Technicals, not fundamentals, driving US equity rally

It has been a strong start to the year for almost all asset classes, as China’s unexpectedly rapid reopening, improving Eurozone growth prospects amid a warm winter, and signs of resilience in the US labor market have helped buoy risk sentiment.

The S&P 500 is up 4.7% so far this month, on track for its best January performance since 2019. Meanwhile, the VIX measure of equity volatility fell below 18 last week, its lowest in a year. Many of last year’s big losers, such as tech and cyclical sectors, are now leading the rally in equities. US large-cap growth stocks are up 8.7%, and emerging market equities have rallied 9.2%. In other asset classes, long-end Treasuries are up 5.7% on speculation that the Federal Reserve is close to the end of its rate hike cycle.

But we think technical factors are also likely to have provided tailwinds for the rally. This might have important implications for investors.

Investors were lightly positioned in risk assets at the start of the year. A few months ago, the global economic outlook was grim with many investors expecting global recession. China was persisting with its zero-COVID policy, Europe was bracing for an energy crisis heading into winter, and the Fed was warning of further rate increases due to stubbornly high wage growth. As a result, many investors were lightly positioned in risk assets at the start of 2023.

That has started to change. Systematic strategies are adding risk, while hedge funds are not just covering shorts, but starting to add new longs. The put-call ratio on S&P 500 index options has climbed significantly since November, an indication of more hedging of new positions, which is consistent with an increase in net longs in S&P 500 futures. This change in positioning has supported equities.

Purchases of single stocks by retail investors have helped to offset the wider outflows from ETFs. But a closer analysis of the bounce in risk assets reveals a different underlying picture: US equity ETFs have actually seen retail outflows, most notably from tech, growth, and Nasdaq ETFs. This stands in stark contrast to heavy equity ETF inflows at the start of 2021 and 2022, and also contrasts with the recent inflows seen going into European and emerging market funds.

This is because the decline in inflows into US ETFs have been masked by retail buying of single name stocks in January, a repeat of the phenomenon witnessed two years ago. As a result, this has lifted the NYSE FANG+ index by 16% YTD, giving the impression of a strong rally in growth stocks.

Rate hikes have reignited a preference for carry trades. Aggressive rate hikes of 425bps by the Fed last year have left nominal yields at relatively high levels. As such, carry trades appear attractive with yields now ranging from mid- to high-single digits for the first time in years, versus equities with significant earnings risk.

This has resulted in increased demand for such trades. An estimated USD 100bn has gone into US money market funds, while USD 50bn has flowed into fixed income funds with 40% going into investment grade and high-yield corporate bond funds. Investors have also been picking up long-duration assets—which is as much about hedging as it is about yield—as concern shifts from inflation to growth risks. All these have combined to give the impression of a turnaround in risk sentiment.

So, as we think that technical factors may have played a large role in the market performance so far this year, we expect this to eventually wane as fundamental factors resume the dominant position as market drivers. Therefore, we advise investors to be cautious of those assets that were the biggest beneficiaries of such flows, like growth and tech equities. We are also least preferred on the US over the near term, and we advise investors with strategic overexposure to the US to diversify. By contrast, we expect emerging market and German equities to be among the main early beneficiaries from an inflection point in global growth in 2023.

Read more in our recent blog, “What's going on? Tallying the technicals” (published 30 January 2023).