IMPACT COMMENTARY
“Global economic conditions remain good by historical standards and corporate-profit growth has been strong. However, the cycle is shifting. Moderating growth, the new Omicron variant and fading monetary stimulus have resulted in volatility in capital markets which likely continues in 2022”.
Summary:
The global economy encounters a variety of headwinds
A new coronavirus variant, Omicron, higher inflation, ongoing supply-chain challenges, and China’s economic slowdown are among the main headwinds facing the global economy in 2022. Moreover, policymakers are acknowledging the economic recovery is maturing, which allows for a gradual dialing back of monetary accommodation and less generous fiscal support. As the recovery progresses and economies reach their potential, it is natural for global growth to become less buoyant. We believe the recovery is still in decent shape and expect growth to persist in 2022, albeit at a slower pace relative to 2021. Amongst the headwinds, there are two key catalysts we see supporting the ongoing expansion. The first, is consumers are flush with cash, and they have much lower financial commitments, putting them in a better position to increase their spending. The second, is businesses have expressed a desire to rebuild inventories and boost capital expenditures. Weighing the positives and the negatives, we are expecting 3.5% global growth in 2022.
The coronavirus regains traction… again
The pandemic has become more challenging in recent months thanks to the Omicron variant. Infections are once again rising throughout the world. Colder weather, in the northern hemisphere, the reopening of schools and the relaxation of social restrictions have made it easier for the virus to spread. The impact is most obvious in Europe, including the U.K., but cases are also now ramping up in North America. The Omicron variant is proving to be more contagious (2x Delta) though perhaps less deadly, superior at resisting vaccines and better at re-infecting people. Vaccine makers are working diligently to adapt their formulas, but it might take several quarters before production ramps up sufficiently and distribution gets to the point where sizable portions of the global population are protected.
Inflation continues to run hot
The rate of inflation has increased further over the past quarter and now stands at levels not encountered in decades. Economic demand has snapped back faster than supply, causing higher commodity prices, a lack of workers, and shortages in a variety of goods. Inflation data has consistently remained hot. Supply-chain constraints are showing signs of receding and oil prices may come down, other inflation pressures can persist. Central banks worldwide have printed significant amounts of money and appear accepting of higher inflation over at least the next twelve months. Our view remains that even after distortions from the pandemic settle, we should see a return to a more normalized historic level of inflation.
U.S. stocks are fully valued, so profit growth will be critical to sustaining the bull market in 2022
Global equities extended gains from 2020 to record another strong year in 2021 resulting in equities reaching fully valued levels. At these valuation multiples, equities are pricing in a favorable outlook for both the economy and corporate profits. A key risk we will be focusing on, this year, is the demanding valuations for U.S. large cap growth equities. Disappointing sales and/or profit growth will not be treated kindly by investors. Continued strong gains in corporate profits will be critical to supporting higher equity prices overall and U.S. large cap growth equities in particular. We believe an environment of still historically low interest rates, with inflation transitioning back to more normal levels can still allow for robust growth in corporate profits. Assuming our thesis plays out, the U.S. equity market could deliver mid-single-digit to low-double-digit gains during 2022.
U.S.: Nothing to worry about except… Fed policy, politics, inflation, and Omicron
On the monetary-policy front, the U.S. Federal Reserve (Fed) has started reducing stimulus, and policymakers have signaled that bond purchases related to quantitative easing will end by June this year. Recent 30-year highs in inflation have prompted investors to expect the Fed to begin raising interest rates as early as April. The Fed’s goal on achieving full employment may have been achieved, and it now seems convinced that last year’s inflation jump should ease, as supply-chain congestion is relieved, and demand shifts from goods to services. The path taken by the pandemic will have a lot to say about when and how fast the Fed raises interest rates. The Omicron variant could, potentially, prompt policymakers to pause tightening plans until the outlook becomes clearer. On the political front, Congress has a lot to do. We have been assuming little/to zero new fiscal stimulus for 2022. In large part due to the uncertainty of Democrat support for Biden’s Build Back Better plan. Senator Manchin clearly dealt a significant blow to President Biden’s plans in December. Our expectation is for the private sector, not Washington DC, to be the economic growth driver, via strong profits, job creation, and rising wages this year.
Even prior to the appearance of the Omicron variant, we had begun reducing exposure in our U.S. portfolios to “riskier” companies with higher valuations and beta. Data reflected the number of new COVID-19 cases began rising in most U.S. states during the last week of October, hospitalizations began rising over the last two weeks of November and this trend has continued into the New Year. Despite this, we have refrained from shifting to an overweight allocation in defensive stocks because, in our view, the U.S. economic backdrop remains constructive. The job market is improving, with first-time unemployment claims at a 50- year low and both wages and salaries growing at a double-digit rate. According to the Atlanta Fed, real GDP growth for the fourth quarter 2021 is forecast to exceed 8%. For 2022, economic growth is now forecast to slow to between 3% and 4% but based on our models this still translates into corporate revenue growth of 7% and earnings growth of 9% which would be positive for equity markets.
