- U.S. stocks higher; info tech, materials lead
- STOXX close up 0.65%
- Dollar down; gold, oil, bitcoin up;
- 10-yr US Treasury yield ~1.73%
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DON’T MOVE YOUR EGGS FROM THE U.S. STOCKS BASKET (1348 EST/1848 GMT)
Goldman Sachs Investment Strategy Group (ISG) reiterated its bullish stance on U.S. stocks on Wednesday despite growing concerns over a hawkish Federal Reserve, impact of higher inflation, risks of new coronavirus mutations and lofty stock market valuations.
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“We are very cognizant of the fact that valuations are high and that late 2021 appear eerily similar to early 2000. Yet, are careful analysis, we continue to recommend client remain invested,” strategists led by Sharmin Mossavar-Rahmani, CIO for GS Consumer and Wealth Management, and Brett Nelson, head of tactical asset allocation for GS Investment Strategy Group, wrote in a report.
U.S. stocks have posted double digit returns for the past three years, prompting worries over a market bubble, frothiness and irrational market exuberance even.
However, strategists argued that equity valuations and outsized returns are not reason enough to underweight equities.
They also dispelled worries over a high level of equity market concentration in megacap tech-related companies, citing a comparison between an equal-weighted index of the S&P 500 to the market capitalization-weighted index that confirmed that market returns in 2021 were broad-based.
Among the top risks to Goldman Sachs’ ISG outlook is a more transmissible COVID-19 strain and a spike in inflation that could spur a faster than expected pace of monetary tightening.
Latest data showed the largest annual increase in inflation in nearly four decades, which could bolster expectations that the Fed will start raising interest rates as early as March. read more
Additionally, the strategists highlighted that they did not expect the strong outperformance of the FANGMANT basket of stocks to drive the equity market higher from here on. They also expressed concerns about China’s long-term growth trajectory.
HOW TO PLAY THE FED WITH SECTORS (1315 EST/1815 GMT)
Now that the market has accepted the Federal Reserve will raise rates this year, DataTrek’s co-founder Nicolas Colas is looking for a sector investing plan to go with liftoff.
But the strategist finds history shows hugely variable sector performance after the Fed hiked rates following the last three recessions.
In the cycle starting in 1994, healthcare and technology were relative winners with 1+% gains while their S&P weightings of 9-10% weren’t even in the top five.
In the 2004 cycle, technology – with the second-biggest S&P weighting at 17.2% – and consumer staples – with an 11.2% weighting – actually underperformed.
Financials, with the biggest 20.4% weighting and healthcare, ranked No. 3 in weighting, held their own. Energy, with a 7-9% weighting, was the only outsized winner from a cycle a 4+ return from mid-2004 to 12 months later.
In the cycle that started in November 2015, the S&P rose 2.3% with healthcare and consumer discretionary lagging most, while financials was the relative winner with technology and industrials keeping pace.
So if history is no help, where to look?
Colas notes that capital always flows to stocks and sectors with the highest probabilities for future earnings surprises given the economic environment at the time and out of sectors with less likelihood for suprises.
So he sees cyclical sectors like energy (.SPNY) and financials (.SPSY) as the logical bets for 2022. To make that happen he expects capital to flow out of technology to some extent but also from consumer staples as well as communications and consumer discretionary companies that don’t have a technology component.
If this is the case, the broader S&P 500 will likely not gain very much unless the winning sectors recover enough weighting to move the index higher.
On the positive side, Colas notes that none of those 1-year returns were negative and “there were plenty of ways to beat the index by overweighting sectors that outperformed.”
BOND MARKETS: DOING ONE’S HOMEWORK PAYS OFF (1120 EST/1620 GMT)
“Don’t fight the Fed” is an almost trite adage in bond markets. With at least three Fed hikes priced in for 2022 after U.S. inflation data released today, some fund houses and bank research desks have a different view – focus on buying credit that’s closely linked to the real economy.
“While the big recovery trade is behind us, ongoing economic growth is likely to support the credit-sensitive sectors for some time yet, so spreads on these may continue to tighten, boosting excess returns,” Robert Tipp, chief investment strategist and head of global bonds at PGIM Fixed Income, told the Reuters Global Markets Forum on Friday.
“We see opportunities to add value across a range of fixed-income markets from structured products and corporate bonds, to opportunities in emerging markets … It will require more effort in terms of research etc, but opportunities remain and I’m not sure that’s widely appreciated,” Tipp said.
Similarly, BofA Global Research’s strategists tout a “Prudent Yield” approach to fixed income, entailing buying bonds with more “real economy” exposure and less exposure to risks from inflation and rates.
They say the best sectors to own have been “fallen angel” corporate bonds, high-yield municipal bonds, emerging market debt, leveraged loans and convertibles. They expect these instruments to outperform equities and rate-sensitive bonds.
Among stocks, however, the bank’s equity team expects 13% dividend growth this year, double the rate of earnings growth, noting a high dividend yield strategy tends to outperform broad equities by 6.7% in late-cycle markets.
