S&P500 prospects in 2022

AFTER a stellar performance for 2021 with 26.9 per cent full-year returns, the S&P500 (SPX) started this year tumbling 7.5 per cent to a low of US$4,410 on Jan 24. The movement broke past its 200-day moving average, which was not seen since March of 2020 when Covid-19 hit American soil. The dip also saw the index break out from its ascending channel, finding support around the US$4,290 levels that could be traced back to September and October last year.

But the decline in the SPX fell short of a correction territory criterion (which typically sees the index fall by more than 10 per cent), unlike the Nasdaq 100 index (NDX), which dropped 15.9 per cent to a low of US$13,724 on Jan 24. Investors can attribute this to the difference in components of both indexes. The SPX consists of 500 companies representing diverse sectors - in contrast to the 100 companies of the NDX, which are mainly technological sectors.

What caused the decline?

Several reasons could have been used to explain the decline but the main attributed factor was a hawkish US Federal Reserve (Fed). It was exactly a year ago (January 2021) when the Fed was advocating that inflation would be transitory while continuing to pump liquidity into the market through its bond-buying programme and almost zero interest rates. Back then, the Fed said it was only expected to make its first rate hike by the end of 2023.

Fast forward one year, the Fed's chair Jerome Powell turned around and shifted to a more hawkish stance to stop its bond-buying programme, hike interest rates by at least 3 times or more and possibly reduce its balance sheet.

Upon the release of the news, the US 10-year Treasury yield, which is used as a proxy for mortgage rates, rose 24.5 per cent since the start of this year to a high of 1.883 on Jan 19. The move was more evident when looking at the US 2-year Treasury yield, which spiked 67 per cent since the start of this year to a high of 1.2280 on Jan 28.

This faster appreciation narrowed the spreads between the US 10-year and 2-year yields, creating an inverted yield curve. The spread is one of the most reliable leading indicators of a recession within the following year when it falls to zero, and has been eerily proven right for 2020, 2007 and 2001.

Currently the spread (between 10-year and 2-year Treasury yields) has fallen to 0.63 from its March 2021 high of 1.58.

The current high-interest-rate environment has posed a headwind, especially for growth stocks, due to a higher discounting rate used for valuation, higher borrowing costs for expansion and reduced consumer spending resulting in lower potential earnings. We therefore saw a rotation from investors out of technological stocks into cyclical and financials, explaining a larger decline in the NDX as compared with the SPX. Companies with negative earnings were also affected much more as they would have to work doubly hard to maintain their valuations.

Other potential market catalysts?

Apart from a hawkish Fed, the geopolitical and structural landscape coupled with the never-ending Covid-19 virus continue to trouble investors and could serve as potential catalysts for market movements. The Russia-Ukraine conflict has caused WTI oil prices to rise over US$90 a barrel, with analysts expecting a break above US$100. Higher oil prices, as a key contributor of inflation, would lead to a further decline in the financial markets. Supply chain bottlenecks will also continue to persist; they do not seem to be easing anytime soon as there is too much money chasing too few goods.

The effects of Covid-19 have persisted for the third year (and are on-going). They has yet to subside, with cases steadily increasing in the European region and some parts of the US. Border openings remain susceptible to closure.

Where do we go from here?

The year started on a bad footing for the US financial markets as over-valuation and rising interest rates hammered many stocks leading to a decline in the index.

As we move into the year, more volatility could be expected with range-bound trading between the ascending channel. Analysts also expect more than 3 interest-rate hikes, with some expecting as many as 6 hikes this year.

• The writer is strategist at Phillip Nova