Top 10 investment themes for 2022

It’s fair to say that 2021 was quite a year for financial markets with the emerging force of inflation the dominating theme that caught most off-guard and is still proving much more persistent than many had expected. Global bond markets subsequently struggled after very strong returns in 2019 and 2020, whilst equity market performance remained robust amid global supply-chain disruptions, meme mania mayhem, and ongoing Covid concerns. The global economy started transitioning from a vaccine-fuelled and policy-led recovery to a more fundamentally-driven expansion, and we expect this to accelerate in 2022. In many ways 2021 has finished not too dissimilarly to how it began, with Covid once again dominating the agenda as the highly transmissible Omicron variant continues to spread. It may bring with it fewer lockdowns than a year ago, but the absence of infected workers will most likely result in continued supply-chain disruptions and an unsavoury combination of slower growth with elevated inflation.

We expect 2022 to be a year of deceleration and desynchronisation for the global economy, as the journey out of the pandemic towards normalisation continues but on an uneven and still moderately uncertain path. We still expect economic growth to remain relatively healthy as many economies slow from their strong and unprecedented 2021 pandemic rebounds, however, the pandemic is not over, and some economies will likely experience sharper slowdowns relative to others. Some, like China, may even accelerate in the second half of the year in response to new policy stimulus. Remarkably, within this backdrop and thanks to these very strong 2021 pandemic rebounds, the world economy is set to surpass $100 trillion for the first time in 2022, two years earlier than previously forecast, according to the Centre for Economics and Business Research.

The fourth global wave in new Covid-19 cases that emerged in November from the spread of the Omicron variant has not yet translated into a similarly exponential rise in the fatality rate. As at 9 January 2022, the world recorded nearly 17 million new weekly cases as the heavily mutated and highly transmissible Omicron variant demonstrated that the pandemic is far from over. Despite the current global supply of Covid-19 vaccinations providing lower protection against the new variant, they are still having a positive effect on mitigating the risk of severe disease and hospitalisation. Two months in to this fourth wave and pressure on hospital capacities worldwide is still somewhat below that of the Alpha and Delta variant waves in 2020 and 2021. Consequently, most countries should avoid lockdowns this year, and with pharmaceutical companies expecting targeted Omicron vaccines to be ready in March, we expect the world economy to keep growing at a notably healthy pace in 2022.

One of the biggest surprises of 2021 has undoubtedly been the overshoot of inflation measures across the globe. Even core inflation in the Eurozone, which has spent most of the last twenty years below 2%, is currently experiencing an overshoot. Despite robust pandemic rebounds across global economies, the lingering existential risk of the pandemic has slowed the policy response to tackling growing inflation dynamics. Inflation is now being fuelled not just by supply bottlenecks, in particular supply chain disruptions and labour shortages, but also by the threat of new Covid variants and the changing behaviours of both households and companies. That makes its drivers broader and longer lasting. In the US, with the quits rate reaching an all-time high, household surveys reporting that jobs are plentiful, and wages rising at an annual rate nearly twice that of the Federal Reserve’s 2% inflation target, the labour force – which has contracted following pandemic induced early retirements and workers afraid to re-join the workforce – is now looking fully employed and a cycle of interest rate hikes will now follow. However, with long-term average inflation targeting around 2% becoming more widely adopted, we don’t expect central banks to hike too fast.

Central banks have been holding an accommodative stance ever since the world economy started decelerating in 2019, several quarters before the Covid-19 pandemic officially gripped the world in March 2020 and accelerated the global rate cutting cycle. During 2019, the G20 average central bank interest rate declined by 150 basis points from 8.2% to 6.7%. If it wasn’t for Argentina and Turkey, both of whom had (and currently have) abnormally high policy rates averaging 65% and 20% respectively in 2019, the G20 Bank Rate would have declined to near zero during the pandemic. However, that phase of the global monetary cycle is over and we now expect tighter financial conditions for the world economy and financial assets, as the rising G20 bank rate accelerates back towards its 2019 pre-pandemic level. This trend had already started in 2021, albeit tentatively, as inflation reared its head once again after a long absence, and we expect central banks to sharpen their attention on this lingering issue in 2022.

Whilst rising interest rates usually result in higher nominal bond yields, it doesn’t always translate into rising real bond yields – that is nominal bond yields adjusted for inflation – as was the case last year. In 2021, 5-year nominal US treasury bond yields tripled from their near historic lows of 0.42% at the end of 2020 to 1.26% at the end of 2021. Yet, equivalent 5-year real yields remained deeply negative around -1.5%, pinned down by a combination of unusually high inflation levels and nominal bond yields that, despite increasing threefold, did not rise as much as expected. What transpired was a sceptical bond market that did not believe the US Federal Reserve could tackle the growing inflation problem, and normalise its bank rate back to its 2019 range of 2-3% without substantially damaging the economy. That said, the bond market isn’t always right, and we expect inflation levels to peak in 2022 as fading Covid effects and a resilient global economy open the door to higher interest rates and bond yields.

