2022: a year of proper economic recovery?
Richard Watts, co-Head of Strategy, UK Small & Mid Cap, looks at a volatile start to the year in equity markets, and appraises the prospects for economic growth in 2022 as Omicron and inflation continue to make headlines.
Alongside extreme movements in bond markets, the start of this year has been the best for value stocks on record. The underperformance of growth, and especially the unprofitable parts of the tech sector, can be traced back into Q4 last year as well. That has unwound much of the valuation premium accrued during the first half of the pandemic to date, putting valuations today at a more reasonable level than they have been for some time. Parallels with the dotcom era of the early 2000s are overblown, in my view, as back then US technology stocks were on a 125% valuation premium to the wider market, but today they’re at a 25% premium – elevated, undoubtedly, but far from extreme.
The general thesis we have for this year is that markets will generally grind higher, helped by a pretty robust economic backdrop with strong GDP growth (although not as strong as last year). The world is in a tough place right now with Omicron, but the virus data is actually much more encouraging than was feared several weeks ago. To my mind, 2022 will be a year of proper recovery coming through and I see a supportive backdrop for select cyclical/value stocks.
There continues to be a big debate about inflation, and the rhetoric from central banks about inflation being ‘transitory’ has now been dropped. It seems inevitable that inflation will be high for at least the first half of this year, coming off a low base from H1 2021, but inflation is a backward-looking measure and, in my view, the second half of this year will see inflation growth moderate.
That relative bullishness notwithstanding, one of the lessons that investors will have learned last year is that highly-rated stocks that suffer disappointments get punished hard by the market. That makes due diligence and a hard-nosed approach to what makes the cut for a portfolio, and what doesn’t, all the more important.
Bond yields off to the races in early 2022
Mark Nash, Head of Fixed Income Alternatives, discusses a turbulent start to the year in bond markets, and considers whether the market isn’t yet pricing in enough interest rates rises in the US.
The US growth and inflation picture has changed significantly and that’s reflected in the eventful rise in Treasury yields that we’ve already seen this year. We think yields will continue to rise and the 10-year bond yield could potentially increase towards 2.25%.
This anticipation can be attributed to three factors: expectations of where rates could reach this cycle, a potentially higher term premium, as well as the macro picture. Investors aren’t happy owning treasuries at these low yield levels.
The US output gap has closed and the recent unemployment and wage numbers bear that out. This fully justifies the Federal Reserve’s (Fed) aggressive U-turn over the past three months. The central bank is now talking about quantitative tightening going forward, compared with mild tapering previously. ‘Transitory inflation’, the buzzword most of last year, has kicked dust and central banks across the board have had enough of that phrase.
The Fed still thinks that inflation is going to fall from the supply-side angle over the course of this year. But they are gearing up to tackle cyclical inflation pressures, which are on their way up. The market has priced in three Fed hikes for this year, but we think more can potentially happen. We think the market pricing in a peak in Fed rates of around 1.7% is just too low considering the macro changes that we are seeing.
At the beginning of last year growth looked good and inflation wasn’t an issue. But the picture changed as a new variant of the virus kicked in after the summer. Also, the inflation coming through was generally seen as damaging for growth, consumer demand and businesses. That’s why we think the curve flattened and yields were low.
Now, the virus scene is set to get better. Supply-side issues are starting to ease up, which is good for growth. Even if this causes inflation to ease a bit over the course of this year, the Fed can’t relax. Financial conditions over the last year have eased a lot and they’re still very easy, while the market has done little to tighten the conditions. That’s why the Fed has gone into overdrive. But I don’t perceive the market impact from this to be as negative as a lot of people think. The situation is clearly bad for duration, a measure of a bond price’s sensitivity to changes in interest rates, but good for risk markets overall.
The US needs to tighten as growth is looking better across the board. If the virus does ebb it should be a positive for global growth and will help rectify supply chain issues. This scenario should keep the dollar in check. They may also ensure that we don’t see a repeat of 2018 when the dollar rallied as the Fed hiked, even as growth in the rest of the world slumped.
Treasury yields should rise across the board and the front end of the curve – up to 10 years – could potentially steepen. As US yields rise, volatility is going to pick up but I don’t think it will be too aggressive because the cyclical picture does look pretty good.
The European Central Bank should also look to tighten, although China is a wild card. The growth picture is getting a bit more supportive, but we certainly think it is reflected quite heavily in markets already.
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