#1: Fed Chair Powell’s renomination yesterday had a marked effect on market expectations for future rate policy. The chart below, courtesy of CME FedWatch, shows the odds of various rate scenarios at the end of 2022 using Fed Funds Futures prices timestamped at today’s 4pm US equity market close. We’ve noted the change from Friday’s probabilities in red:
As you can see, the probabilities have shifted noticeably. The odds for 0 – 2 rate hikes in 2022 declined as compared to Friday, while the odds for 3 hikes or more increased. The chances for 4 rate hikes (to 100 – 125 basis points) saw the largest bump, from 15 percent to 23 percent.
US Treasuries prices seemed to have had a similar take on Powell’s renomination. Two-year yields (most sensitive to changes in Fed policy) spiked to 59 basis points (a 1-year high) from 51 bp on Friday. Five-year yields closed at 1.31 percent (also a 1-year high), up from 1.21 pct on Friday. And, while 10-year yields did not make a 1-year high (1.75 percent), they did close at 1.63 pct – up from Friday’s close of 1.54 pct.
Takeaway (1): while Chair Powell was broadly expected to be renominated, markets still factored in some possibility that Governor Brainard would get the nod. Since she is perceived to favor lower interest rates, that skewed both Fed Funds Futures and Treasury prices. Now that we know Powell has another 4 years as Chair, both markets have reset to incorporate just one fact: investor sentiment regarding future rate increases.
Takeaway (2): the modal probability in the distribution of Fed Funds odds is for 3 rate hikes next year but, as noted above, the odds of 4 hikes is rising. The last FOMC meeting of 2021 concludes two weeks from this Wednesday (December 15th), and the committee will be releasing a new Summary of Economic Projections/”Dot Plot” of expected future Fed Funds rates. We doubt the FOMC will be as aggressive as markets are currently discounting. This could be what sparks a year-end rally in US stocks.
2: Yesterday’s shifts in rate expectations had a visible effect on US large cap sector performance, with Financials among the best groups (+1.4 pct) and Technology among the worst (-1.1 pct). At one level, the narrative here is pretty easy:
- Higher interest rates imply faster economic growth, and cyclical sectors like Financials should benefit.
- The same thought also implies that investors should rotate out of Technology and into Financials because the latter is more likely to show future positive earnings surprises than the former.
- And, of course, Tech stock valuations should see some compression if long term interest rates increase. History is fuzzy on that point, to be honest, but we include the thought just to be complete.
But … There is another, and not mutually exclusive, explanation: large cap Tech may simply be overextended after its recent run up, setting up more cyclical groups like Financials for a turn as market leadership. We’re big fans of looking at 100-day trailing returns as a signal for near-term sector and market direction. Here’s what that analysis shows:
- Large cap Tech was up 16.0 percent over the last 100 days going into today, a somewhat unusually high short-term return even for this group. That’s just above one standard deviation (8.6 points) from its 10-year average 100-day return (7.3 percent), which totals 15.9 percent.
- Large cap Financials were not as stretched in terms of near-term performance. Their 100-day trailing return through Friday was 6.4 percent. That’s not far off its 10-year average 100-day return of 4.7 percent and well within one standard deviation (12 points).
The upshot here is that large cap Tech is vulnerable to underperforming modestly simply because it has been on a hot streak of late, while Financials can make up some ground now that there’s a catalyst in the form of higher interest rates.
We also ran the latest 100-day returns for the S&P 500 and Russell 2000; here’s what that analysis shows:
- Through Friday, the S&P 500 was up 9.5 percent over the prior 100 days. While that is definitely higher than the 10-year average of 5.1 percent, it is still within one standard deviation of 7.5 points.
- Even with its recent new highs, the Russell is still only up 1.5 percent over the last 100 days. Unlike the S&P 500, that is below its 10-year average 100-day return of 5.0 percent. The standard deviation of these returns is 12.2 points.
Takeaway (1): we like Financials here more than Tech because the group is not as extended and higher interest rates should push capital into the group going into year end. We do not think Tech is a short here, however, because the group’s fundamentals remain strong. To our thinking groups like Consumer Staples and Utilities are reasonable underweights in a rising rate environment.