As part of a common prosperity and social stability push, Chinese policymakers took aim at the domestic property market in 2021 by introducing tighter regulations to curb what was deemed as excessive leverage and profiteering in the sector. There followed a near 50% decline in China real estate US Dollar high yield index returns as some of the country’s largest property companies defaulted on their debts and caused a wider crisis across the broader credit market, which has led to expectations of a hiatus in real estate regulations. Furthermore, Chinese developers have raised billions of dollars via asset sales, equity raises and cash injections from founders and major stakeholders to bolster their balance sheets. With the jump to default risk already well baked in for weaker property credits and a now attractively priced broader credit market, we view this as a rare value opportunity within the global fixed income universe where historically index yields of around 15%+ have led to significant returns for investors.

With the core PCE measure of inflation reaching 4.7% year-over-year in December, the highest rate in 32 years, and US equities currently trading at a relatively lofty valuation multiple after three successive years of double-digit returns, investors have begun to ponder a very legitimate question – what level of inflation can the stock market tolerate? Examining the historical relationship between inflation and the price investors are willing to pay for future earnings growth (that is, the valuation multiple) delivers an unequivocal message. Since 1960, high rates of inflation have always been accompanied by lower valuation multiples. The corollary, therefore, is that inflation at these high levels is, in our view, likely to erode investors’ willingness to pay high prices, contracting the valuation multiple and, hence, denying the US stock market of one source of return. However, the outlook for corporate earnings growth, dividends, and share buybacks – the other return drivers – is somewhat stronger, which should help support the stock market during 2022.

One year ago the political polarisation of the American people manifested itself in the storming of Capitol Hill by an angry Trump-supporting mob that shocked the world after the deeply contested November 2020 presidential election. Since then, the world has looked to President Biden and his Democratic Party for a return to a more stable path, however, the country still remains divided. President Biden’s approval ratings have steadily declined in 2021, precipitated by a gross mishandling of a US troop withdrawal from Afghanistan in August. Recent results from a CNBC/Change Research poll show 60% of respondents said they disapprove of Biden’s handling of the economy as he nears the conclusion of his first year in office. A 55% majority of respondents also signalled disapproval of his leadership during the pandemic, an area in which he campaigned on. Congressional voting polls for the Democrats have also taken a hit, raising the odds of the Democrats losing their Senate, and potentially House of Representatives, majorities in the mid-term elections this year. This would leave the country with a lame duck President and political gridlock where nothing of significance would pass quickly, if at all, in 2022 to 2024. Not necessarily a bad thing as this maintains some stability and status quo, but neither is it a positive thing for reform.

Asset price volatility has been steadily rising since the summer from its pandemic lows as growing inflationary concerns have prompted global policymakers to start dialling back support for their economies. US equity volatility as represented by the VIX index is now back at its long-term average, and US treasury bond volatility as represented by the MOVE index is closing in on its long-term average. We expect both to continue trending higher this year as risk premiums increase, not only from the rising tail risks of central banks over-tightening in order to tackle overshooting inflation dynamics, but also from increasing geopolitical risks that are emerging around the world. In Europe, the mass build-up of Russian troops on its Ukraine border has NATO on red alert for an invasion or another provincial annexation. In Asia, China has stated clearly its ‘reunification’ intentions with Taiwan and continues sending more military aircraft into Taiwan’s airspace, and finally in the Middle East where with rising tensions between Iran and Israel, with the latter under new hard-line nationalist leadership.

The 2020 Covid crisis was not only a tail risk event for financial markets, it was also a once in a decade buying opportunity for investors in risk assets. The potent combination of trillions of dollars of worldwide fiscal stimulus to households, the growing accessibility of financial markets to these households via fintech trading platforms, and the pervasive integration of social media into everyday lives, resulted in a sharp pick up in retail investor participation in the stock market and meme investing mania that severely disrupted the hedge fund and wider financial sectors. The rise in total margin debt across US retail accounts is now at a record high near $1 trillion and has caused a substantial rebound of leverage in the financial system. However, household savings have also ballooned since the Covid crisis, leaving record levels of liquidity also in the financial system. The corollary of this being that the ‘bubble-like’ behaviours of 2021 in financial markets from meme stock investing, SPAC frenzies, and cryptocurrencies are likely to continue unless central banks put an abrupt end to the party.

In conclusion, we expect 2022 to be a more difficult year of transition for the global economy as growth rates normalise and tail risks from inflation, Covid, and geopolitics persist. Nonetheless, our outlook for stocks is still positive but tempered somewhat from last year. The fading of fiscal stimulus measures and monetary accommodation by policymakers will be a major macroeconomic shift to follow as we start 2022. It does not necessarily mean poor financial returns for investors this year, rather, the very strong double-digit performance of developed market equities in 2021 is unlikely to be matched this year and instead more modest single-digit returns are more likely. Given a decelerating but still robust global economic recovery, we expect dispersion in fortunes across companies, sectors and countries that was evident in 2021 to continue in 2022, but some of last year’s losers have the potential to become this year’s winners. Corporate and household balance sheets remain healthy and have accumulated notable levels of cash and savings, which have the ability to sustain a prolonged period of economic expansion, barring any material realisation of tail risks. We welcome 2022 with open arms but remain cognisant of the lessons learnt over the last two years in both rising and falling markets. Happy New Year!

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