Market resilience post first Fed rate hike
#Market Strategy — 11.04.2022

Market resilience post first Fed rate hike

US Equity Perspectives - April 2022

Alexis Tay, Senior Adviser, Equity Advisory Asia, BNP Paribas

What was behind the market rally?

  • The S&P 500 Index has rallied close to 10% since the March Federal Open Market Committee (FOMC) meeting, with notable outperformance by growth stocks against the backdrop of a much anticipated first 25bps rate hike.
  • We think the sharp bounce in the markets were due to a few factors, including oversold conditions, light positioning, depressed investor sentiment, and hopes around a potential ceasefire between Russia/Ukraine.
  • Growth stocks continued to rally despite the climb in government bond yields, leading us to believe that rate hikes may have mostly been priced in.

Near term recessionary risks may be overblown

  • Worries mount against a backdrop of slowing growth as yield curve spreads narrow and near inversion levels, but we think near-term recessionary risks may be overblown. And as Omicron cases peak globally, the global economy will enjoy tailwinds from re-opening. Easing geopolitical tensions should lead to some consolidation in commodity prices and remove worst-case-scenario growth impacts.

Earnings revision trend still suggests caution

  • Global earnings revisions continue to fall across all regions, and across most sectors. In the US, we begin to see more earnings downgrades vs. upgrades. Earnings upgrades are concentrated in select sectors including Energy, Banks, Materials, and Semiconductors.
  • The weakness in earnings revisions suggest caution for equities, but opportunities still exist in some cyclical sectors.
  • We adopt a barbell strategy of quality/defensive stocks, and selective cyclical plays as we maneuver the volatile equity markets.

Spotlight on Semiconductors

  • Despite supply chain fears due to the Russia/Ukraine conflict, major semiconductor companies’ recent commentaries have pointed to sufficient inventory in key materials to withstand the current disruptions, together with availability of alternate suppliers.
  • 4Q21 results were exemplary, with most companies in our coverage beating revenue expectations for 4Q21 report and 1Q22 outlook.
  • Though we are in the later part of the semiconductor cycle, due to stretched lead times, high order backlog and tight capacity, this peaking process is elongated and can continue for 2-3 more quarters. During this process, stocks are unlikely to make new highs and will likely range trade.
  • Our preference is for foundry, memory, compute and semiconductor equipment names. We are more cautious towards consumer-driven sectors  like smartphones and autos.

Market resilience post first rate hike

The S&P 500 Index has rallied close to 10% since the March FOMC, with notable outperformance by growth stocks (the Nasdaq Composite Index rallied ~13% during the same period).

The broad market rally was against the backdrop of a much anticipated first 25bps point hike by the Federal Reserve, even as the Fed’s forward guidance tilted to the hawkish side.

The Fed’s projection pointed to 7 rate hikes for 2022, with quantitative tightening (QT) likely starting in May. Adding to that, Fedspeak remains hawkish, with the committee ready to “hike more than 25 bps each time if needed”, and remains ready to tighten to above the neutral rate if the need arises.

Even more surprising is the ferocious rally in growth stocks, given Treasury yields continue to spike sharply (on the back of higher oil prices and amidst repricing of the short term rate hike path).

What was behind the market rally?

We think the sharp bounce in the markets were due to a few factors, including oversold conditions, light positioning, depressed investor sentiment, and hopes around a potential ceasefire between Russia/Ukraine.

Adding to that, growth stocks continued to rally despite the upward climb in government bond yields, leading us to believe that rate hikes may have mostly been priced in.

Consensus is already baking in high probabilities of 50bps hikes in May and June 2022, and an implied rate of 2.35% by year end. The next key event to watch being the size and speed of QT, which according to details released in the FOMC minutes, were largely in-line with consensus expectations. Inflationary pressures are expected to peak in 1H22, which if it does, will be another positive development for growth stocks.

What about a possible yield curve inversion?

Investors are worried against a backdrop of slowing growth as yield curve spreads narrow and near inversion levels. For example, the 10Y-2Y Treasury yield spread on 4 April 2022 was already inverted, at -7bps.

While we note that yield curve inversion (3M/10Y and 2Y/10Y) has historically been a good leading indicator of recession, both signals typically lead the onset of recession by 1.2 and 1.6 years respectively (See Chart 1). Moreover, 3M/10Y spread currently sits at ~180bps.

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While we may be transitioning to a late-cycle economy, near term recessionary risks may be overblown. In fact, US manufacturing and non-manufacturing PMI sits at 58.6 and 56.5 respectively (Feb 2022). Further, as Omicron cases peak globally, the global economy will enjoy tailwinds from re-opening. Easing geopolitical tensions should lead to some consolidation in commodity prices and remove worst-case-scenario growth impacts. 

However, earnings revisions are not yet at an inflection point

Global earnings revisions continue to fall across all regions, and across most sectors. In the US, we are beginning to see more earnings downgrades vs upgrades i.e. the earnings upgrade to downgrade ratio is now lower than one (See Chart 2).

