Why 2022 Could Be Another Good Year for Equity Markets
January 11, 2022
We wish you a happy and wealthy 2022!
It’s 2022 and right on time we’ve entered a new phase of the cycle, with central banks in most developed markets turning more hawkish in the past month. How much does this matter for risk assets? Our view is that, if economic growth continues to be strong (which we think it will) and provided that central banks don’t over tighten (which we also don’t think they will as inflation pressure will come down in coming months), the recent hawkishness could increase market volatility and cause short-term corrections. Still, it does not undermine the positive case for equities over the next 12 months. Therefore, we remain bullish on global equities.
Global Economic Growth to Surprise to the Upside
Economic growth is likely to continue to be well above trend for the next two years driven by developed economy consumers spending some of the $5 trillion excess savings they have accumulated, and by the unprecedented wealth effect from rising stocks, crypto, and house prices. In addition, companies will do their part via strong capital investments that increase capacity to meet this rising consumer demand.
U.S. households are sitting on $2.3 trillion in excess savings. Around half of these savings will be spent over the next few years, helping to drive demand. Households in Europe, Japan, and Australia are also sitting on large amounts of liquid assets.
The Bloomberg consensus is for real GDP to rise by 3.9% in the G7 countries in 2022, well above the OECD’s estimate of long-term trend G7 growth of 1.4%. Global corporate earnings are expected to increase by 7.1%. Our sense is that both economic growth and earnings could surprise to the upside in 2022.
Given these expectations, it is hardly surprising that the Fed wants to accelerate the rate at which it tightens monetary policy. In the past, the first Fed hike in a cycle has often triggered a mild short-term sell off in stocks but the equity markets typically digest the news rapidly, quickly resuming its upward trend as the Fed continued to tighten. Only when Fed tightening leads to a major slowdown in economic growth (a.k.a. a recession) do we tend to see a major correction in risk assets.
Inflation is Likely to Cool Off
Overtightening would occur only if the Fed is rushed into further rate hikes because inflation surprises even more to the upside. Our view remains that inflation will likely decline this year. The high inflation prints we are seeing now are mostly the result of exceptional demand for consumer manufactured goods, which the supply side has temporarily been unable to fulfill, causing shortages.
We expect headline inflation numbers to come down in the coming months, partly because of the statistical base effect – headline inflation is 12 months backward-looking and some of the price pressure started to show up early in 2021. This means that the rate of growth will slow.
Another reason is that headline inflation was mostly driven by rising consumer goods prices. When prices of goods keep rising, at a certain moment suppliers will find a way to increase supply to profit from this, thereby moderating further price rises.
That said, the year-on-year inflation number will continue to look scary for some time. The risks to inflation remain to the upside, particularly if wages respond to higher prices, causing companies to raise prices further, triggering a price-wage spiral.
Last year the Fed said they expected inflation to be transitory. They changed their tone last month – the message from the December Federal Open Market Committee (FOMC) meeting minutes is that the US Federal Reserve is preparing to accelerate the withdrawal of monetary policy accommodation, highlighting the risk of persistent inflationary pressures and the impact on inflation expectations.
There is little doubt that central banks, including the Federal Reserve, are looking to dial back monetary stimulus. However, there is a big difference between tighter monetary policy and tight policy.
Even if the FOMC were to raise rates three times in 2022, as the market is currently discounting, the Fed Funds Rate would still be half of what it was before the pandemic. Likewise, even if the Fed were to allow maturing assets to run off in the middle of this year, as the minutes of the December FOMC meeting suggest is likely, the size of the Fed’s balance sheet probably won’t return to pre-pandemic levels until 2026.
Where Have All the Corrections Gone?
In hindsight (which is always a wonderful thing) investment in equities throughout the 1990s would have been prudent, though scary as seven corrections of 9% or more occurred between 1996 and 2000.
Similarly, there were six 10%-plus corrections in the 2009-2019 bull market. However, the U.S. stock market has not seen a correction of more than 10% in this cycle (started March 2020), and there were no drawdowns last year of more than 5%. This is unusual and suggests we could see more volatility and uncertainty ahead.
Stocks started the year on a high note, before tumbling following the release of the Fed minutes. We think this nervousness could be an indication of what is to come. We expect to see more short-term corrections, but the overall upward stock market trend will remain well supported by corporate earnings growth.
Market tops often occur when sentiment reaches euphoric levels. That was not the case going into 2022 and it is certainly not the case after last week’s sell-off. Equities do best when sentiment is bearish but improving. With bulls in short supply, stocks can continue to climb the wall of worry.
COVID is Last Year’s Story
While the Omicron wave has led to an unprecedented spike in new cases across many countries, the economic fallout is likely to be limited. The new variant is more contagious but significantly less lethal than previous ones. In South Africa, it blew through the population without triggering a major increase in mortality. The general tendency is for viral strains to become less lethal over time. After all, a virus that kills its host also kills itself. Given that Omicron is crowding out more dangerous strains such as Delta, any future variant is likely to emanate from Omicron, and odds are this new variant will be even milder than Omicron.
Meanwhile, new antiviral drugs are starting to hit the market. Pfizer claims that its new drug, Paxlovid, cuts the risk of hospitalization by almost 90% if taken within five days from the onset of symptoms.
The surge in COVID cases in December will undoubtedly slow economic growth temporarily. But consensus is building that the now-prevalent Omicron variant is mild and its rapid spread could help the developed world achieve “herd immunity” thanks to widespread vaccination and natural immunity. Emerging countries, however, may continue to struggle, especially China.
In the U.S. and Europe, people are fed up with COVID restrictions, with society largely at a turning point from which COVID is treated as endemic going forward. This will mean that in large parts of the world life will return to a (new) normal. This in itself will continue to support economic growth as there is still a lot of pent-up demand among households and companies.
