After a relatively calm holiday break, the first weeks of the year have already confirmed our assumption that 2022 would not be a “straight line”, to say the least. The latest weakness in quite a few markets, especially in the US, led to some technical support levels being broken, as some indexes fell below what were assumed to be price “floors”.

As January tends to be a robust month for risky assets, the retreat comes at an unusual point in time. The fact that many investors still have relatively long exposures or overweights likely explains part of the profit-taking. But the bigger issue may be that markets simply have too much to digest.

While market participants can take one problem at a time in their stride, they came back from the holidays to face several issues, including:

• A more hawkish Federal Reserve (Fed) narrative and the fiscal challenges in the US.
• Sabre-rattling in Ukraine. The prospect of war in Ukraine is understandably weighing on investors’ minds, and the probability of conflict may have worsened in recent days. But the market impact could be short-lived based on the experience of the Russia-Ukraine conflict in 2014, when equity indices recovered rapidly. This time, however, already-high commodity prices and bottlenecks could have a stronger economic impact on the European economy.
• Renewed tensions in China’s real estate market. Our base case remains that the Chinese government manages to control the timing of the real estate slowdown, but even so the probability of a bursting of the debt bubble has slightly increased.

Should investors buy the dip?

Should we fear a repeat of the 2018 market dive that saw US stocks drop 19%? Or is this just another short-lived correction and investors should “buy the dip”?

Despite what we are hearing in the press, it is not entirely true that the market has run out of breath. Indeed, while low-quality stocks have suffered, the equal-weighted US equity markets have remained pretty much aligned with the capital-weighted market. Remember as well that, based on past experience, a Fed rate hike “per se” is not always negative on stocks (see Exhibit 1). This is even less so for stocks outside the US. Since markets have been digesting Fed rate hikes for months, a lot of negativity should already be priced in.

Exhibit 1: US stocks have historically shrugged off Fed rate hikes within a year
Average S&P 500 Index returns during Fed rate-hike cycles (1986-2015)

Source: Bloomberg, Allianz Global Investors. Data as at 17 January 2022. All-time average performance based on rolling overlapping observation period; rate hike period performance based on mid-month observations (15th). Past performance is not indicative of future results.

But we could imagine a secondary scenario, where falling inflation later this year coincides with slower economic growth caused by the impact of earlier price rises on consumers. This may force the Fed to put its rate hikes on hold. Similarly, if inflation starts to impact wages and rents, the European Central Bank (ECB) could turn out to be surprisingly hawkish – resulting in higher or faster rate hikes than the markets expect. This would detract from our positive view on the US dollar.

Overall, however, we must recognise that the overall long-term environment of excess liquidity – with central banks greatly increasing the economy’s money supply – is morphing into a more hawkish, restrictive one. The fight against inflation will be the focus of the Fed’s attention for at least the coming month. As central banks tighten up the money supply, it will likely remove one of the pillars that have supported the strong performance of risky assets like stocks.

Strangely enough, the “good news” about Omicron’s rapid fading and relative lack of fatality could provide comfort to central banks in their new “reaction” function. So it will be a fine balance: good news from the trade logistics and supply chain front could be negated by stricter central bank policies.

Watch for earnings

All of this should encourage us to look even more carefully than in the past at earnings, especially as valuations remain stretched (especially in the US, although arguably less so in Europe and Japan). And here the picture could also start deteriorating as employment and commodity costs start biting into companies’ profit margins (see Exhibit 2).

This trend will likely affect smaller US companies that have trouble finding staff, while larger companies should continue to profit from the “oligopolisation” that has taken place over the last decade in many sectors of the economy. This should allow them to pass on some of the higher costs of producing their goods or services, even though this would be to the detriment of consumers.

Exhibit 2: employment and commodity costs could start shrinking profit margins
Net profit margins vs employment costs (1984-2022)

Source: Refinitiv Datastream, Allianz Global Investors. Data as at 18 January 2022.

What does this mean for asset allocation?

Investors should keep a calm head and observe the situation carefully. As the fundamental picture weakens, and the excess liquidity and support of central banks fades, the resilience of corporate earnings should be the key focus.

Considering the relative valuations, the US stockmarket might be a notch more affected than Europe or Japan. This differential is beginning to be reflected in the relative preference of our Multi Asset expert group.

We continue to support value stocks (whose prices appear to be lower than what the financials support) as opposed to growth stocks (which carry higher prices in exchange for the potential for more growth down the road). More to the point, we prefer cyclical value stocks in particular – those whose prices tend to move in tandem with the economy. And, despite a short-term topping-out, we continue to see valuations as attractive in the longer term (see Exhibit 3).

We expect US Treasuries to fall in value in the short term, as we still expect inflation to surprise on the upside. But with Fed interventions, we could pretty soon be in a position to be more positive about Treasuries if markets move ahead of themselves.

And finally, commodities continue to represent an attractive hedge in this environment if one considers that the inflation risk remains underestimated.

To summarise: agility will be required in the coming weeks.

Exhibit 3: value is still depressed in the long term, though prices may hit a “ceiling” in the short term
Performance of MSCI World Value vs MSCI World Growth stocks (1995-2021; indexed to 100)

Source: Bloomberg, Allianz Global Investors. Data as at 21 January 2022. Past performance is not indicative of future results.

The MSCI World Value Index captures large- and mid-cap securities exhibiting overall value-style characteristics across 23 developed-markets countries. The MSCI World Growth Index captures large- and mid-cap securities exhibiting overall growth-style characteristics across 23 developed-markets countries. The Standard & Poor’s 500 Composite Index (S&P 500) is an unmanaged index that is generally representative of the US stock market. Investors cannot invest directly in an index.

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