Research Review: January 2022

The strong positive momentum across most major asset classes and categories in 2021 encountered meaningful headwinds in the first month of 2022, particularly among rate-sensitive assets, as market participants digested the Federal Reserve’s (Fed) pivot to incrementally tighter policy. With certain economic data witnessing cooling pressures in January, concerns of tighter Fed policy in the wake of moderating economic activity weighed on investor sentiment. Financial market performance was broadly negative in January, as many equity indices dropped into technical correction and—in some instances—bear market territory, with notably poor momentum witnessed across the domestic growth and small cap constituency. Despite overwhelmingly negative equity returns, most major fixed income indices faced similar performance challenges amid a sharp increase in Treasury interest rates and widening below-investment-grade credit risk premiums. Real assets returns were mixed, as the rate-sensitive domestic Real Estate Investment Trust (REIT) sector suffered its worst monthly decline since March 2020. Still, strong gains were generated across the commodities complex, particularly in energy-related sectors.

Economic Update

Despite a Strong Fourth Quarter, U.S. Economic Growth Faces Headwinds in Early 2022

The U.S. economy strengthened considerably in the final quarter of 2021, as real GDP advanced at an annualized pace of 6.9%, easily besting the Bloomberg median consensus estimate’s call for a 5.5% gain. The 6.9% pace was the second strongest quarterly reading in the post-COVID era behind the base-effect-distorted third quarter
2020 reading.

Against a divided backdrop that included near-zero policy rates and a strengthening labor market juxtaposed against persistent supply chain bottlenecks and multi-decade high inflation, the U.S. economy’s inflation-adjusted performance in the fourth quarter added to the overwhelming evidence pointing to the need for policymakers to rein in their pandemic-driven ultra-accommodative stances.

Both the Fed and bond market participants continue to discount multiple increases to the federal funds rate throughout 2022 and 2023, with the latest pricing on fixed income derivatives—such as Eurodollar futures and overnight index swaps—suggesting at least five, 25 basis point hikes could occur in 2022, with the potential for multiple subsequent hikes in 2023.

Despite continued robust sentiment for tighter monetary policy, certain real-time measures of early 2022 business activity have turned lower, sparking concerns of a Fed “policy error.” Through January, for example, Markit Partners reported a notable decline across their Services Purchasing Manager Index (PMI), which declined to an index level of 51.2, dangerously close to the 50 expansion/contraction threshold. The level was nearly 20 index level points below readings witnessed last summer and the weakest print since July 2020.

In addition to weakness emanating from recent survey-based growth estimates, some model-based current quarter growth estimates have also experienced downward pressure. The Atlanta Fed’s GDPNow model, which tracks current quarter GDP growth based on real-time incoming economic data, slumped to an essentially flat reading as of the latest update in early February.

The ongoing spread of COVID-19 variant Omicron has undoubtedly weighed on these measures, yet policymakers in the U.S. do not appear particularly concerned, as persistent above-trend inflation and a labor market exhibiting qualities of “maximum employment” have provided a green light to begin policy tightening.

While a single month of hit-or-miss economic data hardly defines a trend—particularly on the heels of solid late-2021 momentum—the cooling of business activity in early 2022 has the potential to hinder the Fed’s intentions of meaningfully tightening policy absent a near-term resumption of 2021’s positive economic trends.

To summarize, global investors were faced with a revival of volatility to the downside across most major risk sectors and safe-haven assets alike in January, as market participants grappled with continued sentiment for less-accommodative Fed policies paired with potential warning signs of a slowdown in economic activity, the combination of these two forces sparked worries of a policy mishap that could drive market volatility to even higher levels.

Market Returns

Global Equity

• Global equity markets stumbled into the new year in the red following strong performance in 2021. Inflation, expected monetary tightening, rising yields, the Omicron variant, and supply chain bottlenecks helped prompt nervous investors to increase selling pressures on risky assets. Emerging market equities experienced a tough 2021 and ended the year trading at 20-year lows relative to the S&P 500. Consequently, emerging markets did not witness the same declines in January as elevated valuations compressed in developed international and U.S. equity markets.

• U.S. equities saw a sharp reversal in January, despite a solid start to corporate earnings season, with the S&P 500 down approximately 5.2%. Market participants favored value sectors, such as energy and financials, at the expense of information technology and consumer discretionary throughout the market cap spectrum. Energy stocks also benefitted from potential sanctions on Russian equities in response to Russia’s increased military presence along the nation’s border with Ukraine, indicating the threat of invasion.

