As the world moves on from the pandemic, 2022 is likely to be characterised by slower economic growth, higher inflation, elevated volatility, and ultimately outperformance of equities over bonds. But in this uncertain environment, proper diversification and active management remain key to improve portfolio performance.
A year ago, as a second wave of COVID-19 infections was forcing parts of the world to return into lockdown, we published our Outlook 2021. At the time, our message centred around the importance of favouring a balanced and diversified approach to help navigate a very uncertain backdrop. Fast forward to today and, when looking at 2022 and beyond, our assessment remains broadly unchanged. Yet, the sources of uncertainty have evolved dramatically.
From GDP to CPI
As time passes, both Main Street and Wall Street are learning to live with COVID-19. Adjustments have been made to the way we work, travel, socialise and consume. But, by and large, today’s world isn’t very different from the one we were in 2019. The rapid discovery of vaccines allowed economies to reopen and activity to resume at speed. However, this “stop and go”, on a massive scale, has created unprecedented frictions in supply chains and parts of the labour market.
As a result, inflation (and increasingly stagflation) fears, as well as concerns over the path of interest rates, are at the centre of the wall of worry that investors are trying to climb. We expect these issues to dominate the narrative next year again, at least in the first half.
Forecasting isn’t easy
The pandemic and its aftershocks have made forecasting even more difficult than usual. In fact, over the past couple of years, the volatility of the Citi global economic surprise index has more than doubled compared to its historical trend. Yet, as we explained in Outlook 2021 a year ago, many of the disruptions being experienced should be temporary, or, to use a popular word among central bankers, “transitory”.
Although 2022 is likely to remain impacted by, hopefully, the tail end of the COVID-19 crisis, beyond that we expect a gradual normalisation, as reflected in our new five-year capital market assumptions.
From pandemic to endemic
We believe that COVID-19’s status will transition from pandemic to endemic… This process won’t happen overnight and outbursts of infections are highly likely. But these should only be a marginal drag on global growth
Indeed, starting in 2022, and assuming that vaccine-resistant variants don’t spoil the party, we believe that COVID-19’s status will transition from pandemic to endemic, making it akin to the seasonal flu. This process won’t happen overnight and outbursts of infections are highly likely. But these should only be a marginal drag on global growth, rather than the unprecedented shock seen eighteen months ago. Implications for investors include the effects on central bank policy, inflation, the “TINA” mindset and expectations of lower returns, as we detail below.
Central banks’ careful U-turn
The first impact will be felt on monetary policies. After doing “whatever it takes” to support their economies, we expect central banks to accompany this transition to the new normal by removing some of the stimuli they introduced during the crisis. While the normalisation process will probably remain relatively slow, the pace will vary from one region to the other. This should translate into increased volatility in rates and currencies markets. It will also likely promote more frequent sector rotations, and pronounced dispersion in stock markets.
Inflation as the wild card
Unfortunately, this scenario is valid only if inflationary pressures don’t force central banks’ hands. While prices in the sectors most impacted by the pandemic have started to moderate, the recent surge in energy prices has changed the market’s perception on inflation. From “transitory”, higher prices are now seen as “stickier” with five-year inflation forwards, looking at five-year inflation expectations in five years’ time, surpassing 2.6% in the US.
Yet, the consensus is far from discounting inflation of over 3% over an extended period. This appears justified for now, as wages and rents, the real drivers of long-term inflation, are well behaved. While concerns may continue to grow in the first half of 2022, we would expect inflation to be less of an issue in six months’ time, preventing a sharp tightening of monetary policies.
TINA is alive and well
From an asset allocation’s perspective, this normalisation process still favours equities over bonds, in our view.
Although stocks valuations may appear rich on some metrics, the equity risk premium remains in line with its historical average, and continued earnings growth should provide support to equity markets. In addition, stocks tend to offer a better hedge against the inflation risk than most fixed income instruments. As such, we believe that the TINA (there is no alternative) motto will remain in place in 2022.
Lower returns still
Twelve months ago we argued that investors should prepare for lower returns ahead. While this year has been kind to equity holders, it has been much more challenging for those who were heavily invested in low-risk bonds, or in cash.
We expect 2022 to be an average year at best, with upside being constrained by demanding valuations….To escape this trend, we believe investors need to expand their universe
We expect 2022 to be an average year at best, with upside being constrained by demanding valuations across most asset classes. To escape this trend, we believe investors need to expand their universe, both vertically (focusing more on sector and stock or bond-specific opportunities) and horizontally (with the inclusion of private markets and alpha-based, market-neutral strategies).
Taking the long view
When near-term visibility is poor, it may be wise for investors to focus on their long-term objectives. With that in mind, we refreshed our five-year capital market assumptions, which are used to inform our strategic asset allocation. Over this period, we expect the above “new normal” to take shape, bringing growth closer to historical trends and interest rates gradually higher. These assumptions ignore any potential unforeseen shock and are, of course, subject to periodic revisions.
Our message for long-term investors is that being and staying invested continues to make sense, although one should be prepared for more elevated volatility, and potentially slightly lower-than-average returns.
ESG to remain at the forefront
Similarly, environmental, social and governance considerations are here to stay, and will likely continue to influence investors’ choices in 2022 and beyond. They will also potentially play a key role in directing additional government spending, while contributing to volatility in the commodity space as the energy transition gathers pace.