Panorama - December 2021 -
Reviewing an overall positive year in 2021 and looking ahead to 2022
Head of Investment Strategies
Deputy Chief Executive Officer, Chief Investment Officer
2021 was a good year for the equity markets. The main equity indices set new all-time records, and the terrible global Covid-19 crisis was brought mostly under control. What was behind the equity rally? What is the best strategy going forward?
2022 is shaping up as a more volatile year, but we expect equities to post further gains and to outperform other listed assets.
Context and analysis
The slight uptick in volatility in recent weeks is unlikely to tarnish the market’s positive full-year 2021 showing. The markets were driven by a spectacular economic recovery, which was boosted, in turn, by unprecedented fiscal and monetary support. Corporate earnings soared by almost 45% in the US and by 65% in the euro zone. Bond yields also rose from their March 2020 lows, but only slightly in comparison with the spectacular rise in inflation. This combination of parameters is what drove the main equity indices up by 15% to 20% this year, when they set many all-time records. The rally erased all traces of the crisis. The S&P 500 is now 40% above its 2019 closing level. The CAC 40 soared past 7000 points for the first time, beating its previous record of 6950 points, which dated back to September 2000. And it is up by 15% since the start of 2019…
So, have we gone too high, too fast? Investors will have to analyse and mull over a number of parameters, including inflation, which is at more than 20-year highs; imminent monetary tightening in the US; the return of Covid-19 in the form of a new variant; and a rather tense geopolitical context, involving in particular the world’s two largest economic powers – the US and China.
What are the main challenges ahead in 2022?
Inflation and monetary policies
Global bond markets in recent months have, on the surface, looked like a “random walk”. The 10-year yield is now below 1.5% in the US with inflation at almost 6%, at -0.4% in Germany with inflation of about 4%, at almost 3% in China with inflation that is hardly above 1%, at 11% at Brazil for 10% inflation, and so on.
These figures illustrate how powerful the large Western central banks truly are in steering the world’s main reserve currencies. Confidence in these currencies remains high, despite the massive monetary creation that has occurred. Central banks in emerging market economies don’t have this capacity to conduct similar policies without seeing their currencies depreciate, at the risk of a surge in inflation. US and European central banks therefore had the wherewithal to expand their balance sheets to fund public expenditure and, in a sense, have taken control of their yield curves.
It is against this backdrop that the change in course by the newly reappointed Jerome Powell should be seen. Powell has just gone back on his previous statements in suggesting that inflation may actually not be so transitory, after all. This is the prelude to a more rapid than expected change in monetary policy, i.e., a hike in key rates and an acceleration in the pace of asset purchases.
This is how the Federal Reserve wants to stay ahead of the curve and keep the markets’ confidence. It seems to have succeeded. Inflation expectations priced into inflation-linked bonds have fallen. Similarly, long bond yields receded rather sharply on Powell’s words, and the 10-year T-Note yield pulled back below the 1.50% threshold. So, the markets, at least, believe inflation is indeed transitory.
This has flattened the yield curve considerably, given that shorter-dated bonds have in the meantime changed rather little in anticipation of a key rate hike as early as March or June. The 10y-2y spread came to about 85 basis points, down from 125 basis points at the end of the previous quarter. Historically, a flatter curve has been a leading indicator of an economic slowdown.
The economy continues to recover at a brisk pace in the US and Europe. “GDP Now”, which is the Atlanta Fed’s “real-time” growth indicator, shows that the US economy has been turning at an annualised 9.7% since the fourth quarter began. In the euro zone, economic activity remains strong in both consumption and business investment.
That being said, the coming months are looking more challenging. Output is beginning to be hit hard by the various bottlenecks that have formed in recent months, while spikes in prices, energy prices in particular, could drag down household consumption. On top of this, a new Covid-19 variant that we don’t know much about is spreading. It does not seem to be causing very serious illnesses, but we don’t know whether vaccines are effective against it. In the meantime, lockdowns are being instituted in many countries, something that is slowing down economic activity.
We can therefore expect a shift in growth trends in the coming months, meaning a likely slackening in the currently positive momentum of company earnings. Global growth is expected to approach 6.0% this year and 4.5% in 2022, but with risks of downside revisions.
In the longer term, however the outlook looks rather promising. The world is exiting this crisis far more leveraged, due to the additional debt created to support companies and individuals. The dogma of fiscal austerity is now a thing of the past. Quite the contrary, central banks will probably continue to finance governments for many years to come by keeping real rates negative or close to 0%, which will hurt bondholders. But such debt could be useful if it favours investments that will promote potential growth in economies and if it hastens the switch to a decarbonated economy. This will help many companies to expand in many sectors, including technology, energy, infrastructures, agriculture and healthcare. With enhanced potential growth and nominal growth rates at two-decade highs, debt/GDP ratios will decline naturally.
This is the deleveraging path that has been chosen over the austerity route that was taken up too rapidly after the 2008 financial crisis. This long-term outlook is naturally likely to favour equity investments over bond investments.
The regulatory crackdown in China
The latest events in China have triggered a rather serious economic slowdown, particularly in the real-estate sector, which accounts for almost 30% of the Chinese economy.
The government wants to alter China’s real-estate development model, which is based on excessive debt. The model only works for developers if prices keep rising, something that would not make the middle class happy (how is it possible to have a large family in a small home?).
