US Treasuries suffered a massive sell-off after Powell issued a hawkish signal, with the yield on the five-year note jumping 21 basis points in four days, the biggest year-on-year increase in 20 years. The situation worsened after the release of non-farm data on Friday. Although only 199,000 non-farm payrolls were added in December, far less than expected 450,000, the actual situation is not so bad. The unemployment rate continued to fall to 3.9%, the lowest since February 2020, almost near the Fed’s target unemployment rate of 3.5%, the pre-pandemic level. Meanwhile, the average hourly wage rose 4.7% year-on-year and 0.6% month-on-month.
As the Fed hinted that it would cut pandemic stimulus measures and raise interest rates more aggressively this year, and US bond yields soared, investors sold shares of companies with high valuations and uncertain profit prospects, turning to value and cyclical stocks that will benefit from the economic recovery. The share prices of technology stocks and other high-growth companies have been particularly affected by higher bond yields, which means that higher debt costs could hamper cash flow growth. The recent data shows that hedge funds are selling growth technology stocks at their fastest pace in more than a decade. The technology-heavy Nasdaq composite index fell 4.5% in the first week of 2022, underperforming the S&P 500.
The start of 2022 looks a lot like 2021. At that time, driven by strong taper expectations, US bond yields soared, the global market set off a bloodshed, and a crazy rotation switch kicked off. This year, deja vu is happening again. Global bonds collapsed, expensive technology stocks were sold off sharply, and value strategies began to advance by leaps and bounds, as the Federal Reserve sends a signal to speed up monetary tightening. This week inflation-adjusted bond yields rose the most since March 2020.
Nasdaq fell 4.5%, the biggest drop since February. The Dow Jones industrial average, which is dominated by traditional companies, fell just 0.3%.
Looking back at the market trend last year, this scene seems to be a flash in the pan. Under the background of the resurgence of the COVID-19 epidemic and the supply chain crisis disrupting the global economic recovery, US bond yields began to fall, and tracks with bright prospects such as new energy, semiconductors and high technology have regained popularity.
But this year, the situation seems to have changed. The Federal Reserve is becoming more and more determined to fight inflation. No longer cling to the temporary rhetoric of inflation, interest rate hikes are close at hand. The Fed also discussed the shrinking of its almost $9trn balance sheet, which grew rapidly during the pandemic. So not just tapering, even shrinking the balance sheet is on the agenda, and there is growing confidence that the shift is likely to continue. The market has reassessed the risk of monetary tightening.
Real interest rates in the US remained stubbornly low at the beginning of last year, even as the Federal Reserve began to hint at a scaling back of its bond-buying program, but real interest rates have been rising this week. This sell-off is based on real interest rates, which tends to trigger a reaction from the stock market. This is not a one or two-day shift but may be the beginning of a 6-12-month shift from growth to value stocks.
Can the global stock market still take the lead in 2022 over bonds? We believe so. As the Federal Reserve tightens monetary policy, US sovereign bond interest rates will rise in 2022 with interest rate increases expected, and 10-year bond rates may reach 2% by the end of 2022. However, real interest rates will remain negative, meaning that real bond yields will remain negative, or will continue to support the performance of risky assets such as stock markets.
Compared with growth stocks, value stocks tend to be more cyclical and provide stable dividends. Just a month ago, global value stocks were valued at their lowest relative to growth stocks since 2000. Although the gap has narrowed slightly since then, the huge gap still makes internal stock market volatility more sensitive to bond movements.
In 2021, the excess return of the market will come from earnings. In 2022, more of the excess return of the market could come from valuation repair. Analysts argue that the essence of ROE (Return on Equity) or G (Growth) lies in differences over the future market risk adjustment.
In 2022, investors should focus on high-growth and high-margin stocks and avoid companies that are more affected by wage inflation. Most active fund managers missed the stock market’s “excellence” 2021. Some may point out that these fund managers did not find good investment opportunities last year because volatility and market breadth were lower than the historical average. From a profit point of view, a slowdown in economic growth will limit the sales growth of many companies. Therefore, when observed through the profit margin channel, the difference in stock returns will be the most obvious. Be aware of rising input costs and labour inflation will put pressure on some companies’ profit margins. Stocks with high labour cost ratios and affected by wage inflation may underperform. Companies with low labour costs such as Apple, Netflix, Coca-Cola, PayPal etc.
