By William Watts
Who’s going to blink?
A big bounce by technology and other US growth stocks since late last week underlines a continued disconnect between the Federal Reserve’s message on interest rates and investor expectations, analysts said.
“We are now witnessing the biggest game of ‘Chicken’ between the Fed (who says rates are going to above 5%) and the market (who thinks the Fed cuts rates at least twice this year) that I’ve ever seen,” said Tom Essaye, founder of Sevens Report Research, in a Tuesday newsletter.
The tech-heavy Nasdaq Composite is up more than 8% so far in January, versus a 4.5% rise for the S&P 500 and a 1.7% rise for the more cyclically oriented Dow Jones Industrial Average. The Dow outperformed its major index peers in 2022, falling 8.8% versus a 19.4% drop for the S&P 500 and a 33% plunge for the Nasdaq.
Tech is rallying because the market expects the Fed to pivot on policy much sooner than officials are saying, Essaye said. Tech has historically outperformed in a declining interest-rate environment.
It was the rapid runup in interest rates in 2022 that was blamed for the shellacking suffered by tech and other growth shares. Rising rates can be particularly painful for growth stocks, whose valuations are based on expectations for cash flows far in the future. A rise in government bond yields means those future flows are discounted more aggressively by investors.
“For now, the market is telling you, via the outperformance in tech and fed-fund futures, that it believes the Fed will lower rates before year-end,” Essaye said. “If that happens, tech will have a good year. However, I want to point out that if the market isn’t right, then the amount tech can fall in disappointment just got larger.”
The Fed’s so-called dot plot forecast shows that policy makers expect the fed-funds rate, now at 4.25% to 4.5%, to peak above 5% and stay there, in contrast to fed-funds futures that has priced in the likelihood of cuts by year end.
Meanwhile, last year’s steep tech stock selloff has also provided fuel for the snapback in 2023, Essaye argued. Tech continues to underperform based on longer term measures. For instance, the Vanguard Growth exchange-traded fund (VUG) was down 18% over the past 12 months versus a 1.3% fall for the Vanguard Value ETF (VTV).
Now, either through natural declines in position sizing or actively reducing exposure, many managers and investors are now “underweight” tech compared to previous allocations, Essaye wrote. “So, this sudden burst of outperformance has extracted ‘FOMO’ (fear of missing out) from them and as such investors and managers are adding back tech exposure and pushing the space higher,” he said.
The market action looks familiar to Gargi Chaudhuri, head of iShares investment strategy for the Americas, at BlackRock.
“So far, price action in January 2023 bears an eerie resemblance to that in July 2022 when risk assets rallied and rates fell as investors bought into the idea of a ‘soft landing’ — the notion that slowing economic growth would slow inflation and obviate the need for further Fed rate hikes, the strategist said in a Tuesday note.
“That argument faded and price action reversed as the Fed held firm and went on to hike policy rates by 75 basis points in September. Fast forward to now, many investors once again seem convinced that inflation is all but beaten and that slower growth will not only obviate the need for further hikes, but even allow the Fed to cut rates before the end of the year,” Chaudhuri said.
BlackRock thinks investors are misreading the inflation outlook and ignoring consistent warnings from Fed officials.
“We expect inflation to stay persistently high and we take the Fed at its word that it remains committed to achieving its mandate of long-term price stability (which it defines as about 2% inflation) and raise rates to between 5-5.25%, Chaudhuri said. “We do not expect the Fed to ease this year, even as growth slows, making it likely that we will see a recession in the US in the second half of 2023.”
-William Watts
(END) Dow Jones Newswires
01-24-23 1626ET
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