Focus on fundamentals not short-term flows

The S&P 500 fell 3.3% last week, erasing January’s gains to finish the month down 1.1%, the worst start to a year since 2016. Volatility spiked, with the VIX rising 11 points to 33 last week, the biggest weekly increase since June 2020, when the second wave of COVID-19 infections hit the US.

Risk-off sentiment has been driven by a number of factors, including the spread of new variants of the coronavirus, delays to vaccination rollouts, uncertainty over the timing and size of further US fiscal stimulus, and concerns over bubble-like market conditions. Near-term market dynamics have been further complicated by a coordinated short squeeze led by retail traders in heavily shorted stocks.

At the end of a turbulent week, we make the following observations about the outlook:

Volatility reflects market positioning, not growth worries The S&P 500 was down 1.9% on Friday, but the yield on US 10-year Treasuries rose 4 bps, led by breakeven inflation rates and commodities rising. This is not consistent with a growth scare, but it is with repositioning within equities after big moves in recent months. At the end of January, the S&P 500 remained 13.6% higher since the end of October and was up 66% from the March 2020 lows.

Repositioning flows dominated the news headlines last week. Socialmedia- driven retail buying prompted a squeeze on short positions in heavily shorted individual stocks, generating broader offsetting sales as investors covered positions. Many institutions have been adjusting their books to account for the risks to short positions arising from this coordinated retail buying. But given the speed and magnitude of flows in recent days, we think most of the pressure is now behind us.

Overall, we maintain our view that a diversified portfolio of equity longshort funds should perform well in the months ahead and expect the current setback to be temporary. More broadly, recent events re-emphasize our opinion that the best way to diversify with hedge funds is through a portfolio that is well-balanced across a range of individual funds, strategies and styles.

In addition, while some price movements in individual stocks last week appear difficult to justify based on fundamentals, the broader sector rotation behind the trend has been going on since the first positive vaccine news in early November. Investors rotated away from the stay-at-home beneficiaries of 2020 into the pandemic’s laggards and more cyclically exposed areas. We believe this trend has further to run. In particular, we highlight opportunities in emerging market stocks, led by China, and global small-caps, which are more economically sensitive than US large-caps. Read more here.

Vaccine headlines are noisy, but efforts to contain the COVID-19 pandemic appear to be progressing. Case counts in South Africa, the US, the UK, and Israel have started to fall, reducing stress on hospitals. Meanwhile, restrictions in the US could be loosened further in the coming weeks, due to the falling case counts and an accelerating vaccine rollout. Early last week, California Governor Newsom ended strict stay-at-home orders throughout affected parts of the state, and on Friday New York Governor Cuomo announced that indoor dining at 25% capacity can resume in New York City on 14 February.

In addition, although vaccine production has started more slowly than we had assumed globally, the major developers have been raising their output targets for the year. Pfizer recently increased its 2021 target from 1.3bn to 2bn doses, and said the slowdown in deliveries to Europe is due to a scaling up of facilities. Meanwhile, Moderna has raised the low end of its target range from 500m to 600m.

At the end of last week, results for JNJ’s single-shot vaccine showed that it reduced moderate or severe COVID-19 by an average 66% in a key phase 3 trial. These figures are also lower than the efficacy figures for the Pfizer/BioNTech and Moderna vaccines. But, importantly, severe disease was reduced by 85%, and the vaccine showed a 100% reduction of hospitalization and death across all regions.

Earnings and economic data have been encouraging. With 52% of S&P 500 companies having reported fourth quarter earnings, 88% have beaten profit expectations by 20% in aggregate. Globally, economic data has continued to surpass expectations, with the Citi Global Surprise index at +82 up from -79 at the peak of COVID-19 concern in April last year. In China, which is leading the recovery, we expect GDP growth to increase by 8% this year, and in the US we expect it to exceed 6%.

Fiscal and monetary policies remain supportive. Fed chair Jerome Powell last week provided further reassurance to investors, saying “the whole focus on exit is premature.” Powell also pushed back on worries that ultra-accommodative monetary policy might be contributing to bubbles, describing financial risks as “moderate.” On the fiscal side, while we expect Congress to scale back Biden’s proposed USD1.9tr stimulus package, and partisan conflict will delay approval, we continue to expect a fiscal package to be approved over coming weeks, of sufficient size to support growth and the earnings recovery.

So, while positioning and flows can add to near-term volatility, they are not the fundamental drivers of the markets over the medium term. As detailed above, the macroeconomic policy and earnings outlook, set against a backdrop of widening vaccination efforts points to further equity upside. We retain a risk-on stance and recommend investors use volatility as an opportunity to add medium-term exposure to risk assets. Read more here on easing into markets.

Mark Haefele

UBS AG