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Analysis: Fed tightening a sign to get the 'heck out' of US stocks

The US Federal Reserve building in Washington DC. Picture: REUTERS/Kevin Lamarque

The US Federal Reserve building in Washington DC. Picture: REUTERS/Kevin Lamarque

Published Jan 27, 2022


By Sujata Rao and Lewis Krauskopf

LONDON/NEW YORK Jan 26 (Reuters) - US stock markets, after enjoying their best three-year run in more than two decades, may soon have to cede the top spot.

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With the US Federal Reserve preparing to raise interest rates for the first time in almost four years, capital is starting to fan out of rate-sensitive US shares into other parts of the world where markets are cheaper and potentially more resilient.

The S&P 500's near 10% drop so far this year has surpassed losses on most non-US indices and some reckon that recent investment outflows from the market are only the beginning.

Goldman Sachs's analysis of eight Federal Reserve hiking cycles since 1975 appears to support that view.

The bank found European stocks outperformed US peers by four percentage points on average over six months following the first Fed rate increase.

It also observed a clear rotation into so-called value sectors such as banks and commodities which are better represented in European and emerging market equity benchmarks.

"What it means is get the heck out of the United States,"said Mike Kelly, head of global multi-asset at PineBridge Investments. "It's all about selling longer duration assets, so we are underexposed to US equities."

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Longer-duration stocks, in a nutshell, are those whose prices are driven by expectations of future earnings potential and therefore fare well when interest rates are low.

US tech companies with their exorbitant valuations as measured by their price-earnings ratios (PE) are a prime example and they account for over a third of the S&P 500.

For years, those stocks were an investment magnet, benefiting from rock-bottom interest rates and recently the pandemic time-shift to working, shopping and dining from home.

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Of the $1 trillion which flowed into stocks last year, US-dedicated funds took a third. They would also have received a lion's share of the near-$500 billion absorbed by global mandate funds, according to Deutsche Bank.

Now Kelly says, markets are at an inflection point, away from when "PE went higher and interest rates went lower".

Given that five mega-cap firms accounted for a third of the S&P 500 performance last year, unloved US sectors should also benefit from rotation.

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Martin Schulz, senior portfolio manager at Federated Hermes, said he went overweight international developed markets already last autumn, betting on a broad global economic recovery. "The cyclicality of the European markets, the Japanese markets... we think are going to be the big beneficiaries of this near-term globalised upturn."


Almost $6 billion fled US equities in the week to January 19, while Europe and emerging market funds absorbed $2.7 billion and $5.2 billion respectively, according to Bank of America.

Morgan Stanley strategist Graham Secker also cited internal data showing $5 billion outflows from US exchange traded equity funds (ETFs), while those focused on US domestic equities shed $8.5 billion. European stock ETFs gained $3.6 billion.

"We are detecting it qualitatively from investors around the globe, to shift a bit of weight from the US to elsewhere," said Secker.

Monday's rout rippled out globally, as European shares plunged 4% for their worst day since mid-2020 and emerging equities shed 2%. Yet they may be relatively better positioned to cope with tighter policy.

Europe trades at a 27% discount to Wall Street, compared to an average 15% discount before the previous three Fed cycles, Goldman Sachs estimates. And value shares overall are 50% cheaper than growth peers, double the discount seen before past rate rises.

Europe is also delivering more positive economic data surprises and upward earnings revisions than the US, Secker noted.


All markets will feel it when central banks slow the flow of cash, and depending on what the Fed does, the net supply of cash from the four big central banks may even shrink for the first time in years.

But this cycle differs in one respect from its last one: China, which hiked rates in 2018 alongside the US, is now easing policy to support its economy.

Easier Chinese policy will benefit other emerging economies and export-focused Europe via trade and commodity prices and could spell a 10% upside for Asian shares in 2022, JPMorgan wrote.

Kevin Mahn, chief investment officer at Hennion & Walsh Asset Management in New Jersey, remains bullish on US stocks but reckons other markets may soon start to shine as well.

"Perhaps they will start to experience some of the growth that we have seen in U.S. markets over the last three years," he added.


(Additional reporting by Danilo Masoni, Saikat Chatterjee and Marc Jones. Editing by Tomasz Janowski.)