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The Fed has been playing with fire for some time in its attempt to keep financial markets inflated while pulling the economy out of the post-COVID recession. If he had simply operated under his dual mandate of maximizing employment while keeping inflationary pressures out of control, he would have stopped buying Treasuries a long time ago and started raising rates ago. a year. But this is not the case. Instead, he made his political decisions with the prices of risky assets in mind. Anything that could tip the boat prematurely for stocks was irrelevant.

It worked for a while, but now the Fed is starting to understand the consequences of a kick in the box down the road.

What we have today is an environment where we are likely to see a 7% year-on-year inflation rate printed later this week, the highest number since 1982. We have seen the growth of wages climb to around 6% as the The Great Resignation continues. We forecast GDP growth of 3-4% in 2022. Yet the Fed ALWAYS buys Treasuries for at least a few months and we ALWAYS have a 0% fed funds rate. If you can explain why this makes logical sense, you are smarter than me.

Now, however, the Fed’s hand is going to be essentially forced. Remember when Jerome Powell and the Fed Dot Plot report suggested a first rate hike in June with the plan of 3 quarter point hikes by the end of 2022? It was barely a month ago. Today we have an 80% chance of a hike at the March meeting and over 50% chance of a 4+ hike by the end of 2022 (according to the Fed Funds futures market). The Fed is now way behind the 8-ball, it’s going to have to tighten at a much more aggressive rate and financial markets are finally starting to react.

Let’s break down the events of the past week one by one.

The great rotation in cyclical values ​​and value

Over the past year, cyclicals have only managed to outperform in spurts. This usually happens when we get an indication of a lower or higher rate, but the rebound usually loses steam once the stock fades. The difference between yesterday and today is that we just talked about the general idea of ​​when the tightening could start at some point in more than 6 months. Today we are talking about how the tightening needs to happen NOW and it needs to be aggressive as inflation and wage growth start to spiral out of control.

Once we had the double whammy of a few minutes of very hawkish Fed meeting and a jobs report suggesting wages were rising well above expectations, it was off to the races. Financials have long been linked to Treasury yields, so it was not surprising to see them up 5% on the week. Energy tends to be one of the more cyclically volatile sectors, and its 10% gain last week on the heels of oil at $ 80 is also not surprising, although the size of the gains is not surprising. probably was.

The biggest pivot, however, has occurred in value stocks. The stock outperformed growth by over 7% last week! We rarely see this kind of change so quickly, unless there is a massive upgrade in expectations. With rates likely to rise significantly over the next 12 months, high valuations in tech and growth stocks become less justifiable and, therefore, we expect the shift to value stocks instead. The decisive character of the movement was notable.

This is a rotation, not a sale

This is one of the problems with a US stock market where 30% of the weighting of the S&P 500 comes from half a dozen stocks. This can obscure much of what is going on below the surface. The S&P 500 may have fallen 2% and the Nasdaq 100 may have fallen more than 4%, but if you are reading this and assume that means there has been a big sell off in the market, you are wrong. . Take a look at how several asset classes performed over the past week.

  • Finances + 5%
  • Energy + 10%
  • Value + 2.4%
  • Consumer Staples + 0.5%
  • High dividend yield equities + 1.9%

It was a rotation, not a massive sale. Investors turned mainly to finance and energy. The other cyclicals were still mixed. Consumer Staples and Utilities outperformed. Even international stocks were relatively unchanged for the week. As the FAAMG + Tesla names disappear, the S&P 500 and Nasdaq will also disappear. As a general rule, always look under the hood.

Treasury market resets

The big thing the markets will be talking about is the Treasury yield curve. Long-term Treasury yields (I’m especially careful about 10 years) rose 30 basis points. The long end of the curve tends to reflect more of the outlook and general economic conditions. What I think we are seeing here is the expectation of still good growth, but inflation will be an issue throughout 2022. This tends to lead to a higher and steeper yield curve. If the economy starts to slow quickly, expect the curve to flatten and the 10Y-2Y spread to narrow. This is when the risk of a recession begins to increase.

