Panorama - February 2022 -
More volatility, but probably little amplitude
Head of Investment Strategies
Deputy Chief Executive Officer, Chief Investment Officer
Overall market sentiment has changed since the bout of euphoria that prevailed towards the end of 2021. This is partly because the new Omicron variant is spreading and restricting business activity, particularly in China. But the biggest concern is that inflation is making a comeback and that the Federal Reserve is sounding more hawkish. But despite all the risk factors, company fundamentals seem to be on solid ground.
We therefore believe the markets might become more volatile but we do not expect any vast fluctuations, i.e. movements in excess of 10% to 15%.
Context and analysis
Economies and companies as a whole have proved remarkably adaptable during this crisis, albeit with the help of central banks and states which have provided the necessary liquidity. For instance, the Federal Reserve’s balance sheet amounted to around $850bn at the time of the financial crisis of 2008/2009; it now stands at close to $8,800bn. This success can also be seen in the strong rally delivered by stockmarkets in recent months.
But after performing so well, it makes sense to question how much longer the momentum can last.
Let us first approach the matter from a technical angle:
- After delivering returns of over 15% for three years in a row, markets tend not to turn in this kind of performance for a fourth year running. Similarly, Citigroup’s technical analysts have noted that there have only been four cases of bullish outside years since 1935: in 1935, 1982, 2016 and 2020. The average annual performance following such a configuration is 23% (27% in 2021). However, outcomes are a lot less favourable the following year, with gains of just 1% in 1984 and declines of -37% in 1937 and -6% in 2018.
- The recent rally has been driven by a very small number of stocks, mostly large caps in the growth category. So indices are heavily concentrated: for instance, the seven largest caps in the S&P 500 account for close to a third of the index.
- Share sales by company executives have reached a high in recent years, as have M&A deals (mergers and acquisitions); these are generally indicators that a stockmarket cycle is drawing to an end.
- Retail investors bought a lot of shares last year. Yet such investors are renowned for being weaker hands, moving into the market late and prone to panicking in the event of a downturn, thereby speeding up market consolidations.
From a fundamental viewpoint, it seems clear that global economic growth will be slower this year than in 2021, which was a recovery year; but it will be quite perky, nonetheless, and still above its “usual” cruising speed. Global economic growth is thus expected to reach 4.4%, including 3.9% in the USA and 4.2% in the eurozone.
It is the impetus provided by China that appears to be least reliable right now. 2021 ended with growth in excess of 8%, but some worrying signs have emerged in recent months: business activity is being penalised by the effects of several property developers going bankrupt and various cities affected by the Omicron virus have reinstated lockdowns. The government has thus brought in a certain number of economic stimulus initiatives, even if this means temporarily suspending the series of regulatory measures launched under its “common prosperity” drive. 2022 is indeed going to be a big year for the country’s image (with the Winter Olympics but also, more importantly, the National Congress of the CCP in November, which could decide to let President Xi Jinping remain in power for life). SOEs (state-owned enterprises) have thus been asked to take over struggling property developers in order to complete any construction work that was already in progress. Similarly, local governments are issuing loans to shore up investments. Banks are also being asked to grant more loans to SMEs. The aim is to step up investment in 102 key projects that were identified in the 2021-2025 five-year plan, with a focus on various priority industries: food and energy security, high value-added industries, mid-range real estate and infrastructure (primarily the transition to 6G, very high-voltage power lines, big data centres, the internet industry and artificial intelligence). The economy should thus be able to reach its initial growth target of 5.0% to 5.5%.
The big issue for the markets over the coming weeks will be inflation and its consequences for overall interest rates. This marks a sharp contrast with the underlying deflationary conditions that have prevailed over our economies in recent years.
Inflation is at its highest levels for several decades, at close to 7% in the USA and 5% in the eurozone. For the time being, the markets remain somewhat convinced that this will not last as long-run inflation expectations have not risen all that much: they are settling in the region of 2.75% in the USA and 2.50% in the eurozone. Investors have also fully integrated the Federal Reserve’s message and plans to raise key interest rates quite rapidly. They thus see the Fed Funds rate reaching about 2% by the end of this cycle, i.e. at the end of 2023. By then, 10-year interest rates should therefore lie at around 2.5% as yield curves naturally tend to flatten towards the end of a cycle. This is why US bond yields are only quite moderately stretched, for the time being at least, even though the tension has been stepping up since the start of the year.
There are currently two schools of thought surrounding the topic of inflation.
The first is consensual and argues that this is only a temporary situation. It is the core scenario adopted by central banks and is based on the fact that the latest statistics refer to temporary situations created by bottlenecks which formed when economies began to open up again.
Similarly, base effects are unlikely to last: for instance, used car prices and house prices have surged in recent months, but these are the kinds of goods that consumers do not buy each year. So prices should calm down once the euphoria created by reopening economies has faded. The same goes for energy prices: oil prices have more than doubled since bottoming out in 2020, and they are not going to double every year. Meanwhile, it is also worth pointing out that if prices rise too rapidly, they can drag demand down and then prices will eventually fall back too. So, in a way, inflation tends to “self-absorb” itself. Those adhering to this school of thought believe that the underlying deflationary forces are still there: structurally rising debt levels, the digitisation and robotisation of the world’s economies, ageing populations…
But this core scenario is increasingly under fire, and the idea that inflation is going to last is becoming more widespread.
First of all, inflation is beginning to feed through into wages, particularly in the USA. This is what is known as the price/ wage spiral. Wages have risen by 4.7% over 1 year in the USA and by close to 15.0% in certain service segments of the economy, while unemployment has returned to 3.9% (which is close to its pre-crisis level of 3.6%). This shortage of labour has been exacerbated by a combination of factors: the deeply emotional nature of this crisis has prompted some to rethink their search for meaning in their lives, so much so that they have not returned to the job market and will not do so in the current circumstances.
