Rising Inflation and Interest Rates Could Push Investors to Focus on Value Investing
The January Effect May Not Have the Effect on Small-Caps that Some May Hope for
This Mid-Term Election Year Has Some Unique Challenges for Investors and Politicians
JJ Kinahan, Chief Market Strategist, TD Ameritrade
January 2022 is inheriting a lot of obstacles from 2021, particularly the threats from inflation and the possibility of rising interest rates. This means 2022 could be a big year for active fund managers because these issues have the potential to increase volatility. The Fed’s easy money policies over the last decade created kind of a “set it and forget it” passive investing environment for investors. However, the environment could be changing thanks to rising inflation and interest rates.
In 2021, many investors starting to shift from growth stocks to value stocks. The threat of rising interest rates made investors and analysts begin focusing on a company’s actual earnings growth and less on promises of future growth. Rising inflation also means that company management matters when it’s time to start controlling costs. Additionally, threats like the COVID-19 Omicron variant compounds these risks because of the pressure on the supply chain and cooped-up consumers buying products.
In these first few months of the new year, money managers start picking stock that they hope will help them outperform their benchmarks over the next year. Money managers take time to accumulate their positions because the positions are so big and can move the market. To get a better price, they’ll often buy a little at a time, allowing the ebbs and flows to help them get a better price. However, the accumulation process can still result in stocks generally rising. Attentive investors may want to do their homework and look to identify some of these characteristics in stocks for themselves, so they can benefit if they rise. Let’s discuss places investors may choose to explore and some risks that are ahead.
According to the Stock Trader’s Almanac, the January Effect is a phenomenon that occurs when small-cap stocks tend to outperform the market in the month of January. Overtime, the cycle has changed where small-cap stocks often start gaining strength in late December and will extend through February.
The reason why this is the case is because money managers take on riskier assets at the first of the year in an attempt to beat their benchmark or index in which they compare their performance. Small-cap stocks are riskier because they are smaller, less-established companies. Therefore, they have a greater risk to the downside. However, because they are small, they also have higher upside potential because they can grow quickly and have the potential of partnership with or acquisition by a larger company.
In recent years, the January Effect has been less successful as investors haven’t focused as much on small-cap stocks at the beginning of the year. While the 2021 Santa Claus rally started out as the strongest in 20 years, large-cap stocks grabbed most of the attention. With that said, small-cap stocks as a group underperformed for most of 2021, and they could be set for leadership rotation if the earnings and economic picture improves.
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One issue that could hold back small-cap stocks is the same issue that has recently caused problems among growth stocks—interest rates. The threat of rising interest rates has caused investors to start focusing more on stock valuations. After the Federal Reserve’s December meeting, Fed Chairman Jerome Powell announced the Fed had planned to cut its bond-buying stimulus program at a faster rate than previously scheduled. This means the Fed will have less influence on how the yield curve rises and falls at various maturities so longer-term rates will be more subject to market forces.
Even with the Fed buying longer-term bonds throughout 2021, rates have risen across the yield curve. With less influence by the Fed, longer-term rates could continue to rise.
In December, Chair Powell also announced that the Fed will target a federal funds rate of 0.9% by the end of 2022. While he didn’t specify when and how many times the Fed would raise rates, conventional wisdom is that there is likely to be at least three hikes. As of the end of December 2021, the market is pricing in June for the first rate hike.
The rate hikes will likely be determined by the growth of inflation, and January could be the month where inflation peaks. Many economists are projecting that once the holiday season is over that consumption would slowdown and companies could get caught up on production and inventories, which would relieve pressure on the supply chain and allow prices to pullback.
Because the Fed’s biggest current concern is inflation, if it doesn’t start seeing signs of improvement, it may start raising rates sooner. Which is why the market appears to be shifting from a June hike, at the end of December the Cboe® FedWatch Tool was projecting a 58.4% chance of a rate hike in March and a 73.1% chance of a hike in May. So, the January 12 Consumer Price Index (CPI) report could be an important piece of data for the Fed.
One of the biggest threats to getting supply chains and consumption back to normal are the COVID-19 Delta and Omicron variants, as well as any other variants that might appear later. While the initial reports are saying that Omicron is more contagious but less severe, the data is still out. More importantly, many countries are implementing pandemic prevention methods that also cause economic issues. In December, Denmark added new restrictions, Thailand announced plans for quarantining travelers, New Zealand postponed its plans to open its borders, and Germany implemented restrictions on gatherings.
Therefore, even if Omicron is less severe, the prevention methods are still an obstacle. For example, The Wall Street Journal reported that the UK has approved support packages for locked-down citizens. Policies like these could keep spending focused on products and not on services, which could confound the post-holiday relief many economists are hoping for and then compound the supply chain problem as orders keep coming. Additionally, if people aren’t getting back to work, then production can’t rise to get the goods to market in order to meet the demand. This means we could continue to see low supply failing to meet the same demand, which normally results in higher prices.
Of course, lockdowns aren’t happening in all countries, and President Joe Biden ruled them out in his December 21, 2021 press conference as part of the United States’ fight against CVOID-19. In fact, the United States Centers for Disease Control and Prevention has recently loosened up protocols around COVID-19. For example, isolation times have been reduced from 10 days to five days. Because the U.S. population is the largest group of consumers in the world and one of the largest manufacturing countries, 2022 isn’t likely to be a repeat of 2020 or 2021.
