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Tipping point has been reached
The economic whirlwind in 2020 and 2021 has effectively created its own cycle: a very short and sharp reopening cycle has occurred within the longer, traditional business cycle, and it’s not clear how these forces will mingle throughout 2022. Most of the headwinds though relate to the reopening cycle.
In the wake of a sharp recovery, as restrictions were lifted and initially aided by easy base effects, growth was always bound to slow. That tipping point has been reached and will continue through 2022, but we think that the overall balance of risks will tilt towards a soft landing rather than a hard one.
A range of risks
The primary risks at the moment are slower earnings growth, higher inflation and interest rates, disrupted supply chains, high debt levels and the regulatory storm in China. Some of these risks are more transitory, while others have the potential to become structural headwinds. For example, strong demand for certain goods and services driven by the economic reopening and supply chain bottlenecks are transitory, but wage inflation and climate change policies could be tenacious drivers of inflation.
Covid-19 is turning into a more persistent drag on growth; vaccines are proving effective in breaking the link between infections and hospitalisations but not in stopping cases altogether - the virus is here to stay. And just as growth is slowing down, policy support is starting to be rolled back.
The withdrawal of policy accommodation will be a delicate balancing act for most central banks including the Federal Reserve, whose credibility will be regularly tested by the market. Investors will have to assess the Fed’s commitment to its new flexible average inflation targeting framework (FAIT) if prices keep rising. We expect interest rates to rise around the world throughout 2022, but this should not pose too much of a problem for equities as long as we remain in a world of historically low (and negative) real yields with low nominal rates.
The bigger risks for equity markets are high valuations and narrow leadership. Valuation multiples are high, but not unprecedented considering the limited alternatives. Valuations are, however, near the top end of the spectrum on several measures, which could invite a correction. Market leadership is concentrated in a small group of stocks and any weakening of sentiment could lead to a rotation at the expense of mega cap names.
Investors should also monitor the trajectory of China. Not only is it a big market in its own right but it was also among the first in and first out of lockdowns, and the first major market to show signs of earnings fatigue. Its performance in the coming months may indicate how things will play out in developed markets.
Sustainability is going to be a test for much of the market in 2022. With commodity prices elevated, there is likely to be a performance drag for high ESG performers and a temptation to compromise on sustainability considerations in order to benefit from high energy prices.
Investors who pick the better operators within the energy sector or those showing the most potential to transition to net zero, as opposed to shunning the industry altogether, may have an advantage because their engagement often encourages positive corporate behaviour while avoiding skewed portfolios with concentrated risks. This approach also complements a bottom-up investment strategy.
Building resilience into portfolios
A soft landing appears to be the most likely outcome for equities in 2022. Nonetheless, given the confluence of risks, we think it prudent to build more robust portfolios with a quality bias, limited leverage and not too much exposure to China. There is a stronger-than-usual fear of being disappointed, so we would avoid regions that are priced to perfection and highly dependent on growth.
We are selective within value stocks, preferring cyclical and industrial names but remaining cautious on banks. It’s still uncertain whether there will be a lasting rebound in bank stocks given their exposure to a potential default cycle if rates rise and the fact that real rates continue to be negative.
We are also cautious about growth stocks with the most expensive valuations, such as high-end technology and software. Instead we prefer tech opportunities in emerging markets, where good value has emerged following market corrections in 2021.