Mon, 20 DEC 2021

Pro-cyclical beliefs had already been under pressure over the past four weeks prior to the decision over the weekend by Senator Joe Machin’s rejection of the US Administration’s $2 trillion spending plan. US small cap and “value” equities have corrected by 10% and “high beta” stocks have sold off by more than 30% from the high recorded earlier in the year. The correction in value and high beta equities has been materially larger than the decline in the S&P500 (global risk proxy) which is less than 3% below the record high.

The narrative for the sell off before the developments over the weekend was the potential for renewed mobility restrictions related to the Omicron variant and the Fed’s decision to accelerate monetary policy normalisation. The correction is also likely due to an unwind of crowded positions and the reversal of super abundant liquidity as we noted last week. The good news is that the later appears well advanced at least in a short term tactical sense and might set up a short squeeze and cyclical-biased rally into year end and January. Curiously, the US yield curve stabilised late last week despite the correction in cyclical equity (chart 1).

As we reinforced last week, history shows that equity markets almost always de-rate when the Federal Reserve tightens. However, that does not necessarily imply negative returns as corporate earnings are likely to continue to grow in an expansion phase. Equity returns tend to be positive in the months leading up to and following the first Fed rate hike. The real damage from higher rates tends to occur later in the cycle when tighter policy flattens or inverts the yield curve.

Tactically, the yield curve has already flattened a lot over the past few months and cyclical/value equity has also corrected materially in the past few weeks. In the short term, investors might have become too pessimistic on cyclical beliefs particularly related to the influence of the Omicron variant. As JP Morgan noted on Friday, COVID deaths are actually at the lowest point this year and cases have actually flattened out. The data from South Africa suggest that the mortality rate is actually very low (approximately 25 times lower than the previous variant peak). This is consistent with Omicron being a bullish rather than bearish market development.

Of course the prevailing bias is also adjusting to the environment of reduced policy accommodation next year (both monetary and now less fiscal than previously thought). The good news is that policy and broad financial conditions still remain exceptionally loose. On the negative side, the rate of change is more negative at the margin. Perversely, the negative development on the fiscal impulse might ease some of the concern about the pace of Fed policy normalisation and fiscal driven inflation pressure.


In conclusion, our sense is that investors have probably become too pessimistic on the cyclical outlook in the near term. However, we would still have a bias for entities with strong cash flow, low balance sheet leverage and reasonable valuations in a more challenging liquidity and risk environment.