As 2021 draws to a close, I would like to reflect upon the year for the economy post lockdown and share with you our views on the outlook for markets in 2022. A lot has happened over the past year, so please bear with me as this bulletin is a little longer than usual.
The demand outlook is firm
Global economies continue to make strong post-lockdown recoveries. In the developed world, demand is firing on multiple engines: The outlook for consumer spending appears particularly strong, households are sitting on considerable savings, and for homeowners, their ‘equity’ has risen from the significant asset price increases of recent years.
Governments have also set in train multi-year spending plans, particularly on infrastructure and the transition to low carbon technologies. Furthermore, what is noticeably different from the last economic cycle is the shift in nearly all government behaviour. There will be no return to the austerity policies following the 2008 banking crisis.
The problems are in supply – the results are inflation
While there is no shortage of demand, the question is whether supply can keep up. Just-in-time supply chains are sorely tested and exacerbated by shortages of raw materials, pre-production items for finished goods and, of course, labour. These factors are also affecting costs, pushing up prices all along the supply chain and into the shops.
Central banks may be able to increase liquidity but they cannot manufacture new workers. Only rising wages will encourage people back into the workplace. The net result is higher inflation, and it’s only recently that central banks stopped using the word ‘transitory’ in relation to their comments on the inflation spike.
Central banks are acting in unison
The expected rate rises for November never happened. One by one, central banks failed to deliver what they had repeatedly threatened. What is increasingly clear is that central banks are not willing to take any risks with the recovery. Strategically, they would much rather be proven wrong for having tightened monetary policy too late than too early. Consequently, while rates will increase in 2022 they are unlikely to exceed 0.75% in developed economies. Bond yields however, will be a little higher as central bank asset purchases, or Quantitative Easing (QE), will slowly be wound down in an actively ‘managed’ way. They will do all they can to avoid the ‘taper tantrum’ of 2013 when markets experienced a bout of volatility as the US Federal Reserve reduced its asset buying.
Company earnings won’t be eaten by costs
Although companies will face stubborn cost pressures through higher wages, higher energy prices and supply chain bottlenecks that raise input costs, companies can respond through improved productivity or pass these higher costs on to customers. Margins remained around record levels for the third quarter of 2021, an encouraging sign that corporate pricing power is robust. Consensus estimates currently expect developed market earnings to grow by just over 7% which JP Morgan believes to be relatively undemanding in an environment where it expects above-trend economic growth and supportive policy.
From a sector perspective, margins are more volatile in cyclical sectors of the market where earnings are more closely linked to economic growth and where earnings estimates still have further catch up potential to the broad market. Financials and industrials are two areas of opportunity that stand out on these metrics.
Finding value in value
The Covid pandemic has been instrumental in accelerating change, the most significant being the digital transition. The restrictions imposed on mobility benefited technology stocks and ensured the outperformance of growth stocks versus value stocks. The pandemic leaves us with the widest valuation gap between growth and value in history. In 2020, the ratio between the trailing Price/Earnings of World Value versus World Growth stocks was 42% – a gap wider than the tech bubble of 2000.
While history isn’t always a good indicator of the future, it is worth noting that since 1975, value has always outperformed growth over the next five years when value has traded at less than 60% of the growth valuation.
2022 and beyond
So that’s the big picture. Let me now summarise these key issues and explain the implications for a coherent investment strategy. I am starting with two fundamentals:
First, the recent re-introduction of travel restrictions in response to the rising cases of the Omicron variant of the Covid-19 virus highlights the ongoing risks to society and the economy posed by the pandemic, while better analysis in global data reveals a greater number of deaths from undiagnosed diseases and illnesses as a result of Covid.
But we are getting better at dealing with Covid, and vaccines are controlling the virus. The positive conclusion is that we are slowly taking control of the disease and the impact should not derail the economic recovery, a recovery that is highly supported by both fiscal policy from governments and monetary policy from central banks acting in unison.
Second, climate change has become a significant theme in 2021, and the recent COP26 Climate Summit in Glasgow saw the UK in particular set some highly challenging targets to achieve significant reductions in carbon emissions.
But the most significant issue of climate change is the cost. Transitioning to green energy is going to result in significant increases in the cost of energy. Coupled with all the known factors currently affecting prices, the outlook for inflation is ‘higher for longer’. Furthermore, we won’t see a return to the ‘Volker strategy’ of the 1980s when Paul Volker, then head of the Federal Reserve, increased interest rates to 15% to fight inflation. There is no political will to control inflation.
Valuations for some growth stocks are high, particularly some in the US technology sector. These stocks are more likely to see higher volatility and could shed some gains if rates and bond yields rise through 2022 and beyond. Bear in mind that just six growth stocks make up 25% of the US S&P 500 Index. But generally, global stockmarkets are not in a bubble and there are a lot of value stocks that pay dividends currently trading at attractive prices. Equities therefore continue to offer the best opportunities for long term capital growth.
Rising interest rates means Government Bonds will become less attractive. We prefer inflation-linked bonds. Despite the fact that the price of inflation-linkers is always on a premium to their inherent value, they offer a more stable inflation hedge over the long term.
Additional asset sectors to diversify portfolios in an economic environment characterised by growth and inflation include good quality commercial real estate, commodities and actively managed strategic bond funds.
Finally, David and I are regularly undertaking active assessment of our asset allocations and selection of funds and fund managers. We are committed to ensuring that our portfolios are suitable for our client needs and match their risk levels. This means that when facts change, we need to respond and, if necessary, make changes.