More muted upside for equities leaves room for sector rotation

15 November 2021

By Julien Lafargue, CFA, London UK, Chief Market Strategist; Dorothée Deck, London UK, Cross Asset Strategist

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  • Summary
    • We remain constructive on equities in 2022 but expect returns to be more muted, as the economy slows from very elevated levels and the growth/inflation mix deteriorates
    • An environment of above-trend growth, low rates and accommodative policies should support risk assets and warrants a modest pro-cyclical stance in portfolios
    • While equity returns at the asset class level appear more limited, we see the potential for tradable rotations between sectors and style
    • With the risks of inflation and yields skewed to the upside, we believe financials, energy, industrials and materials are well positioned in the next three to six months. By contrast, technology at the broad industry level, as well as the more defensive parts of the market seem more vulnerable
  • Full article

    As global growth slows from exceptionally high levels and a period of sub-par equity returns looks likely at the asset class level, where do opportunities lie and how should investors position portfolios?

    We remain constructive on equities in the coming year, in absolute terms and relative to bonds. However, we expect returns to be more muted, as the economy slows from very elevated levels and prospects for the growth/inflation mix deteriorate.

    Economic momentum is slowing

    While global growth momentum has peaked, we believe it will remain robust in coming months. That said, momentum is likely to rotate from the US to the rest of the world, supported by the reopening of economies, further progress on the vaccination front and continued accommodative monetary and fiscal policies. In the G7 economies, we expect growth to slow from around 5.1% in 2021 to 4.0% in 2022, which remains well above trend growth of 1.4%.

    We believe that this environment will be accompanied by a modest rise in nominal yields and inflation, which is unlikely to hurt the economy and derail financial markets. Long- term rates remain well below trend nominal GDP growth of around 3.5%. Our economists forecast a gradual increase in US 10-year yields to 1.50% by the end of the year, and 1.65% by next September.

    This environment of above-trend growth, low rates and accommodative policies, should support risk assets and warrants a modest pro-cyclical stance in portfolios.

    Investment risks

    However, the growth/inflation mix has deteriorated since August, fuelling concerns of stagflation among investors. Macro data have disappointed since August, especially in the US and China, while inflation expectations have been sticky in the US and rising in Europe.

    The main risks to our base case scenario are:

    1. a disappointment in global growth, driven by resurging COVID-19 cases and the reintroduction of lockdowns, as well as a China slowdown;
    2. a more persistent rise in inflation, putting pressure on central banks to tighten policy. As we move away from a post-COVID-19 recovery to a mid-cycle phase, inflation might be stickier than generally assumed. Additionally, supply-chain disruptions and labour shortages may persist for longer than expected, and the increase in energy and input costs might put more strain on businesses with more limited pricing power.

    All in all, we feel that the risks to inflation and nominal yields are skewed to the upside, and portfolios should be positioned accordingly, see Our five-year forecast and scenarios: strap up for a two-speed recovery in this issue.

    Equity market outlook: earnings versus valuations

    We believe that markets will continue to be supported by earnings growth in 2022, albeit at a slower pace.

    We also expect modest multiple contraction to persist as the growth/inflation mix deteriorates. According to IBES estimates, bottom-up analysts anticipate earnings growth to slow from 49% this year to 8% next. Given the macroeconomic backdrop, these expectations look reasonable. Factoring in some multiple contraction, to account for the risk of a growth slowdown and/or an inflation shock, would justify mid-to-high single-digit total returns for global equities in 2022.


    The stellar performance of equities since their March 2020 lows was driven by multiple expansion as earnings contracted. However, since January, this trend has reversed and equities have been driven by earnings growth, as economies have reopened, while valuations have contracted.

    Earnings have outpaced price gains in 2021, on the back of strong margin expansion and modest revenue growth.

    With non-financials’ EBIT margins (earnings before interest and taxes) at a decade-high of 11.5%, up from 7.5% in December 2020, the room for further significant margin expansion looks limited, especially in the context of rising input costs.

    However, our analysis suggests that in times of rising inflation, companies have generally had the ability to pass on higher input costs to customers and protect profitability. In fact, since 1983, such a scenario has played out 70% of the time (see figure 1). As such, we expect top-line growth to be the main contributor to earnings next year, helped by stable-to-modestly higher margins.


