1 year loan prime rate alongside easing credit conditions for property lenders. In Chile, the recently elected President Boric appointed a orthodox, centrist Finance Minister. In Brazil there have been clear signals towards moderation by Lula, most likely the incoming President, while inflation is showing signs of peaking. This has been reflected in asset prices where Chinese, Brazilian and Chilean equities, three of the largest underperformers last year are all up on the year.
This is an extremely interesting macro set up. For the last number of years and especially since the pandemic US fiscal, monetary and pandemic response policy lead to US exceptionalism. There is now a clear case for this to be unwound and paradoxically, EM could be in position to benefit. The case for equities is likely one of outperformance if global equity beta is under pressure but if growth is slowing, inflation is falling then the type of inflows we saw into bond markets this week could be a sign of things to come.
In the near term, as we have been writing, the level of underlying volatility argues for a tactical and relatively beta neutral portfolio stance. Hence, we have reduced the portfolio’s aggregate equity beta. For EM however, we did not see any of the signs of weakness that characterised the rates shock in Q1 2021, in fact EMFX rallied and bond spreads tightened. The Fed this week will be key, if Powell is hawkish we would expect US equities to remain under pressure, curves to flatten and possibly a window for selected EM to outperform.
COVID Pandemic
World COVID cases increased again last week, with global COVID cases hitting new highs and rising in all regions but the United States. In Asia, cases rose in India while falling in China, where Chinese authorities continue to follow an aggressive zero-tolerance approach in the lead up to the upcoming Beijing Olympics. In CEEMEA, recent COVID waves receded in South Africa and Turkey, while rising on the week in Russia and Poland. Latin America rose across most countries in the region last week to new record highs. Despite the record cases many EM countries are currently recording, the impact of recent Omicron waves on fatalities and mobility levels remains generally benign compared with previous waves.
In Europe, cases rose to new record highs last week, with the Omicron wave broadening into Central and Eastern European countries. Similar to the trends seen in the rest of the world, Europe's COVID deaths relative to cases remain far below the levels seen in prior COVID waves, as the chart above illustrates. In the US, cases fell over the last week, with positivity rates declining to 24.8% from a recent high of 26.4% in early January. Leading data we track on the US COVID wave, including search data for COVID testing and symptoms, and regional wastewater data, suggest the downward trajectory in the US Omicron wave will likely continue over the next couple of weeks.
Consistent with the clear break in the relationship between cases and deaths seen globally, more studies this week came out supporting lower Omicron severity. A Nature preprint released Friday of hamsters found lower viral lung viral loads, lower pathology, and milder disease with Omicron relative to other variants - in line with previous studies that also found lower lung viral loads. A preprint released on Sunday from Portugal found that Omicron was associated with a 75% reduction in hospitalizations and a reduced length of average hospital stays after adjusting for sex, age, previous infection, and vaccination status.
Calvion’s view: We continue to see short-term headwinds from the elevated Omicron waves variant, disrupting mobility-sensitive demand and labor supply. In China, we also continue to see risks related to the zero-COVID policy - a risk that is particularly elevated in the coming weeks with the upcoming Beijing Olympics. In the medium-term, we view Omicron's lower severity as an accelerant in a transition that helps bring COVID towards an endemic, less fatal, and less economically relevant phase.