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As we approach the end of 2021, global communities remain in the thralls of COVID and have yet failed to reach the long-prophesised ‘return to normality’. Like 2020, the financial world had to strap in for another bumpy ride this year: Markets have been steadily moving upwards, but investors have had to embrace high levels of volatility. But even with news headlines jumping from new COVID-variants to rising inflation and supply chain constraints, markets have continued to chug along.
What is next? Will 2022 offer investors a bit of respite, and give them some breathing room to put their portfolios in order? How can we identify new trends and orient investments accordingly? Let’s take a look at the different asset classes and discuss 2022’s prospects and pitfalls.
INFLATION: LESS TRANSITORY, BUT MANAGEABLE
Inflation continues to surprise on the upside, causing quite a stir in the fixed income markets. While the next couple of prints might continue to be high and volatile, there are good reasons for inflation to ease over the next twelve months. With indications that current supply chain issues have peaked and commodity markets are re-pricing higher energy costs, inflationary pressures will abate over the course of 2022. On top of this, base effects will kick in, limiting the potential of strong and persisting overshooting of central banks’ targets. Even so, vigilance is key, as we cannot fully rule out that we will have to deal with higher inflation for longer. Indeed, inflation becomes increasingly broad-based, meaning that -going into 2022- volatility will still be high and it might take a little longer for it to taper off.
EQUITY: DON’T BE SHORT-SIGHTED, FOCUS ON EARNINGS POTENTIAL
On the equity side, supply-chain bottlenecks have become common in corporate communication: Semiconductor production issues have paralysed several sectors and transportation constraints are keeping companies across the world in a stranglehold. To top it off, oil and gas prices portend an expensive winter. Low inventories and delicate relations with Russian suppliers add further fragility to the markets. These headwinds are affecting equity’s ‘risk/reward’ balance as we enter the new year. Expect some short-term turbulence in the early months of 2022.
Still, these gloomy prospects need not deter the rational investor. In fact, the medium-term outlook is a lot brighter, as underlying fundamentals offer plenty of opportunities for continued optimism. Excess savings should propel consumption, corporate investments are picking up and we have yet to experience the full impact of the fiscal stimulus packages. Central banks will remain cautious not to tighten monetary policy too soon or too aggressively. Investors welcome a simple normalisation of policy rates, which should not cause equity markets to correct significantly.
European markets in particular provide fertile soil for growth in months to come. Unlike their American counterparts, European equities are still mid-cycle and reasonably cheap. Moreover, Europe is the key beneficiary of the vaccine roll-out and profits from sustained accommodative monetary policy by the European Central Bank. However, we don’t entirely dismiss American equities either. Betting against the sheer number of innovative and disruptive companies in this market, and the administration’s fiscal boosts seems unwise. We are prudent when it comes to Asian emerging markets and China in particular. The latter is currently dealing with an economic slowdown, potential liquidity events in the real estate sector and the government’s strict regulatory oversight on some of its biggest companies. This cocktail of risks makes for a lot of uncertainties and depressed valuations. Until we have more clarity on Chinese policy intentions, we remain cautious.
In terms of styles, 2021 has given us all ingredients, from value to rally. Yet, the style performance has, once more, underdelivered. This could give rise to further, short-lived style rotations going into 2022 given the continuation of the economic recovery and the inflationary environment. Cyclical picks should continue to outperform defensives, albeit at a slower rate than in the first half of 2021. Small caps will likely continue to benefit more from 2022’s economic conditions than large caps.
FIXED INCOME: AN ATTRACTIVE DIVERSIFYER
Finally, let’s take a look at fixed income. For government bonds, we don’t think the upside risk for rates is that high. Central banks will likely remain dovish. We don’t expect any aggressive rate hikes to counter the recent bout of inflation, capping upside risk. Inflation expectations could go higher still, but a lot has been priced in already.
We are constructive on the European periphery, but remain prudent on the core (e.g. Germany, France, Netherlands). Therefore, within Europe, we enhance yields while maintaining a bearish duration profile on the core. As far as US government bonds are concerned, we are underweight. However, value has been created here, as nearly five interest rate hikes have already been priced in. The US is becoming interesting again, though we would like some clarity on the FED’s policy stance before fully committing.
In EMD, we see some interesting opportunities. Our in-house strategists believe that real policy rates will start to turn positive in 2022, which would stabilise EM FX markets and offer some potential opportunities in 2022. Furthermore, while we remain prudent on Chinese equities, Chinese government bonds seem attractive. Given the macro picture, policy tightening is off the table which makes the current yield very attractive and prone to trend lower.
We are more neutral on corporate credit. Spread tightening beyond current levels is unlikely, but we don’t see a strong widening either. Lower supply will provide support to the asset class, making it an ideal foundation and diversifier for the multi-asset portfolio. Communication from the ECB will be crucial, as we seek more clarity on how (senior) investment grade bonds will be further incorporated in the asset purchase programme.
Going into 2022, we maintain our preference for equities. Despite higher valuations, the asset class should remain the most important performance driver. Going into 2022, we maintain our balance in terms of investment styles, as headline-driven markets can turn quickly and fiercely, but the patient investor will see earnings feed through during the year. Fixed income remains a diversifier, but one needs to invest selectively. We turn to new havens, like Chinese bonds for diversification, emerging markets and periphery for yield, while holding US Treasuries for risk-off hedging.