• UK equity performance was essentially flat for the month, while companies reported healthy earnings growth across various sectors. The materials, financials, and consumer staples sectors drove returns in the UK as investors’ most robust demand was for the inexpensive areas of the market. The UK economy grew 0.9% in November, ahead of expectations and reaching pre-pandemic levels. Conversely, European equity performance trended with global markets and posted negative performance in January, with the situation between Russia and Ukraine hurting equity performance. However, like the UK, the eurozone economy returned to its pre-pandemic level, with GDP growing 0.3% in the fourth quarter.

• Japanese equity market performance was negative in January. The technology and consumer discretionary sectors were hit hard because the semiconductor shortage has continued to put pressure on chip manufacturers and automobile companies, both of which contribute significantly to the Japanese economy. While the rest of the developed world is dealing with record-high inflation, Japan’s inflation remains muted due to a three-year low wage growth rate of 1.9%. The government is encouraging companies to raise wages, as consumer spending has been dampened by minimal wage growth.

• Emerging market equity returns were negative but fared better than most regions. South Korea and Russia were poor performers over the month due to Korea’s Q4 earnings disappointing to the downside and Russia’s escalating tensions with Ukraine. Emerging market oil exporters such as Saudi Arabia, Qatar, and UAE all benefitted from the rising oil and energy prices and the tensions between Russia and the West.

Fixed Income

• Interest rates sold off along the curve as the market discounted hawkish Fed policy guidance. The 10-year U.S. Treasury yield rose 25 bps to 1.79% during January. The 10-year Treasury also reached a new cycle high, eclipsing 1.9% before retreating. The 10-year/2-year Treasury spread continued to flatten, with the leading indicator falling 18 bps to 61 bps. Highlighting rate movements, the ICE BofA MOVE Index, which tracks interest rate volatility, reached its highest level since March 2020 as rate volatility moved in tandem with equity market volatility.

• January’s employment data release surprised to the upside, providing more ammunition to the central bank to remove accommodative policies. Despite January’s ADP Employment Report showing results falling below expectations by nearly 500k jobs, nonfarm payrolls beat sell-side estimates with over 450k new jobs added during the month. Additionally, December saw over 700k net revisions while the labor force participation ratio surpassed estimates, rising to 62.2%. Rounding out the report, average hourly earnings beat estimates, increasing 0.7% and 5.7% on a month-over-month and year-over-year basis, respectively.

• Increasing interest rates and widening spreads created a challenging backdrop for investment and non-investment grade credit. Floating-rate bank loans outperformed their fixed-rate counterparts, with the S&P/LSTA Performing Loan Index returning 0.4%. The outperformance was driven by positive fund flows as investors repositioned into floating-rate sectors and the lower interest rate sensitivity profile of floating-rate loans.

• Within securitized credit, CMBS and ABS outperformed agency mortgages as agency spreads meaningfully widened. The Bloomberg US Aggregate MBS Index saw spreads widen 4 bps to reach 42 bps. Lower coupon mortgages—the target of Fed purchases—saw the widest spread widening as rising mortgage rates caused prepayment expectations to fall, thus increasing extension risk. Lower coupon agency mortgages also face technical headwinds as the Fed reduces purchases and eventually reduces the size of their balance sheet. The exit of a constant buyer during the quantitative easing era has led to the expectation that higher coupon mortgages may outperform.

Real Assets

REAL ESTATE

• Publicly listed real estate posted negative performance to start 2022. Property sectors with longer life contracts and less inflationary related pricing power—such as data centers and cell towers—were most impacted, each declining more than 13% for the month. The hotel/lodging (-2.0%), retail (-5.2%), and healthcare (0.2%) sectors outperformed with less material declines. The prospect of higher interest rates was a key factor in the weakness in public real estate during the month, as investors favored REITs for their relatively attractive yields. As of the end of January 2022, the yield on the FTSE-NAREIT Index stood at 2.8%.

• Healthcare REITs led U.S. REIT performance through January as the only sector to post positive performance for the month but returned just 0.2%. Healthcare facilities have generally struggled since the onset of the pandemic because many providers have had to cancel elective surgeries—procedures that typically drive hospital profits—due to the impact of COVID-19 on patient populations, hospital staff, and hospital systems. However, healthcare REITs recovered in January as investor sentiment on the sector improved.

• Self-storage REITs continued to outperform, returning over 65% over the trailing 1-year through January. Self-storage continues to attract capital because the sector is viewed as a hedge against inflation due to its relatively low capital and labor needs. Additionally, the sector benefits from month-to-month leases, which allow owners to raise rents more frequently than properties with multi-year leases. Self-storage REITs were not immune to the January slowdown and declined nearly 8.2% on the month.