January 2022 – Overreaction to inflation?

It’s been a tough month for our strategies. SFRR ends January at -10.86%, SFPG at   -15.82%, and at SFQS -7.00%. After reporting 2021 returns of +12%, +21% and +31%, respectively, our Funds are giving back part of those earnings this month. Although 2022 starts on a downward trend, company fundamentals and a strong economy –well into an expansive cycle –point to a return to positive performance sooner rather than later. Corporate earnings are beating all expectations and it is foreseen that the S&P500 will rise 9.5% in 2022.

What has been moving the markets?

January has been a month of rotations. Quality and growth equities fell more than the rest of the market, dragged by concerns about inflation and the withdrawal of Central Banks’ stimulus. A higher inflation makes markets seek short-term positive returns in sectors that will thrive the most against this backdrop, such as energy, financials, commodities…, and to exit higher growth, higher quality, less price sensitive stocks, such as technology, software, healthcare, etc.

Will the rotation be reversed soon?

Companies with above average growth, strong cash flows and price fixing capabilities normally demonstrate their competitive and financial superiority by rising prices and repurchasing shares, and it is this that will make such company’s share prices recover in the second to third quarter this year. Amazon is a perfect example: it has not hesitated to increase its service subscription price and, nonetheless, it is unlikely it will lose market quota and its listing price has responded well to earnings release.

Inflation is probably about to peak, as we are told by Central Banks and top financial houses, and the first signals of inflation containment will trigger higher rises in growth shares than in more cyclical assets, that have already discounted an overly advantageous scenario.

Is this a year to make in-depth portfolio changes?

Growth vs. Cyclicals peaked in February 2021. Companies most involved in the new economy, that are revolutionising the way value is provided to their clients and how they interact with them, surged on the back of the pandemic, but have been correcting for over 12 months now –in the case of the more volatile companies – and for over 3 months –in the case of higher quality companies.

Taking into consideration these companies’ growth, in many cases listing prices are more attractive now than before the pandemic. Is this the year to rotate from cyclicals to growth, over the next few months? Although we won’t find the floor until it is actually over, prices already offer a good entry opportunity for those that are underinvested in Growth.

Are these sharp falls normal?

Not for us. This month, we’ve suffered a bit more than usual, but months of strong revaluation are the down the line. We normally diversify hedging among several indices to dampen systemic, regional and sector risks. In January, index dispersion was extremely high, which impaired the effectiveness of our hedges. Eurostoxx 50 falls were quite contained, around 6.5% at the lowest point, slightly higher for the S&P500 –reaching 10%–, and even higher for the Nasdaq that reached approximately -15%. Diversification and good corporate data prompted us to start January with our standard hedging levels. By mid-month it had contributed 3.5%, having returned most of those gains at month end. Likewise, equities’ performance was also extreme and unusual: in the growth segment, higher quality shares fell more than shares with less healthy financials. Growth shares fell a maximum of 24% in January and were gradually recovering at month end. The wide spread of equity and hedging valuations had a strong impact on the Fund’s NAV. The Momentum strategy had a relatively good performance this month as we have been lowering –even exiting– companies that had lost resistances and favouring those with more encouraging trends (as long as they continue to offer attractive long-term growth). This strategy is followed in the Sigma Real Return and in high value managed portfolios.

Will it recover soon?

It probably will. Overall, our portfolio equities have been announcing very good Q4 earnings and promising prospects for 2022. Market movements caused by speculations on how many rate rises there will be and where inflation will be in 12 months’ time usually tend to converge to fundamentals, that in the case of our equities are excellent indeed. In the two previous rotations –2015 and 2018– equity price falls were similar and had recovered after four months, and both years were followed by 12 months of market rallies. In 2015 a rate hike started that was to continue to the end of 2018: a period that resulted in a considerable revaluation of stocks pushed by economic growth.

Have we made any changes?

In general, we have gradually decreased exposure to less solid companies and companies with a lower short term recovery potential and have adjusted our hedging strategy to increase its sensitivity to index dispersion. We have undone our short positions in Eurostoxx 50 to adopt a more tactical hedge using Nasdaq to reduce portfolio volatility. Over the next 12 months, we foresee bullish markets, coupled with a certain degree of volatility caused by inflation and monetary policy concerns. For now, there are no signs of an immediate recession nor have markets reacted in any way that could be interpreted as backing such scenario.

Do we need worry about interest rates and Central Banks?

The intervention of the FED and other Central Banks has been crucial to limit the pandemic’s economic impact and has successfully achieved its objective of reactivating the pre-2020 bullish cycle. The two main side effects that need to be managed are the distortion in the bond market after the FED multiplied its balance sheet by 10 in 15 years, and the inflation caused by the lack of supply-demand synchronization. As stated by Powell, the FED can act on the demand side by using a more, or less, restrictive policy but there is no way it can act on the supply side. Post Covid normalization should be accompanied by the suppression of domestic and international mobility restrictions, which together with the announced production increase should be enough to improve supply, leading to a natural reduction of inflation that will slow down restrictive policies and rate rises by Central Banks.

A second natural ceiling to rate hikes is the difference between 2-year and 10-year US bond rates. The FED can act easily on 2 year bonds, but there is not much it can do for 10-year rates. If markets perceive recession risks, they will begin to buy 10-year debt, lowering its effective rate and curtailing any rises that may be applied in 2 years. When 2-year and 10-year rates are the same, economy slackens as the financial sector’s appetite to back longer-term projects decreases. Although the yield curve has shown no symptoms of recession, Central Banks are very careful not to raise unwanted fears. It doesn’t seem likely either that we will enter a long period of unprecedented high rates, as we have read in some reports. The speed at which Central Banks can reduce their balance sheets is limited: they may reduce 10-20% over the next years, but it will be hard to reach 2007 levels. With the current levels, rates need to be kept considerably lower than in 2007. Central Banks’ announced plan is to keep real rates below zero for some years to come to gradually absorb debt, and harm economy as little as possible. We should not expect, therefore, great gestures by Central Banks. Rather, let’s focus on corporate earnings.