    From a valuation standpoint, equities may look rich on certain measures, but they are in line with their historical average relative to bonds. Global equities trade at 18-times forward 12-month earnings, versus 16 times on average over the past 30 years, and down from a recent high of 20 times last January. Relative to bonds, stock valuations are in line with history, with the global equity risk premium standing at 4.1%, essentially in line with its 20-year average.

    Allocation views

    Over the medium-to-long term, we maintain a preference for quality, structural growth and idiosyncratic risk. Coming into a period of sub-par returns, active management and skilful stock selection will be key. However, over the short- term (less than six months), rotations between sectors and styles may persist.

    Given our expectation of above-trend growth, with the risks of inflation and yields skewed to the upside in the coming months, financials, energy, industrials and materials appear well positioned. Indeed, these sectors tend to benefit from strong cyclical momentum and have been positively correlated with yields and inflation (see figure 2).

    Because the previously-mentioned sectors’ top-line growth is influenced by specific factors (such as oil and basic resources prices for energy and miners, and interest rates for financials), their profitability can be more easily protected. This is why they have been more able to increase margins in times of rising inflation. In addition, industrials should benefit from an increase in capital spending, fuelled by the economic recovery and digitisation of manufacturing processes.

    Conversely, an increase in interest rates could be detrimental to the more defensive parts of the markets, which tend to be treated as bond proxies by investors. Utilities, consumer staples and communication services appear particularly exposed.

    Finally, the healthcare and technology sectors continue to exhibit very attractive long-term growth prospects. However, their performance could be challenged in the short-term should interest rates rise.

    Banks: tactical opportunities remain

    In the near term, we believe that financials, and banks in particular, should continue to benefit from a rise in interest rates and a solid macroeconomic backdrop.

    Despite their outperformance of over 20% in the past 12 months, global banks are still trading at a steep 45% discount to the market on a price-to-earnings basis. This compares to a 26% discount, on average, over the past 20 years. The broadening recovery should support their fee income businesses, boost their loan growth, keep a lid on credit defaults, and lead to a continuing reversal of loan loss reserves, while also placing upward pressure on bond yields and net interest margins.

    There is a tight correlation between banks’ relative performance and long-term bond yields (see figure 3). Out of the 20 sectors we examined globally, global banks’ performance appears most tightly correlated to higher bond yields. While a possible flattening of the yield curve remains a risk for banks’ relative performance, we see economic growth as a more significant driver of earnings and relative performance in the short term.

    Technology: selectivity is increasingly required

    During the worst of the pandemic, the GICS technology sector became a “risk-off ” trade and a “place to hide”, due to the visibility it offered. As the global economy continues to recover, we believe that its risk-off status may be challenged. This might put pressure on the sector’s valuations, in particular if bond yields rise and work against the long duration of its cash flows.

    Technology trades on a substantial 52% premium to the broader market, over two standard deviations above its 15-year average, which leaves it exposed to potential disappointments. While we continue to see attractive long-term opportunities within the sector, we believe that increased headwinds (greater regulatory oversight and possible far-reaching tax reforms) may weigh on sentiment and penalise parts of the industry in the short term.

    Implications for regional equity allocations

    Based on regional markets’ sector composition, our sector preferences point to increased support for non-US markets in the first half of 2022, and more specifically to Europe, including the UK, followed by Japan and emerging markets. Indeed, Europe and Japan, and to a lower extent emerging markets, have a greater exposure to the most cyclical parts of the market, with Europe and emerging markets being more heavily weighted towards financials.

    Historically, non-US equities have tended to outperform in times of improving economic growth. With the dollar being a contra-cyclical currency, these periods have often coincided with a weaker dollar.

    Stock picking can add value

    Our sector and regional views are top-down driven, and do not reflect the potential for idiosyncratic opportunities at the stock level, which we expect to remain a key source of alpha in 2022. Indeed, we have observed that in the past six-months or so, the environment has become more attractive for stock pickers, compared with the second half of 2020 or first quarter of 2021.

    Between April 2020 and February 2021, stocks in Europe and the US were strongly correlated with each other, as the market was driven by COVID-19 fears and macro-related risks. However, since February, we have seen a significant decline in correlations, suggesting a higher dispersion of returns among stocks, and therefore more opportunities for stocks pickers to generate alpha (see figure 4).

Outlook 2022

Our investment experts look at why active management looks key for equity investors, what elevated inflation and promised rate hikes mean for bonds, our five-year capital market assumptions and the potential opportunities created by climate change that investors need to consider.

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