The chart below contains the story of the sudden shift in the investor consensus on interest rate increases and the consequent rise in risk asset volatility. Inflation has not proved to be transitory, rising persistently through 2021, and finishing the year at close to 40 year highs in the U.S. Supply chain disruptions and continued commodity price gains have lasted longer than expected, or really hoped for, by the Federal Reserve. Persistently high goods inflation has now started to be transmitted to the more sticky price categories of rents and wages. The result – 40 year high inflation, virtual full employment, and strong consumer demand, all present with the Fed still busy winding down its bond buying programme and interest rates at levels consistent with a full blown economic crisis. Very simply, the graph below shows the Fed is way behind the curve with real interest rates at the lowest level since the 1970’s. The market is being jolted out of its complacent expectations of infinite liquidity and forever low interest rates.

Source: Strategas Research Partners

Bond investors have been quick off the mark this year to reprice their expectations for rate increases in 2022 and 2023. The first chart below shows that global negative yielding debt continues to decline, and we have surely witnessed the peak in this cycle back in Q4 2020. This interest rate story is not just confined to the special situation in the U.S. The second pair of charts below show that Swiss yields have finally turned positive for the first time since 2018, and German yields are about to follow for the first time since 2019.

Source: Strategas Research Partners

Source: Bloomberg Finance

We have provided ample detail in previous writings on how persistently high inflation has a negative impact on company valuations primarily through the path of higher interest rates. The chart below shows the forward short-term returns (up to 1 year) for U.S. equities based on history when inflation has been in the range of current readings. Very simply, forward returns are almost half what could be expected in a more normal inflation environment.

Source: Strategas Research Partners

Many investors would be content with lower positive returns given the strength of the market over the past few years. However, the forecasted returns in the above chart do not adjust for the valuation level from which we are starting this normalization process. An extended period of excess monetary liquidity and zero interest rates have created the conditions in which excess valuations have been accepted and even viewed as a sign of company superiority to some. The chart below shows that even after a sizeable correction to the vast majority of the most expensive stocks in the market over the last year, valuation levels as measured by price relative to sales remains at levels above the 2000 internet bubble. Should interest rates continue to rise, the valuation normalization process still has some way to go and will be particularly painful for certain segments of the market.

Source: Strategas Research Partners

The internal strength of the Nasdaq, home to the majority of overvalued growth darlings, has been in decline for sometime. All new highs in the index since June of last year have been supported by fewer and fewer stocks in an uptrend (first chart below). The largets names in the index have been carrying it and hiding the underlying weakening condition. However, despite this underlying deterioration, investors appear still addicted to the past returns of the index as inflows have been and remain at historically extreme levels (second chart below). Stretched valuation and extreme positioning are not a great place to start the normailsation process as rates rise.

Source: Bloomberg Finance

Source: Bloomberg Finance

The first chart below is interesting as it shows the market rotation out of the most expensive stocks into the more reasonably valued stocks is well advanced in the smaller stock segment of the market. Value stocks have been outperforming Growth stocks in the Russell 2000 (smaller 2000 U.S. companies) since the beginning of last year. However, Growth investors have so far remained loyal to the largest names which have continued to outperform up until the end of 2021. There has been a sharp reversal so far in January and it would be extremely strange for these two lines (relative performance of large and small companies) not to converge in the short-term. The second chart below shows the same January reversal in the performance of Value stocks in Europe. Also interesting is that despite the more stringent lock-down measures adopted in many European countries during the past few months, Value stocks never made new relative lows against the more expensive names – a standard feature of previous lock-downs.

Source: Bloomberg Finance

Source: Bloomberg Finance

In summary, we do expect that rates will continue to rise and will lead investors to place a greater emphasis on company fundamentals and valuations versus the recent tendency to purely focus on price momentum. If so, investors would do well to avoid those markets and sectors most at risk of a significant valuation derating. Within this context, the chart below would seem to favour exposure to European equities, particularly UK stocks, over the U.S. where valuation measures have become most stretched.

Source: Bloomberg Finance