Warren Buffett’s famous warning about how inflation discourages companies from investing, erodes the value of future earnings, and results in negative real returns for investors. Berkshire Hathaway got off to a good start to the new year as investors continued to shift from high-growth stocks to safer investments. Thus, its shares rose nearly 7% in the first trading week of the year, with a market capitalization of more than $700 billion. It still trades on 8.6x price to earnings ratio. Its top 10 holdings can easily be searched on the internet. Apple Inc. is its second largest holdings after Bank of America. It is also the third largest shareholder of Apple Inc. Berkshire is potentially pathing its way steadily to be the next company to hit a trillion-dollar market capitalization, joining companies such as Tesla, Inc., Amazon.Com Inc., Microsoft Corp, Alphabet and Apple Inc. Berkshire Hathaway’s shares rose 30% in 2021, slightly higher than the 27% rise in the S&P 500. It is one of the very good examples of value investing.
Even though the auto industry was greatly affected by the “chip shortage”, Tesla was still the winner, with 936,000 cars delivered for the whole of 2021, an increase of about 87% over the previous year. At the same time, Tesla has said many times that it expects the delivery to grow by 50% each year for many years to come. We all know the demand for Tesla cars is far more than its current manufacturing capacity. The new giga plants in Belin and Texas as well as the expansion of Shanghai giga plant are speeding up the capacity increase in the coming year. Tesla has demonstrated its scalability, excellent execution and operating efficiency.
On January 8, Tesla announced that the price of Tesla’s fully autopilot system (FSD) will rise to $12,000 on January 17, an increase of $2,000 from the current price. This is after a broader price increase across their various EV models. Tesla’s software services have brought in $900 million in revenue in the third quarter of last year. The operating speed of Tesla in the fourth quarter shows that the consensus in 2022 might be too low. Tesla’ s profit margin is also likely to rise sharply in this quarter.
Valuation: Tesla’s forward earnings multiple of 128.7 is more than six times higher than the S&P 500 as a whole, making Tesla stock look extremely overvalued. Looking ahead to the next four quarters, the S&P 500’s forward PE ratio looks much more reasonable at just 21.3. Tesla’s forward PE ratio is about four times as high as its consumer discretionary sector peers, averaging a 31.1 forward earnings multiple. Yet when it comes to evaluating a stock, earnings are not everything. The growth rate is also critical for companies that are rapidly building their bottom lines. The price-to-earnings-to-growth ratio (PEG) is a good way to incorporate growth rates into the evaluation process. The S&P 500’s overall PEG is currently about 1; Tesla’s PEG is 4.8. It is a huge valuation justification at nearly five times the overall market average. If Tesla continues to deliver 50% of annual compound growth in the coming many years as per the company guidance, its valuation is expected to continue to stay high.
China experienced a major sell-off in tech stocks in 2021 due to regulations imposed by Beijing, targeting internet monopolies and data security. As companies adjust their business models to comply with new cybersecurity laws and anti-monopoly regulations, monetisation opportunities will recede while putting pressure on earnings.
The technology sector may have enjoyed short term momentum last year, but we remain cautious about Chinese technology stocks. We believe regulatory risk will remain a key overhang for Chinese technology stocks in 2022, despite their attractive valuation. Companies are pivoting to self-regulating to avoid regulatory consequences, which itself will add costs and affect margins in the medium term. Not be surprised if there are potential earnings downgrades for the sector in the 1Q22 earnings season.
Meanwhile, we are still cautious on the real estate sector, as Beijing is determined to continue with sector deleveraging and is ushering in a period of property developer consolidation.
From a macro perspective, the political agenda and a COVID-19 exit will be important for a positive view on China. While the focus of regulation in 2022 will shift towards policy implementation and enforcement, details of many new regulations need to be clarified. China equities will still struggle this year amid regulatory uncertainty and shocks to the property sector. The recent across-the-board reserve cut by the people’s Bank of China may help reduce borrowing costs and offset the economic slowdown. In response to downward pressure on the economy, China may increase its fiscal stimulus measures. While the reserve requirement ratio (RRR) cut represents an easing of the stringent policy stance, a genuine recovery in Chinese risk assets will require a fairly forceful policy shift.
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