In other words, for a large part of the world, COVID will be last year’s story. And while global growth has peaked and the pandemic remains a risk, growth should stay well above trend in the major economies in 2022, fuelling further gains in corporate earnings and equity prices.
China and an Imploding Property Market
Chinese investable stocks were among the worst-performing last year, ending 2021 with a 23% loss. Lately, China’s macro policies have begun to refocus on supporting the economy, and the question is whether cheaper valuations in Chinese equities warrant an overweight stance versus global stocks.
The authorities’ recent cut of the banks’ reserve ratio and more dovish talk does suggest that they are now concerned about how weak growth has become. A tactical rally in Chinese stocks is possible as investors may bid up the market in expectation of more stimulus. The Chinese offshore market remains deeply oversold in relative terms, and further easing in policy in the coming months may significantly improve global investor sentiment towards Chinese equities.
Interestingly, in a potential sign of what’s to come, domestic investors in China’s mainland markets are much more optimistic than foreign investors and have bid up mainland listed stocks in recent months. With 2022 an eventful year in China (the Olympics in February and the Communist Party National Congress in November) the stars may be aligning for a reversal in fortunes for Chinese stocks.
The bigger problem China faces is a possible major correction in the property market. Now that the economy is slowing, several large property developers have run into liquidity problems, and some are effectively bankrupt.
The Chinese authorities will make sure that these developers build the apartments that they have already sold to consumers. But the problem is that when people no longer believe property prices will keep rising, they will stop buying. This will inevitably lead to a correction in the property market, which is a major part of the Chinese economy, including a large portion of many households’ wealth. If property investing loses its allure, people will start looking for other opportunities. Counterintuitively, the stock market may well be a beneficiary of a correction in Chinese property prices.
Fixed Income
Long-term bond yields have risen in the past few weeks but are still surprisingly low, given the hawkish pivot of the Fed and other central banks. One explanation Fed chair Powell has given is the attractiveness of U.S. Treasuries, after FX hedges, to European and Japanese investors. He is correct about this today, but the advantage will disappear as the Fed raises short-term rates, which increases the cost of hedging.
We think the 10-year Treasury yield could rise to 2-2.25% this year. We are underweight duration and expect a moderate steepening of the yield curve. We are neutral on U.S. Treasury Inflation-Protected Securities (TIPs), which have already performed well but still are a hedge against tail-risk inflation.
Commodity Prices and Greenflation
Increased demand for “green” metals like copper and aluminum by the alternative energy sector is not being met by increased supply because the mining sector has underinvested in new supply. This is caused by “green” politics as environmental regulations become difficult for mining companies.
For example, Chile, which is the world’s largest producer of copper, just elected Gabriel Boric, a 35-year-old former student union leader, as President. He has already promised to increase environmental regulations on the copper industry. This could reduce copper supply in coming years, precisely at a time that the world is transitioning to electric transportation. Therefore, it makes sense to have a strategic long-term exposure to base metals such as copper and lithium which are used in electric vehicles.
Energy prices should remain well-supported by global demand, but we don’t expect the oil price to rise by another 50% like in 2021. The Organization of the Petroleum Exporting Countries (OPEC) will carefully manage supply to ensure prices don’t rise materially to prevent aggressive production increases from U.S. shale producers.
We are neutral on gold. Gold could suffer if real long-term rates rise but at the same time, it can still be a good hedge for unexpected geopolitical events or accelerating inflation.
The U.S. Dollar
Relative monetary policy between the U.S., Europe, and Japan could mean some further upside for the dollar over the next few months. However, the dollar is getting expensive relative to fair value.
In the second half of the year, a rebound in China would boost growth in Europe and Emerging Markets, which would be positive for commodity currencies. Bearing that in mind, we remain neutral on the USD.
Portfolio Positioning
We continue to favor risk assets for 2022 but expect to see more market and sector rotations. Last year mega cap tech was again outperforming the rest of the market. This year, we expect to see a shift to more defensive companies and sectors. For example, valuations in the financial and industrial sectors are much lower.
Rising interest rates should be supportive for large cap companies with a relatively low valuation but solid earnings. These are so-called quality value stocks. Often these companies also pay a relatively high dividend yield. In our core portfolios we already started making a shift to more quality and value last year. We also remain positive on commodities and real estate.
It will be difficult for bond portfolios to perform well in this climate and we favor keeping duration short while generating yield by taking on (private) credit risk.
In anticipation of higher volatility, we have created a range of portfolios that invest in high-quality large cap companies that focus on income generation. Dividend income is likely to cushion market volatility.
We offer a Global Equity Income Portfolio as well as portfolios focused on U.S., U.K., or HK blue chip stocks. These portfolios generate between 4.5% and 8% gross yield.
In a global investment landscape that features scarcity of income yield in public equities, Global Equity Income aims to generate sustainable and above-average dividend income streams via investments in high-quality global companies. The portfolio is composed of large cap defensive equities with a heavy tilt to defensive sectors such as Healthcare and Communication Services. As such, Global Equity Income features lower sensitivity (low beta) to the broad global equity indices and its low volatility profile enables strong downside protection. Non-U.S. equities account for 60% of the portfolio.
Portfolio construction is based on quantitative scoring of the global equity universe with a focus on Value, Quality, Safety, Payout, Technical and Sentiment metrics, as well as ESG traits. In particular, the Quality and Safety metrics ensure that stock selection is geared toward low-risk companies that exhibit high levels of profitability and low financial leverage.
We are happy to discuss if this portfolio strategy could be a suitable addition to your long-term investment allocation.
DISCLAIMERS & DEFINITIONS
This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.
Investments in commodities may have greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.