The market sell off we have seen at the start of 2022 suggests that a regime change is underway. To some degree this already began last year, but January’s moves have confirmed the trend. The market is shifting away from low-rate winners and placing more value on companies that are insulated or can benefit from higher inflation and rates. This is both a curse and a blessing. Simple exposure to the market is unlikely to deliver the 20%+ gains we saw in developed markets last year again, but investors with a research-led approach have the advantage as earnings will likely be the key driver of returns through 2022.
Frame January in light of 2021
Equity markets sold off with brutal speed in January, with wild intraday shifts occurring despite seemingly no significant news. This environment is characteristic of a high degree of noise, but we should frame January in context of what we began to see last year - growing recognition that inflation is likely to be more persistent than first thought and that monetary policy will have to adapt in response. January’s volatility has resulted from equity markets catching up to this realisation.
There have been trading sessions where bond yields have scarcely moved or even fallen, yet equities have continued to gyrate aggressively. This points to a recognition that valuations were excessive and needed correcting. Events surrounding the Ukraine may have also had some limited impact on the developed markets; however, this is something to keep an eye on, rather than to become overly obsessed about at this stage.
A sharp divergence in fortunes from Q4 2021
Past performance is not a reliable indicator of future returns.
Source: Refinitiv, 26 January 2022.
Wide dispersion in returns this year
Past performance is not a reliable indicator of future returns.
Source: Refinitiv, 26 January 2022. MSCI indices.
In previous tightening cycles over the past 30 years, policymakers have largely been attempting to influence growth. However, this time around inflation is at multi-decade highs. Ongoing supply chain disruption, upward wage pressure, rising housing costs and elevated energy prices are all conspiring to keep inflation persistent, and although the rate of price growth is likely peaking and will moderate, we expect it to remain above target through 2022. As a result, central banks are constrained no matter what tantrums the equity market throws and inflation targetters are facing a test of their credibility.
Central bankers have a tight line to walk to avoid a policy mistake. Tighten too much or too quickly and growth will choke as bankruptcies spike (given high debt burdens), but act too slow and inflation can become ingrained. History demonstrates that inflation can become extremely difficult to control once it has become ingrained.
Inflation at highs, interest rates at lows
Source: Refinitiv, St Louis Fed, January 2021.
As we move into interest rate-hiking cycles and major central banks tighten monetary policy, we could see equities continue to adjust, sometimes sharply. Commensurate with this, market volatility is likely to remain higher than in normal times.
For equities, rising yields increase the discount rate on earnings, which disproportionately affects growth stocks such as internet companies. Inflation also has a direct impact on earnings (via input costs and selling prices) and when the dust settles it is earnings that will likely exert the greatest influence on equity prices. We expect these dynamics to make 2022 a story of rotation.
The three C’s of 2022: Costs, Covid and China
The three big influences on earnings in 2022 are likely to be costs, Covid and China. Each have the capacity to cause sector shifts; costs directly impact the bottom line, while Covid and China are more top-line oriented.
Companies have enjoyed diminishing costs for years driven by offshoring and falling inflation, and during Covid fewer travel expenses. As supply chains decouple, inflation remains raised and travel picks up, this is reversing. The companies best equipped to protect their margins will be those with pricing power. Identifying businesses that have the ability to pass increased costs on to their customers is going to be crucial in 2022. Simply maintaining margins will be a success - flat is the new up.
Equities tend to act as a hedge for costs and inflation. When moving away from a deflationary threat, as was the case 12 months ago, equities tend to perform well, particularly high-growth sectors such as technology and discretionary. When inflation is around the target rate, equities still tend to perform well, but with banks, cyclicals and value stocks tending to lead market performance. If inflation is high and accelerating most asset classes are at risk, including equities due to the negative impact on both margins and multiples; however, within such environments, commodities and defensives often provide the best protection. As inflation moves between these buckets it’s important to be positioned correctly, with the right companies.
Covid: Omicron could ultimately be positive for equities
Last year we saw how the evolution of Covid affected market sentiment, with vaccines rolled out and the emergence of new variants leading to shifts in style, corporate earnings and performance. This is likely to remain the case in 2022.
It is possible that Omicron could ultimately prove positive for risk assets, given that it is milder but more transmissible than previous variants. This speeds up the transition from pandemic to endemic status, with a lower human toll, and hastens the return of economic growth. With earnings growth less scarce, the market might not pay such lofty multiples for high-growth companies. Instead, attention could turn towards operational leverage - the ability to make outsized gains from rising sales - and this favours value stocks.
However, this is not certain. Omicron was only classified at the end of November and now is the dominant global strain. It is possible that there will be new, more dangerous variants and further challenges ahead.
While most of the world can expect reduced disruption from more contagious but less deadly variants, China may be an exception. Its vaccines appear less effective than others and its population’s natural immunity to Covid is low. China’s ‘zero Covid’ strategy of strict restrictions, including lockdowns, curfews, lengthy isolation periods and quarantine, also causes more disruption than the community mitigation responses increasingly adopted elsewhere.
China: Could slow down more than expected
China’s recovery is more mature, as it was the first major economy to enter and emerge from Covid lockdowns. It has enacted a confluence of policy tightening measures that could cause a greater economic slowdown than anticipated.
In addition to fiscal and monetary tightening, China’s strategic “common prosperity” initiative to tackle the “three mountains” of household expenditure - healthcare, housing, and education - will weigh on growth. This involves regulatory interventions in certain industries, which are depressing corporate profits, and have caught some investors off guard.
The Purchasing Managers’ Index (PMIs) barometer of business activity is decelerating, while the property market - responsible for a quarter of GDP - is under stress. The potential for an abrupt slowdown is greater than the market has priced in and could have a meaningful impact on the rest of the world, including through commodity prices. China’s government could conceivably step in and cushion any sharp reversals in the economy, but it has a high tolerance for economic pain and is less focussed on cyclical growth.
While 2022 could be a relatively weak year for China, with volatility in certain sectors in the short term, its strategic direction of reducing income inequality and guiding the economy towards consumption should be positive for its long-term development. With valuations compelling in places, selective investors have attractive long-term investment opportunities.
Managing market imbalances
We are not on the brink of a crisis, but we are managing market imbalances and excesses; valuations were lofty through 2021, market leadership was narrow, and inflation was increasingly looking persistent. Together with the paths of Covid and China, these factors mean that rotations and sectoral shifts look likely to continue in 2022. However, corrections can recharge markets and are rarely negative in the long run.
The rebound we saw through 2021 is unlikely to be sustained, but we expect earnings to be the key driver of returns in 2022, gradually exerting more influence on market performance through the year. We believe earnings can continue to grow in real terms, with our analysts expecting 6-7% nominal earnings growth in 2022 and 8-9% in 2023. However, there will be significant dispersion across sectors, with pricing power key for corporates; the consumer, industrials, and utilities sectors are likely to see the most growth, while the resource sectors could sharply decline from the rapid recovery of 2021.
Overall, our 2022 equity outlook is one of measured caution. While we do not expect equities to deliver the returns they did in 2021, we think that they can post mid to high single-digit returns, driven by reasonable earning growth.
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