Earnings upgrades are concentrated in select sectors including Energy, Banks, Materials, and Semiconductors, which appear to be benefitting from higher oil and commodity pries, higher rates and a chip shortage (See Charts 3 & 4).

The weakness in earnings revisions suggest caution for equities, but suggest opportunities still exist in some cyclical sectors - in particular, energy and semiconductors, where both three-month and one-month change in earnings revisions remain positive.

We will continue to adopt a barbell strategy of quality/defensive stocks, and selective tactical cyclical plays as we maneuver the volatile equity markets.

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Spotlight on Semiconductors

Supply chain impact from geopolitical tensions manageable

Given the Russia/Ukraine conflict, there have been concerns around supply chain disruptions for the semiconductor sector.

Of note, Ukraine is a major producer of gases required for semiconductor manufacturing (e.g. neon, argon, krypton, xenon). Amongst these, the spotlight has been on neon supply since a significant percentage (>50%) of the world’s neon gas is produced in Ukrainian factories.

Despite these fears, major semiconductor companies’ recent commentaries have pointed to sufficient inventory in key materials to withstand the current disruptions, together with availability of alternate suppliers.

In the case of neon gas, it is a by-product of steel manufacturing and is used in semiconductor lithography process as a source of laser. These lasers are made possible through the mixing of specific gases such as neon, fluorine, and argon, with neon accounting for >95% of such mixtures.

Ukraine currently dominates the global neon supply, but major steel companies have utilized their capacity to meet chipmakers’ order over the past 2-3 months. Companies generally communicated that there is “no severe shortage of neon gas” even without Ukraine’s supply in 2H22, as steel makers have strongly committed to utilize/expand their capacity to meet demand. This is consistent with Korean chipmakers’ notable sourcing shift from Ukraine to Asian countries.

As for materials like xenon/palladium, chipmakers seem to have less concern due to sufficient global supply ex-Ukraine/Russia.

4Q21 results – beat and raise

4Q21 results were exemplary, with most companies in our coverage beating revenue expectations for 4Q21 report and 1Q22 outlook, with the exception of semiconductor equipment companies, which missed due in part to component shortages.

Gross margins on the whole were also better than expected; a reflection of ASP (average selling price) increase for semis. We expect the combination of tight supply and ASP increases will continue to support gross margins throughout the year.

Where are we in the semis cycle?

Despite a strong showing in the recent results season and forward guidance, the question on many investors’ minds is the sustainability of revenue trends given the economically sensitive nature of the sector, against a background of rising macro concerns.

We do think that we are in the later part of the semiconductor cycle as inventories have bottomed and have been building from low levels, though inventory levels remain below trend. It is important to keep an eye on inventory levels as recovery to above-trend levels has historically foreshadowed the rolling over of the PHLX Semiconductor (SOX) Index.

Due to stretched lead times, high order backlog and tight capacity, this peaking process is elongated and can continue for 2-3 more quarters. During this process, stocks are unlikely to make new highs and will likely range trade.

This year, the SOX Index corrected ~25% peak to trough from its January highs to the mid-March bottom. After the rebound over the past weeks, we are trading at the middle of its one-year range (See Chart 5 & 6). We think there is a tactical opportunity, especially if the SOX Index consolidates in the coming sessions to the lower end of the trading range; but it is important to stay nimble and not forget to lock in profits on the way up. 

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Which are our preferred names and subsectors?

We continue to like foundry, memory, compute and semiconductor equipment names.

Semi equipment names remain beneficiaries of localized capex amid geopolitical uncertainty, and offers elevated medium term visibility, despite short term supply chain issues (which are transitory in nature). 

The outlook for key foundry players remains robust. The foundry market leader guided for close to 30% revenue growth for 2022 in the back of broad-based growth across segments. Lately amid the global equities sell off, the company’s executives had bought shares in the market, a sign that stocks may be oversold and undervalued. The second largest foundry player continues to focus on expanding its foundry business and indicated that yield rate at 5nm is better than expected. Further, the company sees the possibility of an earlier memory price rebound in 1H22.

We like Compute names given exposure to resilient capex driven by cloud, enterprise and telco infrastructure upgrades. The hybrid work/cloud environment is here to stay and is enhanced by new artificial intelligence/Metaverse workloads. Chipmakers providing building blocks of compute/AI, networking, security, and storage are well positioned. Meanwhile, valuation of cloud/enterprise exposed chip stocks are now trading at more attractive valuation levels.

Memory – capex growth remains disciplined amongst industry players, with an eye to maximize ROI (return on investment) and free cashflow return. A major memory player is guiding for better memory pricing from 2Q22. Cloud segment growth remains strong for memory.

We are more cautious towards consumer-driven sectors (which tend to be more cyclical) like smartphones and autos. The smartphone market appears the most vulnerable given the China smartphone overbuild and inventory overhang.