Tech rally on strong earnings ends volatile week

What happened?

Technology stocks led a sharp rally in US equities on Friday as focus shifted to strong corporate earnings and away from concerns about rising rates and geopolitical tensions.

Friday’s gains rounded off a volatile week. The S&P 500 closed up 2.4% on the day and 0.8% higher on the week, having been as much as 5% weaker at Monday’s low point. The index remains 7.6% below the record high set on 3 January. Technology stocks were the strongest sector. The S&P 500 IT sector gained 4.3% on Friday and the Nasdaq index finished 3.1% firmer, leaving it flat on the week but 13% down since 3 January.

All S&P 500 sectors rallied on Friday, except energy, which closed 0.6% weaker though it is up 5% on the week and 18.5% year-to-date. Earlier in the day, the Stoxx Europe 600 closed 1% weaker, for a 1.9% loss on the week, amid concerns about tensions in Ukraine. However, the index has outperformed US stocks this year, with losses of 5.8% since the recent high on 5 January. The weekend’s vote in Italy, which maintains the political status quo, could help Eurozone sentiment this week.

Fixed income markets were calmer on Friday, with 2-year US Treasury yields dipping 1.6 basis points and 10-year yields 2.5bps. Over the week, the US 2-year/10-year yield curve flattened from 75bps to 61bps, driven by a 15bps rise in 2-year yields and broadly flat 10-year yields.

The US dollar recorded its best weekly performance in seven months, with the DXY index gaining 1.8%. Brent crude rallied a further 2.4% on the week to finish just above USD 90/bbl, the highest since October 2014. Gold fell 2.3% on the week to close at USD 1,791/oz.

A key driver for Friday’s rally was a strong 4Q earnings release from Apple, with the iPhone maker reporting record sales for the quarter. The company also offered a better-than-expected outlook on easing supply chain constraints. Its shares rallied 7%. US economic data also helped allay concerns about more aggressive tightening by the Federal Reserve. The Employment Cost Index for 4Q21, which is closely followed by the Fed, rose 1%—less than expectations for a 1.2% rise and down from the 1.5% gain in 3Q21. US consumer spending fell 0.6% in December after a 0.4% rise in November, while the core PCE deflator gained 0.5% in December, after a similar rise in November.

This week investors will be looking for further information on the strength of the US economy and the impact of the recent omicron wave from January’s ISM manufacturing and services indexes, the non-farm payrolls report, and a still-busy week of earnings reports.

How do we interpret this?

Friday’s better performance by equities is in line with our base case scenario that the negative impact of Fed tightening in 2022 will be more than offset by continued corporate earnings growth.

Markets are now pricing between four and five rate hikes this year, with the first move in March. We do not think this amount of rate hikes would derail economic growth. We forecast only a modest further rise in US 10-year yields—to 2% by June and 2.1% by the end of the year. Our base case for the Russia-Ukraine situation is for an eventual stabilization and easing of tensions. Read the full scenario analysis in our?Global Risk Radar?publication “What do geopolitical tensions in Eastern Europe mean for global markets?” published 25 January. Against this backdrop, we expect a recovery in S&P 500 valuation multiples to 20x 12-month forward earnings and continued earnings growth. Altogether, our base case scenario would imply a year-end 2022 target of 5,100 for the S&P 500.

A bull case may seem hard to envisage at such a turbulent time for equity markets, but if inflation starts to retreat, markets could go back to viewing the Fed as flexible and responsive to financial conditions. Historically, markets have performed well during hiking cycles if growth remains robust. In this more benign scenario, we would expect the S&P 500 to finish the year at 5,300.

Technology stocks have led the sell-off in recent weeks. Further declines remain possible as government bond yields rise. Our analysis of the global tech sector suggests that a further derating of 6–8% is possible based on rate considerations alone (assuming US real rates move toward zero from current levels of –0.68%). This would put the sector on a forward price-to-earnings (P/E) multiple of 22x (from 23.6x currently), which we would consider attractive. But the sharp fall in many high-quality tech firms is already creating opportunities for longer-term investors to add exposure. Rather than giving up on tech in the face of near-term headwinds, we recommend a more selective approach: balancing away from mega-caps toward companies exposed to artificial intelligence, big data, and cybersecurity—the ABCs of tech—which we see as benefiting most from secular growth.

What should investors do?

Investors will continue to grapple with higher rate expectations and geopolitical risks on one side, set against robust macroeconomic and corporate fundamentals on the other. As a result, volatile trading looks set to continue, which can leave investors reluctant to commit capital until further clarity emerges, or worse, panic-sell. A financial plan, such as our UBS Wealth Way framework, can help investors stay disciplined in times of volatility.

We recommend investors take the following actions:

• Take advantage of tech volatility.?Higher yields as we have seen can hurt tech stocks. But as noted above, we now see select opportunities emerging in beaten-down tech stocks. Investors can use structured investments to earn a yield with the potential to buy on dips. Our preferred thematic opportunities include the ABCs of tech and 5G.
• Buy the winners from global growth.?Despite market volatility, underlying economic growth is likely to stay robust in the first half, supporting cyclicals. Eurozone equities benefit from undemanding relative valuations, and we also prefer energy stocks and commodities. The latter could also be an attractive hedge against geopolitical risk.
• Prepare for rising rates.?In preparation for rate hikes, investors can seek opportunities in areas like financials, value strategies, senior loans, and hedge funds.
• Build up some defense.?With volatility set to continue, we think cyclicals should also be balanced with more defensive exposure. We currently like the relatively cheap global healthcare sector, where the defensive pharma subsector is currently trading at a 18% discount to the global index, close to 20-year lows. We also like dividend stocks, structured investments, and dynamic asset allocation strategies, with the latter helping to smooth overall portfolio returns.
• Position for a stronger dollar.?We think tighter Fed policy and reduced US fiscal stimulus will support the US dollar. More broadly, we expect appreciation for currencies exposed to tightening monetary policies, including the USD, GBP, NOK, and NZD, relative to those still bound to relatively loose policies, including the CHF, EUR, and SEK. A stronger USD could also hurt gold.
• Position for the net-zero carbon transition.?The energy transition is one of the key macroeconomic trends of the decade. Investing in traditional commodities and commodity producers, alongside greentech, is a diversified, realistic way to navigate the volatility created by the trend toward net-zero.

Originally published as a CIO Alert by Mark Haefele, Chief Investment Officer, UBS Global Wealth Management

Ubs.com/cio-disclaimer

UBS Wealth Way is an approach incorporating Liquidity. Longevity. Legacy. strategies that UBS Financial Services Inc. and our Financial Advisors can use to assist clients in exploring and pursuing their wealth management needs and goals over different timeframes. This approach is not a promise or guarantee that wealth, or any financial results, can or will be achieved. All investments involve the risk of loss, including the risk of loss of the entire investment.

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