Week Ahead: Volatility Could Fuel Wild Swings Between Risk-On And Safer Havens

 | Dec 05, 2021 08:25AM ET

  • Expectations increase that investors will reposition portfolios to once again reflect Reflation Trade
  • US small cap index now undervalued while NASDAQ 100 looks to have completed a bearish pattern
  • Volatility will continue to drive risk assets

    • The current market narrative anticipates value stocks will outperform growth shares in upcoming trading after the US Federal Reserve's hawkish U-turn last week signaled that tapering could be accelerated and rate hikes might occur sooner than investors expected. Fed Chair Jerome Powell's comments that the word he once favored on inflation,"'transitory' should be retired from usage," sent additional jitters through risk markets.

    Powell had expected inflation to ease once the post-pandemic global supply bottleneck loosened. That may have been a reasonable assumption from an economic theory perspective, but he was wrong given current supply chain logistics. Powell didn't expect inventory shortages to remain this prevalent for this long.

    Adding yet additional pressure to risk assets and the overall economy—the emergence of a new COVID strain known as the Omicron variant—which could continue to trigger volatility across equity markets.

    In truth, the ongoing fluctuation between growth and value stocks has been in play in one form or another since the March 2020 bottom when the COVID-19 pandemic shut down global economies. In its aftermath the term Reflation Trade was coined to describe the sometimes rapid rotations out of growth and into value investing.

    Growth stocks, often tech companies, tend to be riskier investments since the companies issuing those shares generally don't pay dividends. Rather, they reinvest profits into their product lineups in order to stay ahead of the competition. This can sometimes make the price of shares escalate rapidly, meaning these stocks are also usually traded at high multiples.

    Value shares are driven by economic health. Sectors such as Financials, Energy, Industrials and Materials tend to outperform when economic growth accelerates. These shares also tend to do better after having been neglected in favor of growth stocks as occurred once pandemic lockdowns were rolled back.

    Powell's Senate testimony last Tuesday left investors with the sense that Fed rate hikes could come as early as the first half of 2022. Rising interest rates will benefit banks, whose primary business is loans. Higher rates on loans allow banks to obtain higher markups on the interest they charge borrowers. Of course, investors are well aware of this and increase bank positions in their portfolios accordingly.

    Of interest, however: there has been no obvious rotation away from Technology shares into sectors sensitive to the economic cycle. On Friday, even as Financials fell 1.63% on the day, Tech dropped only 0.03% more.

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    Moreover, on a weekly basis Tech declined by 0.5% while Communication Services—an offshoot of the broader Technology sector—slumped 3.21%, with Financials underperforming at -5.28% for the same period.

    However, when looking at the respective legs down of these sectors, there a visible shift. The Technology sector continues to provide the best results among the three sectors, falling 3.61% during back-to-back weeks. However, the second-best performer is Financials which lost 5.28% in a three-week-straight selloff. Communication Services was the underperformer in this timeframe, shedding 8.57% in a four-week losing streak.

    Of course, there's another theme overshadowing reflation: Omicron. Since technology stocks were the market darlings during the first coronavirus wave, boosted by stay-at-home restrictions, investors may be trying to hedge their bets by shifting between growth and value, but not actually selling off much of either.

    That could help explain why the Russell 2000 has been severely underperforming peers despite listing cyclical shares. The small cap index dropped 2.54% on Friday, significantly worse than the 1.74% decline of the NASDAQ 100. The mega cap Dow Jones retreated 'just' 0.17% while the broader S&P 500 lost 0.84%.

    This underperformance by the Russell 2000 continued on a weekly basis too, with the small cap benchmark plunging 3.86% versus the NASDAQ's 1.74% for the week, and even more than the Dow's 0.94% dip and the SPX's 1.22% fall. Finally, the Russell has plummeted four weeks in a row, losing a whopping 11.40% in value.

    The only other index to suffer a four-week selloff was the Dow Jones, but the 30-component index lost only 4.82% during that time, less than half that of the Russell.

    However, if, per reports thus far, the Omicron variant proves milder than the Delta strain, we might see investors rush back into downtrodden Russell 2000 shares. In addition, the NASDAQ 100 may have just topped out.