The short end of the curve reflects what the Fed is doing. If you look at the 2-year yield history, it was 20 basis points as recently as September. Today it is around 90 basis points. In other words, fixed income traders think rates are going up and that they are probably going up quickly.

Low volatility and quality themes are still lagging behind

Many investors think that value and low volatility are synonymous, but often they are not. Last week is a good example. The value, as mentioned earlier, rose 2% + asset-weighted last week. Low volatility fell more than 2%. The quality theme, which tends to be more closely correlated with low volatility, fell by around 3%. Finance and Energy tend not to be as much of a part of these groups, so it’s no surprise to see such a dichotomy between these groups.

What is perhaps interesting is that high beta only fell around 0.4% last week. Even with the significant drop in the Nasdaq indices and large caps, high beta outperformed low volatility.

The labor market is doing quite well

You can sort last Friday’s jobs report as much as you want, but that shouldn’t lead to any conclusions other than that the job market is doing pretty well. Yes, labor market participation is lower than we would like to see. Yes, there are still a lot of vacancies. Let us not forget, however, that the overall unemployment rate is below 4%. It is not a perfect job market and there is certainly room for some improvement, but it is not weak enough to the point where the Fed should feel it needs to delay policy action while waiting for conditions are improving. The labor force participation rate has been stable for months, so many of these workers may never return. The labor market is more than strong enough today to withstand a spike in interest rates up to 0.25%

OK, with that rant out of the way, let’s look at the markets and some ETFs.

ETF Focus Report Master - SECTOR TECHNICAL REPORT-9-page-001

Short-term relative strength tells us roughly what we already know. Energy and Financials look pretty strong, although they are on the verge of being overbought. Consumer Staples remains the strongest of the major market sectors, as has been the case over the past three months. Materials, industries and utilities appear to be in good shape, while everything else looks particularly weak.

With growth stocks selling off last week, it’s interesting that the S&P 500 is now trading below its 50-day moving average, an indication that short- and medium-term sentiment has started to turn negative in the ‘together. The general theme right now is that the cyclical and defensive sectors are good. Growth sectors are not.

ETF Focus Report Master - Sector Perf_Flows Report-8-page-001

If you look into the tech, communications services, and consumer discretionary industries, there’s not much anywhere that doesn’t look weak. The more defensive telecommunications group is doing comparatively better, which is not surprising. The leisure and recreation group has come together in the belief that while omicron will continue to cause economic disruption in the short term, it will not necessarily have long term disruption, both in terms of health and the economy. . Blockchain has grown from a position of strength to one of the most oversold areas of the market, following the lead of bitcoin and other cryptocurrencies.

ETF Focus Report Master - Sector Perf_Flows Report-8-page-002

The dichotomy within the energy sector is interesting to observe and follows a trend that dates back over a year. When fossil fuel stocks move in one direction, clean energy stocks move in the opposite direction. There still isn’t a lot of money piling up in energy and financial stocks here, but it sometimes takes a week or two to fully play out.

Gains in the financial sector came mainly from the big banks and regional banks, with both groups gaining 8-9%. Other subgroups, such as capital markets and insurance companies, also posted gains, but rate-sensitive stocks performed the best.

Manufacturers are doing much better this week. They tended to move lower against the S&P 500 for a while, but could be on the verge of rising again if cyclical reflation trade holds. Steel producers have seen good growth recently, although gold and silver miners are still struggling as precious metal prices remain stable.

ETF Focus Report Master - Sector Perf_Flows Report-8-page-003

The dollar returns to a neutral position again. It had increased on its “vanguard” monetary policy plans, but the large rate hike globally suggests other major central banks may be forced to catch up. The ECB still looks dovish, but inflation is at 5% and the 10-year German Bund yield could turn positive for the first time in two years. He may also be forced to act earlier than expected.

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