2022 Investment Markets Outlook
It is that time of year in this industry when market pundits attempt to forecast what the coming year will bring. They are inevitably wrong. The old saying is “if you are going to forecast, forecast often.” Another bit of advice for prognosticators is “forecast a level or a date but never both.” The wisdom here is obvious, it is impossible to accurately predict the future. Recall that a year ago inflation in the US stood at 1.4%, now we have just reached 7%. No one foresaw that, not even the US Federal Reserve (Fed), whose job it is to contain inflation and who has hundreds of economists modelling all aspects of the US and global economies. So, no specific forecasts from us, rather some observations on what is going on and a sensible way to think about what is driving economic policy makers.
Firstly, how did we end up with dramatically higher inflation levels than forecast for much of the global economy? In fact, the highest levels we have seen for decades. Recall we have spent the past dozen years since the Great Financial Crisis (GFC) with global central banks worried that inflation was below target and they were doing all they could to push this higher. Governments were concerned that wages were stagnant and the disparity between rich and poor was getting ever wider.
We believe that the best explanation for the surge in inflation is that the massive fiscal stimulus provided during the pandemic collided with monetary policy that was already very loose, even when measured against the monetary policies undertaken post the GFC. The pandemic related fiscal stimulus was aimed at households, and it created a surge in demand for goods that could not be produced in sufficient quantities. Households sought to buy more goods (cars for example) because they could not buy services (no restaurants, travel, concerts etc.) due to lockdown restrictions. Businesses could not produce enough goods, again due to lockdown restrictions. Naturally, this led to price hikes. Businesses scrambled to meet demand and looked to boost production. This led to further price hikes and congestion throughout world supply chains often exacerbated by a variety of travel restrictions and lockdown policies throughout the world. Spring of last year saw the widespread availability of vaccines, which then allowed the service economy to begin to reopen. Demand for services recovered sharply as households were desperate to go out and experience life again. Both goods manufacturers and service providers found the labour market had tightened significantly. Workers had time during the pandemic (and income from government transfers) to think about their priorities. Many workers dropped out of the labour force. Competition for workers intensified and wages rose. Inflation had arrived and was rising steadily. Both governments and central banks were wary of reducing economic support as the advent of new Covid-19 variants raised the potential of new restrictions that would then lead to a slump in activity. The post GFC mindset that deflation and an economic slump was lurking, continued to dominate their thinking. Indeed, the accepted view across central banks was that the rise in inflation was “transitory” due to supply chain shocks and there was no need to change policies - downside risks from the ongoing pandemic were still present.
Inflation has now become the biggest concern, overshadowing even the ongoing pandemic. No one expected we would still be wearing masks and worrying about Covid-19 in early 2022. The presumed “transitory” inflation caused by pandemic induced supply shortages has persisted and continued to climb. It has reached levels that have come to the attention of government leaders who are promising to take action to protect the voting public from an excessive rise in their cost of living. It is not just a US problem, inflation in the UK is at 5.4%, in Germany it is 5.7% and in Spain it is 6.7%. Government leaders are calling for something to be done. Businesses are being accused of gouging consumers and raking in big profits.
Central banks remain confident that they have all the tools necessary to contain inflation and will do what they need to do. Government leaders at present are encouraging them to do just that. What no one has publicly said is that fighting inflation means raising interest rates to slow economic growth, resulting in layoffs of workers, reduced corporate profits and an increase in borrowing costs for everyone: businesses, governments, and households. Inflation is “too much money chasing too few goods.” Central banks cannot produce more goods and they certainly cannot alleviate pandemic created shortages but through the blunt tool of raising interest rates they can reduce the demand (too much money) chasing those goods. The challenge is to determine how high interest rates need to go to bring inflation back down to target. Do the central banks and their respective government overseers have the will to undertake and support the rate hikes required? Our view is that they do not have the courage to do what is necessary, (the ECB for instance has ruled out raising rates despite 5% inflation) but for the moment they want to sound tough and determined. The Fed has forecast they may hike three or four times over the next year bringing the Federal funds rate up to 1% or so. Will that do anything to bring down inflation? We doubt it. If inflation fails to moderate in the first few months of this year, will the Fed do more? Will they start shrinking their balance sheet besides no longer adding to it? The market is worried about this.
At their policy meeting last week the Fed Chairman Powell presented a clearer picture of what the Fed intends to do. They will likely raise the Federal funds rate in March (conditions permitting). He also emphasised it was time to move from a super accommodative policy to a more neutral policy. The Fed will also (after it has begun to raise rates) allow its balance sheet to begin to shrink as the securities it holds mature. They will not reinvest the proceeds. The Fed also stressed that the economy now was very different from the last time they began to raise interest rates in 2015. Inflation is much higher; the labour market is much tighter, and growth is much stronger. Chairman Powell stated that there was a lot of room to tighten policy without impacting the labour market. He warned that the risks were that inflation could stay higher for longer than expected. He was sympathetic the damage this causes to lower income households. This is not a Fed who will back off tightening policy if the equity market stumbles. For the moment the “Fed put” has been removed. There is still a great deal of uncertainty. We don’t know how often they will hike rates or how quickly they will shrink the balance sheet. Given this, it is not yet a comfortable environment for risk assets and we would expect volatility to remain elevated in the short-term.
The end of this period of super easy credit is spooking the financial markets, as it should. We have been mentioning this in our last few letters. Stocks with high valuations, often with little in the way of earnings are particularly vulnerable. Indeed, the vast majority of growth stocks have seen significant moves to the downside. The Ark Innovation ETF has been the poster child for these types of stocks, as it holds many of them, and it began falling sharply in price in November last year. The decline has accelerated into this year. All of the fund’s outperformance vs the S&P 500 since the beginning of 2020 is gone. As is often the case, retail chases performance and the Robin Hood effect that stock trading is a “game” is going to prove fatal for many investors.
Selling often begets selling and we are seeing many other more speculative types of investments suffering sharp price declines. Special Purpose Acquisition Companies (SPACs) have also suffered from significant moves to the downside, whilst Bitcoin offers no diversification. At the time of writing, it has fallen around 50% from its highs in November.
Where can you hide? Fixed income has not been helpful, and will not be until it has priced enough Fed rate hikes. We do not believe markets, or the Fed fully understand what the impact will be of them no longer buying $120 billion a month of securities. Continental European and UK equities have fared better in the early 2022 sell-off and we have been recommending an overweight in them for some time. These markets were never as frothy as the US and offer better relative value. The elephant in the room is China, which is not over the Evergrande real estate bust. In fact, it is spilling over to the rest of the economy. Chinese 2021 4th quarter growth was down to 4% and retail sales are struggling.
The economic situation in China is also being negatively impacted by the massive zero tolerance Covid-19 lockdowns in several major cities. We do not see China as a haven or as something that can offset the impact of quantitative tightening on markets, although we would stress that it is likely that the People’s Bank of China will support the economy via stimulus and these measures could be supportive for domestic Chinese equities which are now trading at a significant discount versus developed market equities.
In our view, quality and value are keys to your portfolio. Not losing is winning in this kind of environment. There will be great opportunities to pick up quality tech names once markets have settled down. For risk assets to stabilise we need growth to hold up while central bank monetary stimulus is reduced and removed and as fiscal stimulus wanes. We think growth will slow but not dramatically, as labour markets are very tight and household balance sheets are in great shape.
We will also need to see a combination of inflation beginning to moderate and eventually decline alongside a Fed that acknowledges they are comfortable with that. That is many months away at the earliest. Meanwhile there will be more weeks like the one we have just had.
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