Market Overview | January 2022
Market Overview January 2022
2021 was generally a good year for equity investors driven largely by strong returns from US markets, which more than offset negative returns from Asia, Emerging Markets and China in particular.
The fourth quarter followed a common seasonal trend with most equity markets managing a traditional “Santa Rally” through the final month of 2021, thus confounding the Federal Reserve’s more hawkish policy signal, the rapid spread of the Covid Omicron variant and increased geopolitical risks surrounding Russia and Ukraine.
Inflation issues remain an ongoing theme with the risks of increasing interest rates for investors especially bond holders. These topics continue to dominate the market narrative heading into 2022.
In the US, Consumer Price Inflation reached 6.8% in November (the highest level since the early 1980s years) and in the UK, the same headline rate is presently 5.1% (a 10 year high). Looking back over the last year inflation was initially linked to pent-up demand, however ongoing price pressures largely reflect higher energy prices and persistent manufacturing and transportation bottlenecks.
You will probably be familiar with how the lack of supply for computer chips is affecting many industries and curtailing production, leading to spikes in pricing on the secondary market. The car sector is a great case in point, where we see the price of many “nearly new” second-hand cars (traditionally available at “cost less forecourt”) higher than new “to order” models as a result of the opacity of delivery times resulting from production delays.
The surge in inflation does not appear to be primarily a labour cost story - typically this is a secondary impact from a period of elevated inflation; however, there are early signs that pricing pressure may now be pivoting to a tightening job market pushing up wages, business costs and output prices. The supply issues faced by many companies are likely to continue and we know inflation will be with us through 2022 this could prove a serious headwind to growth.
Inflation was supposed to be “transitory”- a word that has now been dropped from the Federal Reserve announcements. In December the US Central Bank announced it would accelerate the tapering of their stimulus (albeit still remaining accommodative) with three rises in US interest rates expected later in 2022. In the UK we saw interest rates rise from the emergency 0.1% level to 0.25% in December and the market consensus expects further rises to over 1% through the course of the year ahead.
This is the start of global monetary tightening and the impact on investment markets will greatly depend on the speed and aggressiveness of the hikes. Central bankers are walking a tight rope between a recovering economy, high levels of debt and the risk of rising long-term inflation expectations.
The rapid surge of Covid cases due to the Omicron variant brought with it an element of Groundhog Day, with employees returning to work-from-home protocols and many people entering a period of self-imposed Christmas lockdown.
It is still early days, but it does appear that despite being more contagious and evasive to vaccines there is a decoupling between community spread, which had been very rapid, and the level of hospital admission and mortality rates.
We have seen some attention-grabbing infection rates in the early days of 2022, although the key issue will likely be the impact of those infections on staffing levels and the knock-on impact upon already stressed supply chains and wage inflation. On a more positive note, the rapid spread, combined with additional vaccines and boosters, may well increase overall population immunity and help pave the way to more normal conditions of living with the virus. The fund managers are looking through the short-term figures and many believe that this is the “beginning of the end” and a move to fewer restrictions and living with the virus.
The consensus view is that economies will overcome the current COVID hurdle (through population immunity and medical innovation) and this results in a robust cyclical recovery, a return of global mobility, and a release of pent up demand from consumers (travel, medical, services) and corporates. This will occur against a backdrop of relatively easy monetary policy and a low, albeit rising, cost of capital.
This should be supportive for equity markets. Consensus is predicting high teen growth in corporate earnings, and we wouldn’t be surprised if markets earnings multiples gradually de-rate over the year (in a similar way as 2021 when earnings outpaced market returns). Inflation may be a lesser problem for medium-term earnings, but it has historically been a headwind for current valuations.
In terms of investment strategy, I see no reason to change the current positioning favouring risk assets, predominantly equities and high yielding and inflation linked alternatives, over bonds where fund managers maintain limited exposure. Fixed rate bonds (Corporate Bonds and Government Gilts) are sensitive to interest rate rises. Rising interest rates leads to a reduction in the underlying capital value of fixed interest assets.
At a tactical level we expect a rotation in the returns from equities, with outperformance from cyclical assets and value sectors (energy, travel & financials) against headwinds for sectors that benefitted from extreme monetary policy and COVID and whose valuations are at very high speculative levels – this would encompass areas incorporating crypto assets, electric vehicles, lockdown beneficiaries (tech), high-multiple growth and ESG-related stocks. ESG related funds screen out many of the sectors that will benefit from this rotation to cyclical undervalued stock (Gas, aviation fuel, travel sector etc) and therefore will not participate in any recovery from these specific sectors.
This rotation is already underway. At a regional level we believe that the cyclical and value tilt should draw some interest to markets outside the US and close some of the multi-year performance gap to the US.
There are other risks that we will need to monitor and manage in 2022. These include a looming energy crisis and increase geopolitical tensions.
Energy appears to be entering a new cycle driven by economic recovery, geopolitical tensions and supply and demand frictions built over recent years. As economies unlock and world travel resumes, oil demand is likely to exceed production driving up prices and equally oil companies’ share price is likely to perform well through 2022.
The transition from fossil fuels to renewable energy is expected to take many years. However, the binary nature of government policy and rhetoric with regards to energy - carbon bad (watch out for windfall taxes!), renewable good – and the lack of a long-term energy strategy has made it difficult for companies to make strategic investment decisions. However, as a long-term investment, the transition to renewables is a theme that is here to stay and ESG portfolios will have exposure to this sector.
It should come as no surprise that Russia and Iran are taking advantage of high prices to sabre rattle and push their national agendas. Russia is threatening Ukraine, while China has further consolidated its grip on Hong Kong and made its intention towards Taiwan clear; at the same time Iran has continued to move closer to adding a nuclear capability to its rich arsenal of ballistic missiles (closely watched by Israel) and Turkey is experiencing a currency crisis. Political events will also merit investors’ focus with the key US mid-term elections in November and several elections across Europe (including France) and Emerging Markets. Although many mainstream portfolios will have no direct exposure to many of these markets, geopolitical tension creates uncertainty and established markets don’t like uncertainty.
Conclusion
There are always things to be worried about, however if we look at the global picture now compared to 12 months ago, the world is in a better place. The world has lived with Covid for the last 2 years; there is now a vaccination; restrictions are being lifted and economies are opening up; there is pent up demand, and many companies are cash rich which will lead to Mergers and Acquisitions.
2022 is likely to be a challenging year for investments and a diversified portfolio will be key to allowing the fund managers to seek out the best returns as markets and asset classes are likely to be dynamic for the next 12 months; indeed, identifying and thinking about the risks is a core part of managing the portfolio. Despite the risks and uncertainties discussed above, the fund managers remain broadly upbeat heading into 2022. Inflation, monetary tightening, geopolitical tensions, and political risks are likely to result in significant bouts of volatility, but overall should not derail the economic recovery. Volatility, although slightly unnerving provides opportunities to ‘buy good companies on bad days’.
Marcus Maisey
KDW
14 January 2022