This article is from our January 2022 edition of MarketWatch.
19th January, 2022
What does cautious optimism mean – are we optimistic or cautious? We’re optimistic about the world economy; that it can withstand more COVID-19 strains, that it won’t be consumed by inflation, and that it can continue to grow as central banks gradually tighten policy. However, we’re cautious as investors not to get carried away by market momentum on one hand, or excess pessimism on the other.
Is the economy slowing down and why? After the enormous drop in activity came the enormous bounce. Now that the extraordinary policy support is being withdrawn, how is the economy actually doing? Perhaps the best measure of recovery is employment, and this has come roaring back, only slowed in some countries by COVID-19 restrictions or a reluctance to return to work. Despite the buoyant growth, forecasts for 2021-22 have declined since the summer, causing some to question the robustness of the recovery.
Importantly the slowdown in growth is not due to a lack of demand but to a lack of supply. Looking at the 2022 forecasts, even if we haircut for optimism, the numbers are still well above the growth we’ve seen in the past decade. So yes, we’re slowing down, but to still above-average levels. As long as governments don’t decide to lock down their countries again, the chance of recession in 2022 is remote.
As governments spent trillions of dollars to support the COVID-stricken economy, critics warned that this would inevitably spill out into higher prices for goods and services. Now that the US and Eurozone have their highest inflation since the 1990s, higher than most expected. The question is whether this is a persistent or temporary change. Looking at the causes, we believe the answer is both. Energy prices, which contributed so much to inflation this year, are being held artificially high by producers holding back supply. Price increases in other fast moving items, like raw materials, and new and used vehicles are beginning to fade, at least in the US. This means that headline inflation should fade lower in 2022. However, prices of slower-moving items, like shelter costs and wages, are moving upwards and are more persistent in nature. So while we should see inflation declining in 2022, it will fall to levels higher than we’ve become used to in the past decade.
Apart from reducing the spending power of our money, the downside of inflation is that it can drive central banks to tighten monetary policy and cool down the economy. Jerome Powell at the US Federal Reserve (the Fed) told us for months that high inflation was transitory and immediate action was unnecessary, despite his colleagues and the markets bringing forward their rate expectations. Eventually, facing the facts in December, he conceded the need for faster action.
In the slower-moving Eurozone, where core inflation is several points lower, Christine Lagarde warned markets that EUR rates do not need to be increased in 2022.
At the other end of the readiness scale, the Bank of England indicated for months that higher rates were coming, and then surprised the market by not hiking in November.
Whatever the exact timing, reducing bond purchases and hiking interest rates by a quarter percent every few months is a slow way to cool down the economy. Also, if the cause of inflation is supply disruption, then higher rates are not going to solve that problem. The most immediate impact a central bank can have is to change market expectations, and therefore communication is key. It will never be perfect, but we expect the Fed and others to manage expectations for policy changes very carefully and not to upset the recovery by surprise tightening.
Now that we’ve had the rebound, the fundamental questions for investors are (i) how much growth is left in corporate earnings, and (ii) are we paying a reasonable price for this growth? After a 20% fall in 2020, global earnings are on track to be up over 50% for 2021. Forecasts for 2022 are far more modest, in the 5-10% range.
Given that forecasts tend to be a little optimistic, and we don’t expect valuations to increase in 2022, this represents a realistic cap on return expectations for the year.
As for valuations, price/earnings ratios are generally higher than historical averages, especially in the US. Looking across countries and sectors, we see a relatively consistent relationship between earnings growth and valuations. More expensive markets are growing far beyond their pre-COVID-19 earnings levels, while cheaper areas, like the UK and China, are struggling to grow as fast. Investors are clearly paying up for growth, and growth sectors have delivered. Rather than take sides in the value/growth war, we judge each sector on its own merit, and in our discretionary portfolios we maintain a slight pro cyclical tilt going into 2022 to capture the continued above-trend growth.
Assuming that COVID-19 lockdowns don’t return to crush business activity, and central banks don’t tap the interest rate brakes too hard, the economic cycle is set to continue. Stock markets rarely run smoothly, but absent another recession, a bear market is very unlikely. However, momentum is fading as we move further past the COVID crash, and many fear that the market may no longer have the legs to continue to outrun the various risks, not least its own extended valuation.
Looking back at previous recession-induced bear markets (down 20%), we find that returns do typically hold up in the second and third years of a recovery. Except, as in the early 1980s, when another recession quickly follows.
It’s true that the post-crash rally has been much stronger this time than usual, and valuations are higher than normal. This doesn’t mean another crash, but it would be reasonable to assume lower returns from here on in.
It’s worth remembering that, outside of recessions, corrections (down 10%) do happen often, on average every other year. It would be completely normal to see such a correction in 2022 and still finish up 5-10% on the year. Trying to predict and time these dips is usually a losing strategy, so we prefer to focus on what we can control – ensuring that we have enough liquidity set aside to see us through any bumps, and enough growth in our portfolios to achieve our objectives, even under cautious return assumptions. In other words, a robust financial plan.
Warning: Past performance is not a reliable guide to future performance. The value of your investment may go down as well as up. These products may be affected by changes in currency exchange rates. Forecasts are not a reliable indicator of future performance.