Time to strap in for the ride

• Equity markets have already seen violent price swings this year, as the market is spooked by the prospect of a quicker pace of rate hikes by the US Federal Reserve
• The market is now pricing in five rate hikes in the next 12 months, starting in March
• Hiking cycles in the last thirty years suggest that equities can still outperform bonds during the cycles. Twelve months after the first hike, US and global equities were up 6% and 5% respectively, then up 16% and 13% respectively, two years after the hike
• January’s rotation to value from growth stocks, may have more legs, suggesting a pro-cyclical stance in portfolios, as well as a value tilt. Historically, higher yields and inflation favour financials, energy, industrials, and basic materials. By contrast, telecoms, healthcare, utilities, consumer staples, and technology tend to struggle
• The next few months may see bursts of heightened volatility, requiring investors to be disciplined, diversified and nimble, and to focus on their long-term investment objectives

This year has already seen some sharp price moves and violent rotations in equities. The rotations were triggered by a large rise in yields, following more hawkish signs from the US Federal Reserve (Fed) and other central banks in recent months, given persistent inflationary pressures and tight labour markets.

The need to quicken the anticipated pace of interest rate hikes was also backed by growing signs that the Omicron variant appears to be less virulent than previous strains of the virus, and less of a threat for economies.

Jump in Treasury yields and inflation spooks investors

US 10-year yields hit 1.87% in mid-January, from 1.33% in early December, and were close to their pre-pandemic level. The market is now pricing in five rate hikes in the next 12 months, starting in March. Bond yields in other areas, including Germany, have also repriced sharply higher. As a result, long-duration assets have been hit hard, catching many by surprise. In equities, there was a powerful rotation to value from growth, and to cyclicals from defensives.

Until we see inflation convincingly peaking, those rotations appear to have more legs, favouring a pro-cyclical stance in portfolios, as well as a value tilt. Historically, the main beneficiaries of higher yields and inflation have been financials, energy, industrials, and basic materials. Those sectors seem well positioned in the near term. In addition, they are typically more heavily concentrated in value indices and non-US markets.

In contrast, the sectors likely to be hit hardest by rising yields and inflation include telecoms, healthcare, utilities, consumer staples, and technology. Despite recent underperformance, we believe that group of sectors will remain vulnerable in the near term, as they are more defensive, have longer duration assets, and are more heavily concentrated in growth indices and the US market.

Fed hiking cycles and equities

The most recent eras when the Fed has lifted rates, covering those starting in February 1994, June 1999, June 2004, and December 2015, can be instructive for those wondering how to position portfolios for a period of higher rates that may kick off in March.

Equity markets generally performed well in the months before the first hike in the cycle. They typically saw a mild, short-lived sell-off in the first couple of months following the initial rate hike, but they generally shrugged off the news quickly, and resumed their up-trend as the Fed continued to tighten.

Based on local currency MSCI ACWI indices, both US and non-US equities saw a 5% average drawdown in the first two months. Twelve months after the first hike, US and global equities were up 6% and 5% respectively, then up 16% and 13% respectively, two years after the first hike. The worst drawdown was seen after the 2015 cycle started, when global equities lost 12% in the first couple of months.

As always, those numbers should be treated with caution. How equity markets react to a hiking cycle depends on many factors, including how well the policy moves were flagged, to what extent they were already priced in, and obviously the level of rates, and the speed and magnitude of policy normalisation.

Previous hiking eras, and regional and sector returns

The history of US central bank hiking cycles indicates typical sector responses. In the first eight months of a cycle, non-US equities outperformed American ones by 8%, on average, in common currency terms, helped by a weaker dollar. Afterwards, relative performance tended to converge, to finish in line after twelve months.

Similarly, developed market small-cap equities outperformed large caps by 4%, on average, in the first eight months of the cycle. The MSCI World Value and Growth indices performed essentially in line with each other, as was the case for cyclicals versus defensives.

Time to be diversified

Equities have usually performed relatively well in the run up to, and during US rate-hiking cycles, in the past thirty years. This cycle seems unlikely to be any different, especially as aggressive tightening by the Fed is already priced in. That being said, the next few months may see elevated volatility, requiring investors to be disciplined, diversified and nimble, and to focus on their long-term investment objectives.