Stock and bond markets have had a tumultuous start to the new year, buffeted by a drastic shift in interest rate expectations. As late as in October 2021, US interest rate futures were indicating the probability of just one rate hike of 25 basis points in 2022. Now, investors are betting on four and perhaps even five rate hikes. What is driving this sharp pivot in expectations?
The US Federal Reserve has sold markets on the belief that “inflation is transitory” for much of the past two years. We too agreed with this view — that higher prices were due to manufacturing, supply chain and logistics disruptions resulting from the pandemic and border closures. Such price increases — such as for used cars as chip shortages led to new car production cutbacks — would be temporary by nature. We were wrong, but only just and we will elaborate later.
Local outbreak cycles around the world diverged, owing in part to vaccine inequity, and supply chain disruptions persisted for longer than expected. The reopening of international borders was slow and halting. As a result, US inflation rates trended consistently higher through 2021, hitting 7% in December, the highest since 1982.
Critically, we overlooked the breadth and strength of wage gains. We noticed that there is a significant withdrawal of people from the labour force, in the US and also around the world. Some may yet return in time — when government benefits run out, fear of Covid-19 recedes, schools and childcare facilities fully and sustainably reopen and so on. But we suspect a good percentage of those who left may never return, for a host of other reasons, ranging from exhaustion and mental stress to shifting priorities and re-examination of the role of work in life.
Regardless of the reasons, wages are rising, not just in labour-intensive, low-skilled jobs where worker shortage is most acute but evidently across sectors. A case in point: Big banks — among the first to report 4Q2021 earnings — including Goldman Sachs and Bank of America are paying substantially more for talent. Wage rises are very sticky and rarely ever adjust lower, even when the current labour shortage is resolved, and particularly if the prevailing inflation rate starts getting baked in.
Globally, inflation has been on a broad downtrend over the past 20 to 30 years, attributed primarily to globalisation and trade. The offshoring of manufacturing to low-cost developing countries fuelled consumerism in the rich world and enriched businesses but it also took away jobs. Increasingly, people have come to realise that economics is fundamentally about employment, wages and standards of living — and overall GDP growth is simply an accounting number. That has led to the rise in nationalism and increasingly protectionist policies — whether with trade barriers or more covertly through nontrade barriers under such guises as ESG (environmental, social and governance) and human rights issues. The pandemic has only deepened the fissures dividing our world, widening the inequality, as defined by income-wealth, politics and culture. Supply chain disruptions are also leading to more regionalisation (trade blocs) and reshoring of investments in the developed world.
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We think inflation rates should start to stabilise over the coming months. Over the longer term, we still believe continued advancements in, and rapid adoption of, technology will re-exert deflationary pressures on prices. But broad-based price levels will quite likely be higher than previously anticipated, for all the reasons mentioned above. And this is driving the Fed’s pivot towards a more aggressive reversal of its extreme, loose monetary policies.
There is no doubt that asset prices are being fuelled by excessive liquidity — and cheap, almost free money — since the onset of the pandemic. We see signs of bubbles in markets. This is reflected in soaring prices for digital assets — such as cryptocurrencies and NFTs (non-fungible tokens) — that have zero yield and utility except for perceived scarcity, though in reality the potential for the creation of alternatives in the digital world is in fact limitless. Homes are becoming unaffordable as prices keep rising. Valuations for meme, EV (electric vehicle) and tech stocks — especially those yet to turn a profit or even prove to be a viable business model — are increasingly untethered to reality.
Bond prices rallied, so much so that the US Treasury real yield curve turned negative (see Chart 1). Investors were happy to keep pouring money into these negative real-yield bonds since capital gains from rising prices more than offset the very low nominal interest rates.
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Hence, it should come as no surprise that the shift to a far more aggressive timetable for interest rate hikes — the end of extreme, loose monetary policies, and possibly even the reversal of QE (quantitative easing) — would buffet both the stock and bond markets (see Chart 2).
It is also not surprising that the Nasdaq Composite fell the most, compared with the Dow Jones Industrial Average and Standard & Poor’s 500 index. As we have explained before, the value of a stock is equal to its discounted future cash flows. Therefore, a higher interest (discount) rate will hit valuations for high-growth (tech) stocks harder compared with those for low-growth stocks, because a much larger portion of their expected earnings is further in the future.
In fact, many high-growth stocks — especially the loss-making ones — have fallen by far more than the Nasdaq’s 13.4% decline, which is being held up by the more defensive Big Techs such as Apple, Microsoft, Alphabet (parent of Google), Amazon. com, Tesla and Meta (see Chart 3). A case in point: Cathie Wood’s flagship ARK Innovation ETF has fallen by nearly 27% year to date — some of its top holdings include tech darlings Roku (-35%), Teladoc Health (-24%), Block (-31%), Zoom (-24%) and Shopify (-37%).
What is perhaps more unexpected is the comparatively modest decline for bonds. The benchmark 10-year US Treasury is down by only 3% year to date. Rising interest rates should, mathematically, have a greater impact on valuations for bonds than for stocks. The table shows the changes in valuations for bonds, and no-growth and high-growth stocks as interest rates rise, all else being equal.
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Could it be that the bond market — which has, historically, shown to be less sentiment-driven and more rational — is actually more sanguine about the inflation outlook? In other words, price levels will end higher than previously expected — owing to sticky wage gains — but inflation is still transitory, albeit for longer than we thought. This remains our view. The inflationary impact from the pandemic is short term — a two- to three-year cycle. But technology-driven deflation is a secular trend that has been happening for the past 10 years or so, and will continue for decades more to come.
The Global Portfolio fell another 4% for the week ended Jan 26 as the US stock market selloff continued, and is shaping up to be one of the worst Januaries in recent years. All but one stock in our portfolio closed in the red. Grab Holdings gained 5.1% for the week, recouping some of its recent losses. Nevertheless, the stock price remains well below its offering price. The biggest losers were Amazon.com (-11.1%), The Walt Disney Co (-11%) and PayPal (-9.5%). Last week’s losses pared total returns since inception to 51.4% while the MSCI World Net Return Index is up 51.8% over the same period.
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Photo: Bloomberg
