In our last quarterly commentary, we discussed how a variety of factors were setting the market up for some year-end volatility, and indeed, a little volatility is what we got. In the last two weeks, markets fell by about 5% on fears of the Omicron variant and then bounced back as investors aggressively bought the dip. Despite the rapid spread of the latest COVID variant, the relatively mild illness associated with it has calmed market fears of a broader health and economic disruption, giving the green light to rally back. Nevertheless, a variety of factors remain percolating in the background that have the market still on alert.
Most prominent among these is the Federal Reserve’s recent pivot on monetary policy to reflect ongoing supply chain disruptions, inflation pressure, and rapid improvements in the labor market. Policy makers have indicated a willingness to unwind bond purchases faster than expected and eventually hike interest rates next year, a shift in stance that has caused the treasury curve to flatten, which in turn has caused reverberations elsewhere. Despite the hawkish pivot, treasury yields have remained quite subdued, with the 10-year yield still at just 1.5%. This could be interpreted as the market approving of the Fed’s willingness to respond to changing conditions on the ground rather than trying to force the Fed’s hand by pushing yields higher. It could also suggest that the Omicron variant may be sufficient to dent growth expectations even if some of the initial fears were overblown.
This volatility has driven quite a bit of dispersion in returns in recent weeks. Certain high growth and speculative pockets of the market have underperformed on the specter of rate hikes, while cyclical stocks such as industrials, energy, travel, and hospitality also remain off their highs. On the flipside, the FAANG group has broadly outperformed benefitting from a flight to quality bid. Apple, in particular, is up +16% in the last month as rumors of new products in the virtual reality space have caused some excitement. Semiconductors have also benefitted as pent-up demand and digital shifts from the COVID era transform the sector into a relatively safe play. So it’s not been as simple recently as tech versus cyclicals, as was largely the case for most of the pandemic. Now we are seeing the market enter a ‘shake-out’ phase where the real winners are differentiating themselves in the market.
These fundamental factors are now starting to coincide with year-end technical factors that have historically driven gains in the last few weeks of the year. Tax-loss selling typically runs its course by early December, which then has often set the market up to rally as the holiday season gets underway and volume declines. Not every year is the same of course, but this statistical factor could be another reason why investors so aggressively bought the dip a couple weeks ago.
Looking ahead to next year, we remain cautiously optimistic while recognizing the risks posed by the Fed’s shifting stance and continued supply chain challenges. So far, robust corporate earnings have been sufficient to keep valuations broadly in check, but they will need to continue to deliver next year to counteract the impacts of tighter monetary policy and higher input costs. The prospect of actually ‘turning the corner’ on COVID due to herd immunity is another factor to watch, as that could help build a fundamental floor on the market based on sustained demand. We’re watching all of these factors vigilantly and remain poised to react when volatility provides opportunities to add value in portfolios.
We welcome your comments and questions, and we wish you and your families well.