01.25.2022: The new year is off to a rough start and investors are rightfully worried. Our current inflation flareup has hit its highest level in 40 years. Meanwhile, a newly hawkish Fed is seemingly hell-bent on taming the flame, prompting investors to fret that higher interest rates will reverse the liquidity infusion that has fueled unbridled risk taking since the outset of the pandemic. The world has been awash in liquidity. Since the onset of the pandemic, US policymakers injected nearly $7 trillion of fiscal stimulus on top of the $4.5 trillion of Fed balance sheet expansion. That equals roughly half of the US GDP, so it is no wonder that investors are concerned about tightening.
US large caps have lost more than seven per cent so far this year, representing the fourth-worst start for blue chips over the last 20 years. The NASDAQ Composite, one of the biggest beneficiaries of easy money policies, plunged more than 11 per cent this year; only 2008 started worse for NASDAQ shares. Reactions in international markets were muted: developed-market large caps fell five per cent, while emerging markets slipped only fractionally.
Bonds slid on higher yields as traders brace for tightening. The Barclays Aggregate Bond Index suffered its worst start to any year in the last 20 years, falling 1.8 per cent in the first 16 trading days of 2022. The yield on the benchmark 10-year note surged 0.3 per cent before retreating. High-yield bonds fell in lockstep with Treasuries, suggesting that the issue is interest rates, not credit. Anyone who thought cryptocurrencies were a hedge learned a tough lesson this year. Bellwether Bitcoin (BTC) has plunged 50 per cent from its November high.
Market pullbacks come in three varieties, of varying severity:
- Technical corrections, while daunting, are generally the mildest. Markets must reset when they run too far ahead of fundamentals. Such corrections are generally sharp, often painful, but markets recover quickly. Q4/18 was the last technical correction. The S&P 500 plunged 20 per cent between October and mid-December before regaining its lost ground by February 2019.
- Cyclical downturns, often precipitated by a recession, are more prolonged than technical corrections. The S&P 500 lost 35 per cent of its value between Q4/00 and Q4/01 in anticipation of a recession that began in February 2001. It took six years for large caps to recover.
- Systemic pullbacks are the most pernicious. We experienced one less than 15 years ago in the aftermath of the housing crisis. Between Q2/08 and Q1/09 the S&P 500 fell by half, as headlines called into question the viability of the global banking system. Lehman Brothers defaulted on its obligations; the federal government intervened to support other troubled institutions and provide access to liquidity. It took three years for the market to make up its lost ground.
Notwithstanding long-time money manager Jeremy Grantham’s insistence that this most recent pullback represents an unraveling of three simultaneous “super bubbles” – stocks, bonds and residential real estate – we believe the current downturn is of the technical variety, as investors reset their expectations based on tighter financial conditions. Credit conditions remain robust, suggesting that lenders aren’t worried about the prospect of a recession. In fact, the New York Fed gauges the probability of recession over the next 12 months at just 7.7 per cent.
The Big-Picture Perspective
While the Federal Reserve’s liquidity largess can be traced to 2009, it’s Chairman Powell’s extraordinary measures since the pandemic, combined with massive fiscal stimulus, that were largely responsible for equity markets running ahead of fundamental value. To get a sense of the magnitude, we compared the returns of various markets against their fundamental growth (cumulative earnings and dividends) since the end of 2019. We then estimated the market impact of tracking back to fundamentals by the end of 2022. The results aren’t as daunting as today’s market selloff would imply.
Between January 2020 and December 2021, the S&P 500 return outpaced the Index’s cumulative earnings growth and dividend yields by about 20 percentage points. Seven percentage points of that gap has been closed based on this year’s market selloff. The blue-chip index has already given back about nine per cent this year. Assuming S&P 500 earnings growth of about nine per cent and a 1.4 per cent dividend yield this year suggests the S&P could rise one per cent to close the gap between market return and fundamental growth – not the makings of a systemic selloff.
The technology sector, the biggest beneficiary of the Fed’s liquidity, faces additional headwinds. Over the two years ended in 2021, low interest rates helped push tech shares 94 per cent higher while tech earnings growth and dividend yields expanded by 53 per cent, leaving a 21 per cent overhang. The tech sector has already pulled back 13.5 per cent so far this year, leaving another eight per cent of downside risk based on anticipated 2022 earnings and dividend growth.