In the meantime, at Newday, we continue to maintain exposure to our long-term themes such as digitization, electrification, decarbonization, artificial intelligence and machine learning, and infrastructure improvement. Specifically, within these themes, we have been emphasizing companies with earnings growth and strong free-cash-flow. These are the companies we believe are likely to experience tailwinds for years to come.
China: Regulatory uncertainty needs to be resolved
Last year saw many areas of the Chinese economy come under increased regulatory pressures. In particular, we saw regulatory measures aimed at technology companies including banning unfair competition, restricting the use of personal data, and banning fake reviews and cash incentives to attract positive ratings. These moves have caused investors to question whether Chinese authorities will allow capitalism to flourish. Such fears may be overcome when consideration is given to the crucial role played by the economy’s private sector, which now accounts for at least 80% of new jobs. The private sector is also needed to help upgrade the economy in areas such as technology, semiconductors, automation, and renewable energy. It is difficult for us to predict how long the regulatory overhang will last. However, recent official criticism of internet companies has been less strident.
The other key issue we see hurting Chinese equities has been monetary and fiscal policies that have been relatively tight in contrast to what has occurred in the developed world since the onset of the pandemic almost two years ago. The growth rates of both Chinese money supply and bank lending have fallen to multi-year lows, and on the back of this so has GDP growth. Part of this weakening is due to recent efforts to reduce property companies’ debt burdens through adherence to tighter leverage rules as well as measures to cool speculation in property. These rules have led to the much-publicized financial stresses facing Evergrande, China’s most leveraged developer with debts exceeding over US$300 billion. The Evergrande situation has driven concerns that China may face a “Lehman moment” leading to a collapse in its debt markets. But unlike Lehman Brothers in 2008, China’s current debt crisis has been triggered by its authorities, and we think there is every reason to believe that Chinese policymakers can deal with the fallout through a managed liquidation thus preventing any crisis.
Based on historic actions, we believe the growth slowdown in China will prompt Beijing to introduce monetary and fiscal-easing measures to bolster its economy. These steps could include facilitating credit lines for manufacturing and small businesses, and greater fiscal spending financed in part by sales of government bonds. The government may also boost the domestic supply of coal and other fuels to ease power outages and related supply-chain disruptions. However, based on our research, assuming economic growth can remain around 7%, we expect Beijing continues its measures aimed at reducing carbon emissions as it strives to be a leader in clean energy.
We have maintained for some time the Chinese government’s priorities have shifted in recent years from an emphasis on economic growth to quality of economic growth. That being said, we believe it will be important to be cautious in areas that are vulnerable to government intrusion. Our preference is to be positioned in themes the government is likely to support, such as renewable energy, electric vehicles and technology that reduces the country’s dependence on foreign investment. Chinese companies that are truly innovative and can compete on the global stage should be good investments. This environment should favor high quality companies with strong earnings growth, transparent management teams and clear competitive advantages. These are the companies that could be candidates for Newday portfolios.
Europe: Watching Omicron and bond yields closely
2021 macroeconomic indicators were mostly positive, suggesting economic expansion, although coming into the New Year, they are no longer rising. Historically, a period in which these indicators have flattened often precedes investors to shift into less risky investments. This change is not necessarily a negative for equities, assuming positive macroeconomic indicators continue to support good corporate earnings growth. In 2022, we expect earnings growth to fall back to a more “normal” 7% to 9% from the extraordinary 45% pace that followed the recovery from the depths of the pandemic. We do not consider valuations particularly stretched especially relative to the U.S.
Despite this, we need to be mindful of today’s elevated levels of global inflation and its possible impact on bond yields. The inflation spike in Europe has been driven primarily by the coronavirus-related lockdowns and as global growth recovered, the increased demand for goods which outstripped supply. The global supply chain has been under huge strain, and we have seen industries struggle to obtain labor, component parts and goods in a timely fashion, which has exacerbated the situation. We are confident that the supply-chain issues will resolve themselves over the course of this year, but its continued impact may keep inflation higher for longer. The reaction of central banks and the bond market to inflation will have a significant impact on investor sentiment. Equity investors, historically, do not appreciate swift rises in bond yields. For this reason, we continue to keep a close eye on bond yields. In addition, we are closely monitoring the Omicron situation in Europe, where soaring case numbers and hospital admissions, have led to short-term lockdowns. The latest outbreaks may create further short-term equity volatility. Overall, we do not expect this to hurt the long-term investment case for the companies we own in our portfolios. In fact, as an active investor this may create investment opportunities.
Japan: What inflation…
Economic growth in Japan was starting to accelerate on vaccination progress, but another surge in cases, late in 2021, suggests that in the short-run, economic activity will slow. While the pandemic has pushed Japan back into overall deflation, on a positive note, elevated commodity prices have led to welcome price increases in some areas of the economy. We expect Prime Minister Fumio Kishida to follow a fiscal course of economic expansion, while the Bank of Japan (BOJ) extends its accommodative monetary policy. Business confidence and equity markets have been fueled by optimism in the increased near-term government spending program. While supply constraints have resulted in stagnant production, global demand remains solid, and the sharp increase in prices for raw materials along with intermediate goods suggests that demand will stay strong for finished goods. A slowing Chinese economy may cool sales of Japanese goods, and machinery. At Newday, we continue to advocate focusing on companies that can deliver earnings growth, and strong free cash flow.