There are those who have made the most of the situation to retire a little early, with substantial help from pension funds which are performing at a high. But this antiwork movement, which took off in the early 2010s with the Occupy Wall Street protests, has gathered momentum, especially among the young during lockdown. This movement can also be found in China these days, again among the young, with what is called the “lying flat” trend.
Secondly, the energy transition is incurring costs. Economy decarbonisation means that existing energy production capacity will have to be dismantled and replaced with other capacity, but without ultimately increasing the amount of energy produced: this will therefore incur a cost that will have to be paid for, especially as this transition could trigger a surge in the prices of metals needed to develop these new energies.
Lastly, relocation is an issue. This crisis has shown us how vulnerable supply chains can be if they are spread out too widely, particularly in critical sectors like healthcare and agriculture but also in the tech industry. Relocation is a trend that could increase further because of the “New Cold War” between the USA and China. Western firms might thus seek to become less dependent on China. Above all, the carbon footprint of the products we consume will become a major consumption issue and the solution will be to relocate production, which will probably push prices upwards.
So inflation is not a black and white issue. We are of the view that the world has indeed changed and that inflation could become structurally higher over the coming years, with its cruising speed exceeding the 2% targets set by the US and European central banks. An inflation scenario of ~3% therefore seems plausible, and it would also make it less painful to reduce public debt-to-GDP ratios over time.
Amid all the uncertainty, we believe the markets might become more volatile, especially at the long end of the yield curve; this would impact on the equity markets and a drop of about 7% to 10% would create opportunities to invest again.
Central banks: a matter of speed and scale
The market is now factoring in four interest rate hikes by the Fed in 2022. This is more than is scheduled but has not pushed terminal rate expectations any higher as they remain well below the Fed’s terminal rate for the time being (2.5%). Until this happens, the 10-year interest rate will not spiral upwards. However, we believe expectations will adjust further, pushing bond yields just above 2%. And the uncertainty surrounding the timing and scale of the Fed’s efforts to reduce its balance sheet over the course of 2022 suggests that the term premium will rise.
Over in Europe, German interest rates are expected to move back into positive territory in the first half of this year. They will be driven by US rates, among other things. The ECB is slowing its debt buying more quickly than European treasuries are downsizing their net issuance programmes (by about -€120bn versus 2021). This means the markets will have to absorb about €300bn more sovereign debt this year than in 2021. We believe this will help to keep German bond yields in positive territory for the long run, with the aim of reaching 0.25%/0.50% sometime in 2022.
Investment Grade credit spreads (difference between rates) have come under a little pressure so far this year as interest rates rise. Although yields on euro-denominated Investment Grade bonds have jumped since last August (+0.50%), we think risk premiums could widen slightly further and the interest rate hikes we expect will then offer investors a very attractive point of entry into this asset class.
High Yield spreads have proved a little more resilient during the first two weeks of this year, but the market is being cautious. We maintain our positive stance on this asset class and note that companies are financially sound: their credit ratios have improved, liquidity is in abundance following historically high issuance volumes in 2021, and the outlook is good. However, this asset class is likely to be affected by market volatility resulting from the regime change made by central banks, creating attractive points of entry for investors to move in.
Taking up positions against a volatile backdrop
Equity market performances in 2021 could be described as exceptional. 2022, meanwhile, has got off to a more turbulent start, although indices are still hovering near their historical highs in the USA and Europe alike. If our central scenario bears out, we will see short- and long-term interest rates rise slightly, without making the equity markets any less attractive than the bond markets.
With global economic growth expected to range between 4.5% and 5.0%, earnings per share at US and European firms should increase by respectively 8% and 7% or so this year. We know that earnings are closely correlated with global economic growth, which will therefore provide support. Our central scenario does not, of course, factor in a sudden resurgence of the Covid pandemic, which would take a toll on economic growth and therefore on earnings growth. The other risk is that inflation could persist, which would erode margins if companies fail to pass higher production costs on to their selling prices.
It is precisely the matter of inflation that has been decisive for sector performances so far this year. We had not been used to seeing performance gaps of over 25% build up in the space of two weeks between banking, automotive and oil stocks on the one hand and stocks in “growth” industries like luxury and technology on the other. But there is a simple logical reason for this: if interest rates are going to rise a little higher than expected, then sectors that are valued primarily by discounting their future earnings will be penalised, in contrast with the banking sector, for example, or the energy sector which is benefiting from sharply rising oil prices (among other factors). There is no reason for this rotation to reverse any time soon.
We had upgraded our recommendation by a notch in early December on the back of the market consolidation triggered by the emergence of the Omicron variant. We are now resuming a neutral recommendation following the rally observed in the past 6 weeks as we expect equity market gains over the year to be in line with earnings growth (there is no reason why market capitalisation multiples would increase amid rising interest rates). Stockmarket returns are likely to be a lot more modest than they were last year and merely in the single digits. They should be attractive compared with those offered by the bond markets, but there is no doubt that the upcoming bout of volatility will create points of entry below today’s levels.
Our central scenario
Monetary tightening in keeping with the rise in inflation indices is creating periods of market volatility. Until inflation indices fall back sharply, the speed and scale of the action taken by central banks will continue to fuel concerns about the market for risky assets.
We see interest rate and asset buying expectations continuing to adjust upwards until inflation eases off.
We therefore forecast that interest rates will keep edging up and that the equity markets will adjust accordingly with respect to overall index levels as well as individual investment styles. Having realised our gains of the past six weeks, we now predict that this period of uncertainty will create better points of entry to move back into the equity markets.
Document completed on 20/01/2022
Investing in financial markets involves risks, including risk of capital loss. Source of indexes cited: www.bloomberg.com