Takeaway (2): it’s tempting to think that the Russell 2000 can outperform the S&P 500 through the rest of the year, just given its recent underperformance and lack of Big Tech exposure, but we can’t quite get there. US small caps trade off high yield spreads, and those are already very tight to Treasuries. Also, Health Care is the largest weighting in the Russell (18.4 percent), and the small caps in this space have gone nowhere for 10 months. Lastly, we are concerned that tax loss selling in small caps will keep the asset class under some pressure through year end.
Will accelerating US inflation cause incremental US equity market volatility? History suggests “No”, as measured by our preferred benchmark for how much investors “feel” real-time volatility, namely the number of trading sessions when the S&P 500 moves more than 1 percent up or down from close to close. Any one-day move greater than 1 percent to the upside or downside is +1 standard deviation from the S&P’s mean daily return back to 1958 (first full year of data).
Here are the number of one percent days for each year from 1965 through 1972, a period of rising inflation but also before the 1973/1974 oil shock:
- 1965: 9 one percent days
- 1966: 42
- 1967: 19
- 1968: 21
- 1969: 26
- 1970: 67
- 1971: 32
- 1972: 10
- Average: 28
Takeaway: despite growing inflation, the mid-1960s to early 1970s saw below average US equity market volatility in all but one of those years (1970). The average number of annual one percent days is 54 over the last +6 decades, and the average of 28 between 1965-1972 is almost one standard deviation (33) below it (21).
As for how our vol metric has fared more recently, two points:
#1: Last year (2020), the S&P 500 experienced remarkably high volatility, with 110 one percent days. Getting +100 one percent days has only happened 7 times since 1958. The other 6 instances included: 1974 (115 one percent days), 2000 (103), 2001 (107), 2002 (126), 2008 (134) and 2009 (118).
#2: 2021 has gotten progressively much quieter. There are typically 13 one percent days each quarter from Q1-Q3, whereas this year there were: 18 (Q1), 11 (Q2) and 9 (Q3). While there are usually 14 one percent days in Q4, there have only been 4 so far even with heightened concerns about inflation.
By contrast, after the 6 years (prior to 2020) when the S&P had +100 one percent days, it went on to post an average of this number of one percent days each quarter in the following year: 27 (Q1), 27 (Q2), 25 (Q3) and 19 (Q4) or 98 in total. In year 2 (next year) after those super-high volatility years, it went on to post fewer one percent days each quarter than year one: 18 (Q1), 19 (Q2), 22 (Q3) and 18 (Q4) or 77 in total. This year there have only been 42 so far.
So why has US large cap equity volatility abated so quickly this year and what does it mean for 2022? Three points to wrap up:
#1: Volatility collapsed at an accelerated rate relative to prior historical periods because of unprecedented levels of fiscal stimulus and liquidity provided to the US economy and financial system. That, along with accommodative standard monetary policy (interest rates), helped corporate earnings rebound and valuations stabilize swiftly as a result. Vaccines have also materially improved the outlook. All these factors helped lower equity sector correlations, which dampened volatility sooner than prior post-crisis periods.
#2: Looking ahead, history says volatility should keep receding in 2022 – the second year after a crisis with +100 1-percent days. That’s in keeping with the typical pattern of +/- 1 pct days over the last +60 years. Big market swings occur during the start of a bull market, abate and then rise again towards the end of annual sequential gains in US stocks as the chart below shows:
#3: We caution that history also says the step-function move to lower US equity volatility we’ve just outlined may limit 2022 stock market returns. For example:
- After 2000 – 2003’s higher volatility and bad bear market, 2004 only saw a 10.7 pct rebound for the S&P 500.
- After 2008 – 2010’s greater number of 1 percent days, 2011 was only up 2.1 pct.
Of course, low volatility does not single handily cap US equity performance (i.e. 2012 – 2015, S&P +21 pct CAGR and this year’s +24.7 pct YTD return). Even still, above-average returns have historically required a mid to late-cycle investment environment with strong economic growth. It is also very uncommon for the S&P to see a 3-peat of double-digit annual returns as this year will likely achieve, let alone 4. That’s not to say US equity returns won’t be positive in 2022, but they likely won’t be as strong as the past three.