While pandemic provisions may have worked to make inflation worse, stimulus is likely the biggest culprit in driving inflation. Stimulus usually has an inflationary effect on the economy so the Fed hopes that its tapering plans will help rein in some of the inflationary pressures.
However, inflation often starts with the commodity market, which can be good news for energy and materials investors. Crude oil rose through much of 2021 but recently turned lower. One reason for the recent downturn in oil is because it historically trades in a seasonal cycle. The cycle sees oil prices weaker from October to February, and then in February, oil prices tend to hit a bottom and strengthen through August. Of course, this historical tendency isn’t a guarantee of future results, but it is helpful to be aware of these cycles. And, while you may not have noticed the seasonality of crude prices, chances are you’ve noticed gas prices often rising as the Memorial Day weekend draws nearer, which is a phenomenon related to this cycle.
Money managers who think commodity prices are going to rise in 2022 may use the downcycle in oil to accumulate shares in energy companies. Analysts are mixed on where oil prices will be in 2022, but most are projecting higher prices. In June 2021, Bank or America analysts projected oil prices of $120 in 2022. In November, Barclays analysts weren’t as bullish on oil when they raised their 2022 oil price projection from $77 to $80, which was pretty close to the current price of oil at the time. A week later, J.P. Morgan analysts projected that oil could hit $150 per barrel in 2022 due to the lack of OPEC capacity to meet the demand.
Rising oil prices could be a benefit for oil company investors, but it could also result in the Fed having to raise rates faster and higher than it currently has planned. Therefore, the energy and financials sectors could have a strong year.
FIGURE 1: VALUING THE UNDERDOG. The S&P 500 Pure Growth Index ($SP500PG—candlesticks) has outperformed the S&P 500 (SPX—blue) and the S&P 500 Pure Value Index ($SP500PV—pink) over the last five years. Comparing the growth index to the value index using relative strength (green line), growth showed greater strength until 2021, but value stocks have started to gain strength. Data Source: FTSE Russell, S&P Dow Jones Indices, Nasdaq. Chart source: The thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.
Over the last year, value stocks as measured by the S&P 500 Pure Value Index ($SP500PV) have made a push by exhibiting greater strength when compared to growth in the S&P 500 Pure Growth Index ($SP500PG). While the battle has been back and forth, growth appears to be losing momentum to value stocks when comparing the two indices using the relative strength indicator.
Interest rates are a fundamental shift that’s pushing the value surge. Value stocks tend to perform better when interest rates are rising because of how a stock’s intrinsic value is calculated using fundamental analysis methods like the discounted future cash flows. The Fed has pushed interest rates lower over the last decade through the overnight rate and open market purchases. The lower interest rates have helped growth stocks perform well. The recent turn to an inflationary economy makes it harder for the Fed to keep rates low. This means value stocks could get that fundamental shift that value investors are looking for.
While it’s highly likely that interest rates will rise in 2022, as of today, the Fed has not made any rate hikes and has not announced any definite rate hikes in the immediate future. Of course, the money markets have driven longer yields higher, which are affecting valuation. But until the Fed actually starts raising rates, many investors may choose value stocks.
Additionally, even if the federal funds rate was to go up to the 0.90% the Fed is targeting, that point would still be historically low. We can get some context by spot-checking a little history. In 2019, the average rate was 2.16%. In 2000, the average rate was 6.24%. Clear back to the early ’80s, it was above 20%. The historical rate from the ’50s to today averages about 5%. So, with that perspective, there could still be room for growth stocks if interest rates rise.
Investors may get a better idea of growth versus value during the Q4earnings season, which kicks off in the middle of January when some of the biggest banks report. This earnings season could set the tone for January and the next few months as investors get a chance to see how well companies are managing the higher costs that come with inflation. Companies that have the ability to pass on the higher costs to their customers without hurting their sales too much will likely fare better. However, if you were to watch and see which companies are garnering the most investor attention after an earnings announcement, you may be able to determine if investors are favoring growth or value the most.
A new theme that will crop up in 2022 that we all hope we don’t see a lot of in January is the mid-term elections. The Democrats were able to “de facto” win all three houses in 2020 but have struggled to push through their policies because of small margins in the House and Senate, as well as intra-party differences.
A reason to pay attention to politics is because companies needing or benefiting from government initiatives may not get the funding they need or want because each spending bill is likely to be marred with intense debate and attention. A recent example is when President Biden failed to push through his Build Back Better (BBB) bill, which had provisions to help reduce the installation costs of solar panels by roughly 30%, according to the Natural Resources Defense Council. The MAC Global Solar Energy Stock Index fell 5.60% when news of the failing bill came out. Another casualty of the BBB bill failure was electric vehicle (EV) automakers that had $20 billion in tax credits for the purchase of EVs and funding for domestic manufacturing of battery plants.
One reason the BBB bill failed was inflation. Many citizens were concerned that the increased spending would further add to the inflation problem, especially because the spending would increase the national deficit. With so many people zeroed in on inflation and Washington, DC, it’s going to be harder to pass spending bills.
So, with the Fed cutting its bond-buying program and eyeballing rising interest rates and the executive and legislation branches unable to pass additional spending bills, companies hoping for stimulus or imitative spending are likely to struggle unless they can make their businesses a little more viable on their own or turn to the private markets for support.
The year 2022 has a lot of risks, and January is where it all kicks off. Inflation, interest rates, and elections all have the potential to move the market. However, investors can use the month of January to set themselves for the year, if they’re willing to do a little digging.