07 February 2022
Smaller companies (“small caps”) usually provide a close proxy to the current economic momentum. After all, if the economy is doing well then companies should perform well, and smaller companies, as they form the base of most economies, are likely to follow this trend. Similarly, as economic activity improves, companies with direct exposure to the cycle (cyclicals) should fare better than companies operating in “all-weather” sectors (defensives).
While we have seen cyclicals outperform defensives in the past 12 months, as the world emerged from the pandemic, small caps appear to have been left behind, especially relative to the largest businesses. This discrepancy is unusual, and may create an opportunity for investors looking to join the cyclical bandwagon at a discount. Based on the Russell 2000 and 1000 indices, US small caps trade at a 16% price-to-earnings premium to large caps. This compares to a 40% premium on average over the past 20 years, a 2.1 standard deviation anomaly.
In recent weeks, China has taken measures aimed at easing monetary conditions and boosting its economy. After cutting the reserve requirement ratio for banks, Beijing pressed ahead with interest rate cuts. In late January, the People’s Bank of China lowered its five-year loan prime rate, a reference rate for mortgages in the country, by five basis points.
While modest, the move was the first rate cut in two years. Indeed, actions by most other central banks, chief among which the US Federal Reserve, point to tighter monetary policy ahead. In this context, China’s easing bias makes the country stand out. At a time when global equity markets may appear expensive, the combination of attractive valuations and supportive central bank’s actions should put back China on investors’ radars.
In our Outlook 2022, we flagged geopolitics as a key risk. A month in, and there’s been no shortage of headlines pointing to several potential flashpoints. At the top of the list is Russia and its military activity close to Ukraine’s border. Diplomats have made little progress in trying to find a peaceful resolution to this slow-burning conflict.
Markets are starting to wake up to the risk of an invasion of Ukraine by Russia. While tensions are still below those seen when President Putin’s army first set foot in Crimea in 2014, it’s been steadily rising.
Should Russia invade Ukraine, implications would be numerous and mostly negative. Russian stocks have plummeted despite a surge in oil and gas prices, and could have more room to decline as sanctions loom. An open conflict would likely have global ramifications. For example, the Nord Stream 2 gas pipeline being kept shut, and preventing Europe’s access to much-needed gas.
A large-scale military conflict appears unlikely, but a digital war isn’t, and Russia may rely on cyber-attacks to counter any sanctions coming from the West. That said, history shows that geopolitical conflicts tend to have only a short-lasting impact on markets. Let’s hope this time is no different.
We anticipate that the world will normalise this year as COVID-19 moves from being a pandemic to being endemic. If the UK is any indication, the Omicron variant offers some hope that this scenario is playing out. While much more contagious, this variant of COVID-19 also appears much less lethal than its predecessors. As a result, despite a surge in new cases, hospitalisations, and more importantly deaths, have remained well below the levels reached when the Delta variant was dominant.
With vaccination rates continuing to increase, and with immunity from previous infections becoming more frequent, the worst of the COVID-19 crisis may be behind us. That said, risks remain and, another, more deadly variant may emerge in the coming months. But while this event would likely be a source of short-term volatility, we wouldn’t expect it to be as painful as what was experienced in 2020. Since then, the world has learned to live with COVID-19, and the science has made tremendous progress.
The market is pricing in five hikes from the US Federal Reserve in 2022. This is up from less than one move in September. The Fed’s U-turn on the pace of policy tightening has driven this change. The other main element is the realisation that inflationary pressures are here to stay for longer than initially anticipated.
Strangely, as the market became increasingly convinced that the Fed would act forcefully, the inflation forecast for the fourth quarter of this year kept being revised higher. In other words, it’s like the more the Fed hikes, the higher inflation expectations go. Or, put differently, the central bank’s expected actions are anticipated to fail at bringing inflation under control. This does not make sense. It appears that the market fails to recognise that if the Fed raises rates, this will impact both growth and inflation.
Welcome to the March edition of "Market Perspectives", the monthly investment strategy update from Barclays Private Bank. In this month’s report, we look at just how likely a recession might be, and what it could mean for equities, bonds, and other asset classes.
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