Market Overview: February 2022 Monthly

 | Jan 31, 2022 10:17AM ET

The new year began with a bang. Rising inflation, less government bond buying, and anticipation of more central banks tightening, fueled a substantial rise in interest rates and a dramatic drop in equities. The geopolitical backdrop also lent itself to a weakening of investor confidence.

The US 10-year Treasury yield rose by more than 25 bp, the most since last February. The German benchmark yield rose above zero for the first time since mid-2019, albeit briefly. The yield on the 10-year Japanese government bond pushed a little above 17 bp for the first time in nearly a year and has not been above- 0.20% in six years. After peaking near $18.5 trillion in December 2020, the amount of negative yielding bonds fell almost $9 trillion in January, the lowest since March 2020.

The market is pricing in more aggressive central bank tightening than it had at the end of last year. The implied yield of the December 2022 Fed funds futures contract rose by about 55 bp in January. It has four hikes discounted this year and is confident that the first hike is delivered on March 16. There is more. The market is pricing in about a 2 in 3 chance of a 50 bp hike in March and is pricing in around a 75% chance 125 bp this year rather than 100 bp. The market has moved to nearly discount six hikes by the Bank of Canada this year. At the end of last year, a little more than five hikes were expected. The market leans heavily (~70%) that the Bank of England raises rates five times rather than four. On New Year's Eve, the market was solidly pricing in four hikes.

The Federal Reserve, the Bank of England, and the Bank of Canada will complement their rate hikes with passively reducing their balance sheets by not fully reinvesting maturing principle. To normalize the use of the central banks’ balance sheets, it is essential that they are used when necessary and unwound quickly. Compared to after the Great Financial Crisis, it will happen more quickly this time. The Bank of England has indicated that when the base rate reaches 50 bp, which looks likely at the February 3 meeting, it will allow its balance sheet to begin shrinking. This will happen almost immediately with a large maturing issue in March.

Equities struggled in the face of rising interest rates and stretched valuations. There also seemed to be a rotation out of growth and toward value. This can be seen by the slump in the NASDAQ Composite, which has approached bear market territory (20% decline from the record high set last November). In contrast, the Dow Industrials set a record high on January 5th and the pullback approached the "technical correction" of 10%. Note that in the second year of the presidential term, going back to 1934, the average drawdown is about 16%. Over the last five terms, going back to 2002, the average is a drawdown of 15.8%.

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Consider that the Russell 1000 Growth ETF (NYSE:IWF) is off about 11.3% this year, while the Russell 1000 Value ETF (NYSE:IWD) is off less than a third as much. We should not draw any hard and fast conclusion about 2022 based on the January performance, but the Value Index has not outperformed the Growth Index for a year since 2016.

The European Central Bank and the Bank of Japan are expected to be laggards in this cycle, but the market anticipates some movement. There is about 20 bp of tightening priced into the euro swap curve over the next year. That is about twice what was discounted at the end of last year. Speculation of an early Bank of Japan move was dashed by Governor Kuroda. It seems unlikely that the BOJ raises rates until after Kuroda's term ends in April 2023.

Another dimension of the international investment climate that further crystallized was the monetary policy divergence with China. The People's Bank of China delivered a small (10 bp) cut in the key medium-term lending facility to 2.85%), the first reduction since April 2020. This was followed up by the second 10 bp cut in the one-year loan prime rate in as many months. The rate of the five-year loan prime rate, a benchmark for mortgages, was shaved to 4.60% from 4.65%. It is also allowed other money market rates fall. Officials have signaled more policy support will be forthcoming but hopes for a cut in required reserves before the Lunar New Year holiday were disappointed. Mainland markets will re-open on February 7. The policy divergence that some had thought would be particularly negative for China was offset but the record trade surplus and portfolio capital into its bond and stock markets.

The surging Omicron form of COVID has adversely impacted economies even though it appears less fatal than earlier mutations. The widespread infection though has disrupted work, delayed a return to offices in many countries, including the US. Some countries, like Japan, have re-imposed some restrictions until the middle of February. The rate of infection seems to be passed its peak in the US and UK, but the impact will likely shave Q1 GDP. China's zero tolerance has led to city-wide lockdowns ahead of the Olympics (Open Ceremonies February 4) and stressed supply-chains.

The geopolitical backdrop remains fraught with risk in Europe. Russia has amassed troops and artillery along its border with Ukraine. Moscow is under the impression that bringing NATO to the Russian border contradicts earlier assurances. It has been clear, well before the annexation of Crimea (2014) that Putin would not easily accept Ukraine and Georgia to join NATO. Russia argues that Ukraine stealthily joined NATO in all but name. Ukraine has been supplied with weapons and has conducted joint exercises with NATO.

There seems to be a widespread consensus against conceding a sphere of influence in eastern and central Europe to Russia. Any suggestion to the contrary is dismissed as appeasement, with allusions to Hitler. Yet, without Russia feeling secure, security in Europe will remain elusive. Therein lies the tragedy that is Europe. It has been a source of instability for well over a decade. The threat of economic and financial sanctions may not deter Putin because it is an existential issue.

The US bilateral goods trade with Russia is about $30 bln a year. Europe's total bilateral trade is more than four-times greater. The asymmetry fosters different sensitivities to economic sanctions. This seems to be the case with removing Russia from the SWIFT system. Also, unlike the US and UK, German law prevents selling armaments to countries engaged in conflict. However, the new German government seems willing to put the Nord Stream pipeline as a possible sanction target if Russia invades Ukraine.

An unintended consequence of the US approach to Russia is that in encourages Moscow (and Beijing) to develop chits that can neutralize. Russia has threatened to put troops in Cuba and/or Venezuela. Recall that the 1963 Cuban Missile Crisis was resolved when Russia dismantled its missiles in Cuba and the US removed its missiles in Turkey. China's Belt-Road Initiative is making headway in the Caribbean and parts of central and South America. Brazil is not formally a member of the BRI, but it is one of biggest recipients of China's development funds in the region.

Emerging market currencies were more resilient than one would have expected given the aggressive turn by the Federal Reserve and the risk-off sentiment reflected in the equity market volatility. The JP Morgan Emerging Market Index managed to eke out a fractional gain through January 28 even though it fell by 1% in the last full week of January. Latam currencies were in favor. They accounted for the top four performing emerging market currencies (Chilean peso, Peruvian sol, Brazilian real, and Colombian peso).

The Chinese yuan rose to its highest level in almost five years but reversed lower at the end of the month, ahead of the Lunar New Year holiday. It also rose to record highs on a trade-weighted basis. However, the sentiment toward Chinese stocks and bonds appears to have dimmed recently, and among asset managers, Brazilian assets are preferred. This may take some upside pressure off the yuan. Brazil raised rates aggressively last year and is thought to be near a peak, making the bonds a favorite overweight. Its equity market is heavily weighted toward commodity producers, which is also a popular theme.