Asia Pacific ex Japan: Now seeing potential for growth in both domestic demand and exports
We expect Asian growth to continue rising gradually, and domestic demand to catch up to exports as a growth driver. Developed Asian countries have reached high COVID-19 vaccination rates and developing countries are starting to make progress, which in time should also lead to a surge in domestic consumption. Factors affecting inflation likely remain within central-bank targets. We expect most central banks, in the region, to shy away from rate increases to avoid jeopardizing growth except for those in South Korea and India, where economic growth has been more robust.
In Hong Kong, the pace of recovery likely remains constrained by the pandemic, higher energy prices, slowing Chinese growth and uncertainty over U.S.-China relations. While GDP growth for 2021, should come in at around 6.8%, the economy overall is slowing primarily because of China. A key measure we follow is retail sales which remain 25% below 2018 levels, reflecting a dearth of tourism activity, especially from mainland China. Border restrictions in Hong Kong continue to be among the toughest worldwide which suggests this metric is not changing anytime soon.
In South Korea, we expect GDP growth to continue making strides toward pre-pandemic levels, supporting further policy-rate increases by its central bank. Export growth remains strong, signaling a possible decoupling from slowing Chinese demand. South Korea is benefiting from exports of chemicals and other petroleum products as strong demand has enabled producers to raise prices to a degree. Another positive is personal consumption is gradually improving, boosted partly by fiscal stimulus.
Emerging Markets: China’s struggles have made a significant impact
Emerging-market equities have been negatively affected, primarily, by the weak performance of China, which accounts for approximately one-third of the emerging-market benchmark and has been the weakest-performing emerging-market country over the past 12 months. The decline in Chinese equities, since the start of 2021, was driven by regulatory uncertainty surrounding technology and relatively tight monetary policy. The impact of internet stocks has been particularly pronounced given its weighting in the Chinese benchmark peaked at almost 50% a year ago.
India’s economy has been expanding quickly since the country emerged from an especially bad surge in coronavirus cases during 2021. We view the economy remains strong and progress on vaccinations has been such that the biggest near-term issue is not demand but supply. While aggregate demand shows signs of fatigue, reflected in weaker auto sales and exports, we believe this decline reflects supply-side bottlenecks such as chip shortages. Other key economic indicators exceed pre-pandemic levels. India’s central bank has embarked on plans to tighten monetary policy by ending bond purchases. However, financial conditions still remain loose, and GDP growth is forecast to rise to 9.5% in the 2022 fiscal year from “only” 7.7% last year.
For the emerging market investor, stark valuation differences remain. As an active stock-picker, within our ESG and fundamental investment process we continue to favor the consumer, driven by catalysts such as rising incomes, attractive demographics, and positive employment trends. Among cyclical sectors, we prefer financials based on valuation, improving asset quality and the scope for growth in fintech business, customer acquisition numbers and expanded services.
2022 Outlook: Scotsman’s View
I wrote this outlook as I was watching a favorite Scottish movie of mine: Local Hero. I had the good fortune to have lunch, in Glasgow, with its Director Bill Forsyth. It is, in my humble opinion, a hidden gem of a film. Should you care to watch the movie (for U.S. readers) there is a great line that best ties to my 2022 outlook:
Mac MacIntyre: What’s the most amazing thing you’ve ever found?
Ben Knox: Impossible to say. You see, there’s something amazing every two or three weeks.”
This sums up my outlook for 2022. My base case is for the global economy to continue growing at a robust yet slowing rate as the cycle matures. Central banks will dial back monetary accommodation, meaning that the capital markets will be receiving less support. The northern hemisphere is seeing the worst impact from Omicron, but the virus will spread to every country worldwide. However, countries are doing a better job of testing and vaccinating, Omicron symptoms appear less severe than Delta and hopefully this becomes an ongoing illness like the cold or flu. Nothing more severe.
With this backdrop, we expect another challenging year for investors. Volatility will remain elevated as 2022 brings U.S. midterm elections which will be a further source of uncertainty. Both the economic and business cycle is advancing, valuations are elevated, and markets are vulnerable to correction. In our view, stocks still offer better return potential relative to fixed income and cash. But we also see catalysts for stocks to advance, including significant investor cash on the sidelines, U.S. companies continue to have good operating leverage and TINA (there is no alternative), especially with inflation north of 3%. Prospective returns for bonds are especially unappealing in this environment and any meaningful increase in yields would lead to low or negative returns in sovereign bonds.
As an investor, one of the things that has always attracted me to capital markets is they indeed change, delivering something amazing not only every two or three weeks but every day. At Newday, we continue to redouble our efforts in managing portfolios to minimize exposure to unwanted factors and risks in the market, enabling us to maintain a good risk-return profile for our clients.