This week’s market volatility is rare – even for a Fed policy week. The S&P500 index’s 3.6% drop on Thursday, following the 3% surge on Wednesday after the Fed meeting, suggests investors are not convinced that the Fed will manage a softlanding for the economy. Although Chair Powell took 75bps rate hikes off the table, concerns remain that the Fed may need to maintain an aggressive policy to tame inflation, raising the risk of tipping the economy into a sharp slowdown (the market is pricing another c.200bps of Fed rate hikes this year). Along with stocks, the USD and US government bond yields did a round trip, with the 10-year bond yield rising above 3% (3.26% is the next resistance). Have US rate hike expectations peaked? Is it time to dip back into equities and other risk assets?
The one-day ‘relief rally” in US stocks after Powell said 75bps rate hikes were not under consideration suggests Fed rate expectations have been significantly baked into asset prices. Also, the benchmark global and US stock indices are testing major support levels i.e. this year’s lows. If these supports hold in the coming days, the risk-reward balance suggests wading back into markets, taking advantage of the recent sell-off. These following sectors offer significant value: (i) energy-based assets, on the back of a prolonged Ukraine conflict; (ii) beaten-down Chinese equities and Asia USD bonds, amid promises of more stimulus; and (iii) the US financial sector, on rising rates.
Let’s take the energy sector first. The impact of the Ukraine crisis on commodity prices could be long-lasting if western sanctions lead to a significant decline in energy flows from Russia. The EU’s proposal to ban Russian oil imports raises the stakes further. For now, Russian oil continues to flow into Asia, alleviating supply concerns. OPEC’s decision this week to boost supplies as per a prior plan is unlikely to make a major difference. Oil prices are a key driver of long-term inflation expectations – US 10-year inflation expectations remain close to 3% after surging this year on the back of rising oil prices. Energy-related assets are an attractive hedge against a further rise in prices. Energy sector equities, in particular, have significant room to catch up with underlying oil and gas prices.
China’s equity market remains inexpensive, with the MSCI China index trading at half the P/E multiple of global equities, its deepest discount in 20 years. The index itself is testing key technical support. China’s COVID-19 lockdowns remain a dampener on risk sentiment as it is likely to prolong global supply bottlenecks and hurt domestic consumer sentiment. However, the Chinese Communist Party’s Politburo has sent a clear message that it plans to roll out more growth supportive measures, including promoting infrastructure spending and reviewing regulations on the downbeat internet sector. It is expected these policies, aimed at boosting China’s self-sufficiency in high-end manufacturing and technology, to benefit Chinese stocks, especially in the industrial sector. China and Asian USD bonds are also likely to benefit as policy eases.
The US financial sector continues to offer significant value. The sector has been beaten down on concerns an aggressive Fed could cause a recession. Market worries about an economic slump are excessive and are ignoring the positive impact of rising rates on the financial sector’s net interest margins. Data suggests that the underlying US economy remains robust, as seen from the still-strong PMIs for April and record-high US job vacancies (US payrolls data for April is due later today). A robust job market is likely to continue driving consumption and private investment, as we saw in Q1 (a soaring trade deficit due to surging imports hurt US GDP in Q1).
The robust economy is also reflected in US Q1 corporate earnings – over 80% of S&P500 companies have reported earnings and all sectors have beaten consensus estimates. The estimated 10.2% rise in Q1 earnings (aided by an average 7.3% earnings surprise so far) suggests companies have been able to pass on higher costs to consumers. Technical indicators for US equities are still supportive – despite the pullback, US equity indices have not broken below long-term uptrends. The AAII bull-bear index suggests extremely weak sentiment, which is historically supportive of equity gains over the following months. If the support levels hold, investors under-exposed to US equities may use the April sell-off to rebuild exposure.