These “old” development models have become outdated in the eyes of the government, which wants to steer China in a different direction economically and “morally”. The government unleashed a regulatory crackdown last spring as part of the new goal of “common prosperity”. We have already explained this in greater detail, but we would point out that this new direction has three main goals – first, to boost the birth rate, which has dropped in recent years and is now among the world’s lowest, while the age pyramid is now out of balance after three decades of the single-child policy; second, to accelerate the switch towards a decarbonated economy; and, third, to restore societal harmony while trying to give the middle classes some hope for a prosperous future.
The sudden and radical measures taken (such as limits on video-game playing) have destabilised some sectors, including the very important sector of real estate, as we have seen.
However, the government appears to have understood the short-term risks involved. It is sticking to its longterm goals but seems to be shifting its current position, something that will be very important for the economy in the coming months. A pause in the regulatory crackdown is likely. Mandatory bank reserve rates have thus just been lowered, and the 5.5% 2022 growth target has been confirmed.
Ultimately, the pace of economic growth is shifting, which should help ease inflationary fears, especially if the Federal Reserve acts quickly. Against this backdrop, bond yields are unlikely to change much. Equities still look attractive in relative terms, and the markets should continue rising, albeit more erratically. Potential gains of 5% to 10% look possible, especially after the recent dips, which are an opportunity to add to our exposure, a strategy that we will stick to if the consolidation continues.
Inflation and the Omicron variant are steering the curve
Yield curves have recently been driven by the emergence of the Omicron variant and Jerome Powell’s new line on inflation. The Fed chairman recently deemed the term “transitory” no longer suitable in describing inflation. This sent 2-year US yields up. The market is now pricing a total of 70 basis points of Fed tightening in 2022, and 150 basis points out to 2023. And almost nothing further thereafter. This is why long bond yields have declined rather sharply. This and Omicronrelated uncertainties. Once doubts over Omicron have faded, we expect curves to steepen once again, with a 2% target for the 10-year US yield in 2022.
In Europe, the variant seems to be the only compass for determining the direction of interest rates, as seen in the 10-year German yield, which fell from - 0.10% to - 0.40% in one month. Inflation is setting records in Germany, but the ECB seems to want to use Omicron as a pretext to postpone until 2022 its eagerly awaited decisions – promised for its mid-December meeting – on recalibrating its various monetary policy tools. And yet, the ECB will have to resign itself to buying fewer government bonds in 2022 than it has in the past 18 months, which will ease the rise in long bond yields that we had nonetheless considered to be under control. The Bund yield should converge towards 0% early next year, and we see it ranging mostly between 0.25% and 0.50% at the end of 2022.
As yields fell, investment grade credit spreads (difference between rates) widened by as much as about 15 basis points before beginning a correction. In the short term, spreads should get some support as fears fade of a major impact of the variant, but we do not see much room for narrowing. Performances will therefore be very dependent on the interest-rate component.
We are more bullish on high yield spreads, which, between mid-September and and-November, erased almost all the narrowing seen on the year to date. And yet, high yield companies are faring well. Their credit ratios have improved; they are very liquid after spending the year rescheduling their debts, and their outlook is good. Tactically, we believe this could be a good entry point into the asset class.
Take advantage of volatility for positioning
Volatility has been high on the equity markets in recent weeks. After discreetly pulling back to their April levels, the markets rallied sharply on rather reassuring news on the new variant.
In light of Covid uncertainties and the rather clear trend in the monetary policies of the various central banks, equity markets worldwide are likely to remain highly volatile in the coming months. However, if we assume that bond yields will rise only moderately, then equities still look attractive compared to bonds on a medium-term horizon. We expect equity prices to be somewhat higher than their current levels one year out, but the road there will go through some rough spots like the one we just experienced. Any dips will be opportunities to add to holdings and that’s why we are moving to a slightly more bullish stance than the one we held until now.
Business leaders we have met are surprisingly confident for 2022. In many sectors, such as semiconductors, for example, order books are at seldom-seen heights. Barring a collapse in global growth next year, company earnings on both sides of the Atlantic are likely to improve by about 10%, pushing P/E ratios to high levels in absolute terms, but this would sense as long as bonds are yielding between - 0.4% and 0.5% in Western countries.
By sector, in an environment of moderately higher interest rates, growth stocks are likely to remain in favour, but the banking sector could take advantage of its resilience and its low valuations to continue reducing its lag in relative terms.
Our central scenario
Economic growth will be weaker in 2022 than in 2021 but still well above potential. Inflation is likely to peak early next year before pulling back gradually. In this context, central banks will be able to stick to their very gradual monetary tightening cycle so as to avoid denting economic growth.
We expect equity markets to rise in parallel with forecast 2022 earnings, by about 5% to 10%, albeit on a trajectory far less linear than this year. As we mentioned, bouts of volatility, like the one we are going through, will provide opportunities to add exposure. Bond yields are likely to change little, but still on an upward trend.
Keep an eye on dips in inflation in the first half of next year, for if they persist, regardless of the reasons, they could limit central bank leeway excessively and undermine the economic cycle.
Document completed on 09/12/2021
Investing in financial markets involves risks, including risk of capital loss. Source of indexes cited: www.bloomberg.com