Investment Outlook - Market Update
2021 was yet another year of maximum uncertainty with relentless waves of Covid dominating headlines. Despite this and the reality of higher-than-expected inflation, both the global economy and global equity markets performed extremely well in 2021, with many global equity markets closing at or near all-time highs.
As 2021 progressed, we highlighted a material change in our outlook. After a decade of central banks flooding the global system with liquidity through various actions to counter deflationary forces, a ‘regime change’ now lay ahead and we should expect and plan for a reversal of such actions and next expect a period of increasing short-term interest rates and ‘tapering’ of their bond purchases. This should meaningfully drive a different market environment over the coming years with new winners and losers across asset classes, equity sectors and equity styles.
For 2022, we forecast a year of above trend economic growth and inflation. The key factor that will determine so much for 2022 will be the path of global inflation. While above trend, we forecast a moderation of inflation as we progress through the year. Such moderation should then provoke a more measured response by both central banks and bond markets, which itself will not undermine equity markets and allow them to make further gains.
Equity markets should benefit from another year of strong earnings growth. We continue to highlight, however, that just as global bond markets are excessively valued, components of global equity markets are equally overvalued. Dispersion of valuation within equity markets remains near all-time highs and the regime change highlighted should prove to be a catalyst for further rotation to new beneficiaries within equity markets. Individual stocks and sectors that benefitted from this prior regime such as ‘growth’ sectors remain vulnerable.
As often, we live in very uncertain times, not least with the path of the Covid pandemic, which is clearly not yet over. Apart from a nasty inflation shock, the other shock to highlight would be a negative growth shock during 2022, which is certainly not priced into equity markets. We remain ever vigilant but for now, we view equities as the preferred asset while remaining very optimistic for the prospects for good stock picking during 2022.
Asset class outlook:
At an aggregate valuation level, equity markets remain expensive compared to history, close to the upper end of historical valuation ranges. 2021 was notable, however, with fundamentals such as strong earnings growth impacting positively on returns, and markets weren’t ‘just’ driven by liquidity and momentum as in prior years. This ‘rotation towards normal’ is very noteworthy and we expect 2022 to see a further acceleration towards markets driven increasingly by the strength of underlying equity fundamentals.
In aggregate, against a background of close to historically low bond yields and historically high equity valuations, we expect a strong tug-of-war for equities during 2022. Against an expected environment of rising short-term interest rates and longer-term bond yields, we expect downward pressure on aggregate equity market valuations, offset by another year of positive earnings and dividend growth. We expect further positive returns for equities during 2022, though more moderate. Against an environment of strong growth and rising interest rates, we believe that the rotation towards stocks backed by strong fundamentals such as cyclical and value stocks is likely. It is also an environment that should pressurise highly valued stocks and sectors that have been winners during the period of low interest rates and liquidity driven markets.
Bonds as an asset class have struggled to perform of late, as we finally have seen upward pressure on yields. That said, bonds remain extremely overvalued and still close to decade low yield levels. Upward pressure will be maintained on yields predominantly because of worse than expected inflation as well as the prospects of central banks being much less helpful. Bond markets have for many years been ‘artificially’ supported by central bank intervention and are not reflective, we believe, of their true fundamental value. The change in tone from central banks, and especially with the US Fed turning decidedly more hawkish over recent months, has led markets to now expect an acceleration of ‘tapering’ of bond purchases as well as changed expectations for both an earlier and more aggressive than previously expected increase in interest rates through 2022. In a world where we forecast above trend growth and inflation combined with less bond market-friendly central banks, expect bond markets to struggle against such a fundamentally healthy backdrop during 2022.