Tipp said bond markets have been taking into account both the long- and short-term impacts of inflation in some respects. U.S. consumer inflation soared to a new 40-year high, data on Wednesday showed. read more
He believes bonds will be effective investments from a top-down perspective in the quarters ahead as rates in many markets are near their peaks. This is “typical timing”, in line with rates in recent cycles tending to peak early, as central banks gear up to tighten policy, he said.
(Aaron Saldanha, Sanjana Shivdas)
HOT ENOUGH FOR YA? DECADES-HIGH CPI SEEN KEEPING FIRE LIT UNDER THE FED (1040 EST/1540 GMT)
The latest data released on Wednesday showed the hottest price growth since Ronald Reagan’s first term as president, and reflects the ongoing imbalance between booming demand and a still-snarled global supply chain.
But investors were braced for the data, comforted by Federal Reserve Chairman Jerome Powell’s declaration of war against inflation.
This pushed year-on-year CPI to 7%, the biggest annual increase since 1982.
While that figure “will be shocking for some investors,” it was also “largely anticipated by many,” writes Brian Price, head of investment management at Commonwealth Financial Network.
Line by line, a 2.7% monthly jump in airline fares and a 1.8% rise in new/used autos led the charge higher, while a welcome 0.5% drop in gasoline prices helped keep the headline print in check.
Core CPI, which strips out volatile food and energy prices, jumped 0.6 percentage points to a 5.5% annual rate.
“The market will continue to be laser focused on upcoming changes in the Federal Reserve’s interest rate policy in the coming months,” Price adds, saying the report “may exacerbate those calls for earlier rate hikes and possibly an increased tapering of the Fed’s quantitative easing program.”
On Tuesday, Fed Chairman Jerome Powell, testifying before Congress at his reconfirmation hearing, acknowledged the Fed had misread the inflation tea leaves and said the central bank was determined to keep inflation in check. read more
“Yesterday the Fed put on some pretty tough gloves and came out swinging, making it clear that inflation is their top priority and they’re going to fight it,” says Peter Cardillo, chief market economist at Spartan Capital Securities in New York. “That was reassuring for the market.”
The graphic below shows year-on-year core CPI along with other major indicators, all of which continue to soar well above Powell & Co’s average annual 2% target:
Switching focus to Wednesday’s economic also-ran, demand for home loans increased 1.4% last week, even as increased rates continued to climb, according to the Mortgage Bankers Association (MBA).
The average 30-year fixed contract rate (USMG=ECI) jumped 19 basis points to 3.52%, the highest level since March 2020, just before the pandemic’s full force hobbled the economy.
Still demand for loans to purchase homes (USMGPI=ECI) gained 2.2%, which easily offset the <0.1% downtick in applications to refinance existing mortgages.
The increase in purchase applications could mean some homebuyers are “trying to lock in a mortgage rate before interest rates move higher,” suggests Nancy Vanden Houten, lead economist at Oxford Economics, who also says “The rise in rates will take an added toll on homebuying affordability, which has been eroded by a sharp rise in home prices.”
As the graphic below shows, refi and purchase demand are currently down 50.1% and 16.4%, respectively, from year-ago levels:
Wall Street liked the near-inline CPI print, having girded its loins for the data in the wake of Powell’s testimony.
SMALL CAPS POISED TO SHINE AS FED TIGHTENS -BOFA (1000 EST/1500 GMT
As price-to-earnings ratios expanded in December, small caps remained the least stretched and are now historically cheap on every metric analysts at Bank of America track.
With the Federal Reserve poised to soon hike interest rates the P/E implications for small-caps indicate they’ll contract less than for large caps in the initial phase of tightening, BofA analysts said in a note on Wednesday.
Valuations expanded across stock sizes last month, with the forward P/E rising 3-4% across the Russell 2000 (.RUT) (to 16.2x from 15.6x), the Russell MidCap (to 19.6x from 18.9x) and Russell 1000 (to 21.6x from 20.9x), BofA said.
But for the year, there were multiple contractions, with the P/E falling 14% for small caps, 7% for mid caps and 5% for large caps.
Earnings were the main driver of returns, where expectations rose about 30% across the size segments, led by small caps.
While back above average, small caps’ forward P/E is the least-stretched at 5% above historical averages compared to 30%-40% above average for mid- and large caps, respectively.
The long-term valuation framework suggests that the Russell 2000 could see high single-digit annualized returns over the next decade, versus low single-digit annualized returns for the Russell 1000 and slightly negative returns for the S&P 500 (.SPX).
FUTURES UP; CPI DATA MEETS EXPECTATIONS (0915 EST/1415 GMT)
U.S. stock index futures are higher early on Wednesday, with S&P 500 e-minis up about 0.4%, adding to gains after data on U.S. consumer prices were mostly in line with economists’ expectations.
The consumer price index increased 0.5% last month, the Labor Department said. Economists polled by Reuters had forecast the CPI gaining 0.4%. read more
In the 12 months through December, the CPI surged 7.0%. That was the biggest year-on-year increase since June 1982 and followed a 6.8% rise in November.
Investors have been concerned after from the Federal Reserve released minutes last week from their December policy meeting that signaled the central bank may have to raise interest raise rates sooner than expected to curb inflation.
Focus will turn to earnings later this week, when some of the big Wall Street banks report results, kicking off the profit reporting period.
Here is the premarket snapshot:
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