Markets Weekly podcast - 29 November 2021

Henk Potts (HP): Hello. It’s Monday, 29^th November and welcome to the Barclays Private Bank Markets Weekly podcast, the recording that will guide you through the turmoil of the global economy and financial markets.

My name is Henk Potts, Market Strategist for Barclays Private Bank. Each week I’ll be joined by guests to discuss both risks and opportunities for investors.

Firstly, I’ll analyse the events that moved the markets and grabbed the headlines over the course of the past week. We will then reflect on how equity investors should be positioned, going into 2022. And finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.

The Omicron strain of COVID-19 discovered in southern Africa, as we know, sent a shockwave through global financial markets on Friday, pushing stocks, bond yields, and commodities lower. This is after World Health Organization scientists described the variant as very different to previous strains, with double the mutation of the Delta variant.

Risks around the new strain are that it could be more transmissible, vaccines less effective, and could lead to more serious illness. But South African experts said the symptoms have so far been mild. It will of course take a couple of weeks for the medical authorities to come to a conclusion on those areas, meaning investors could adapt to a risk-off approach until greater detail is known.

It's not just Africa: in Europe the focus has been on the new wave of coronavirus sweeping across the continent. Rising infection rates across Europe are forcing governments to impose tighter restrictions, including, with various degrees of intensity, renewed directives to work from home, the closing of schools and non-essential retail, along with vaccination mandates.

The reimposition of the measures has been stoking social unrest, impacting business confidence, and weighing on demand expectations, particularly for services. That nervousness has already been shining through, in terms of the survey data, which has already been taking a hit from inflationary pressures and supply constraints. If you look at the Ifo survey, it showed business confidence in Germany continued to decline in November. In fact, it’s fallen for five straight months, and is now at its lowest level since April.

In terms of the impact more broadly, the recent variant discovery, and resurrection of restrictions, are a reminder that spikes will continue as the world slowly makes the transition from pandemic to endemic, which we wrote about in our 2022 outlook.

Victory over the virus in the short term is far from assured, particularly given the wide dispersion of vaccination rates. Advanced economies have rapidly outpaced those in emerging and developing economies. African countries, in particular, have been languishing down at the bottom of the league tables, with less than 5% of citizens fully vaccinated. Low-vaccinated regions could create an environment which allows the virus to mutate, which could then be exported to other regions.

The recent development is likely to lead to further calls to meet the global, rather than local, vaccination challenge. However, we don’t anticipate the intense, widespread lockdowns that were implemented during the start of 2020. Science, we should recognise, has made great progress over the course of the past couple of years.

Vaccinations have proved to be successful, and can be adapted to meet new challenges. We should also appreciate that households and businesses have demonstrated that they are able to adapt to tighter restrictions, which should reduce the impact of any renewed curbs on physical interaction.

But there was a stark reaction, of course, from markets. Central bankers are now expected to move from inflation watch to wait and see mode, which has encouraged traders to scale back interest rate-hike bets. Markets are now betting, for example, that the Bank of England will postpone its first rate hike from December to February next year.

Money markets are also predicting the lift off for US rates will come later. So, if you look at Treasury yields, they tumbled the most since the early days of the pandemic on Friday. Ten-year Treasury yields fell 16 basis points, to 1.47%. That’s the largest single session decline since March 2020.

Equity markets, of course, were drowning in a sea of red on Friday. The STOXX 600 sunk 3.7%. It was down 4.5% over the course of the trading week.

A similar picture on Wall Street, less dramatic perhaps, but the S&P 500 registered its worst post-Thanksgiving session since 1941, and was down 2.3%.

In terms of sectors, well, no real surprise that travel and leisure were hit hard. Pharmaceuticals bounced back. Moderna, for example, was up 20%. Pfizer closed at a record high. There was a smaller bump for the lockdown favourites; food companies, delivery companies particularly, along with Zoom and Peloton, also saw a small rise in terms of their share price.

In terms of currencies, money flowed into the safe-haven currencies, particularly the Japanese yen and the Swiss franc. In terms of commodities, concerns over renewed demand shock pushed oil substantially lower, but gold was up around about 1%, holding above the $1,800 an ounce level.

The reassuring news is that markets have regained some of their composure this morning, but certainly not regaining all of those losses. European equities, at the open, up nine-tenths of 1%. S&P 500 futures were trading up nine-tenths of 1% also. Oil has recovered around about 4% of the losses from Friday, Brent trading around $75 a barrel.

Thanksgiving week normally, of course, represents a calmer time for markets. But as Americans sat down to enjoy their dinner, they were forced to reflect upon the new variant, alongside an issue that’s been dominating the minds of investors and central bankers, which has been the threat of inflation.

According to data from the US Farm Bureau, the traditional Thanksgiving meal this year cost 14% more than last year, as the price of turkey is up 24%, cranberries up 11%, and even pumpkin pie was up 10%, with the meal falling victim to supply constraints, rising energy, fertiliser, and animal feed costs, coupled with poor weather and labour shortages.

No doubt FOMC members were considering those factors as they pondered the appropriate pace of policy normalisation over the course of the holiday.

The Fed minutes, of course, were published the day before the Thanksgiving holiday, arguably created perhaps more questions than answers. Deliberations did suggest a more hawkish tone than was anticipated.

So what can we expect in terms of the policy path in the United States?  Well, the Fed will continue, we think, to monitor the incoming data very carefully, particularly the impact from the new variant on activity. There’s no doubt that pressure has been building.

We’ve seen some solid employment figures. Last week initial jobless claims fell to their lowest level since 1969. Also, expecting another red hot CPI print in December. It could come in around 6.4%, which would be above the 30-year high, of 6.2%, that was registered in October.

So if disruption from the new strain is manageable, inflationary pressures prove to be persistent next year, then the Fed would have a clean slate to raise rates in the second half of next year, or potentially before that if tapering is concluded at a faster rate. However, if inflation proves to be transitory, or the recovery falters, hikes could be postponed until 2023.

So that was the global economy and financial markets last week. In order to discuss the outlook for equity markets, I’m pleased to be joined by Dorothee Deck, Cross Asset Class Strategist for Barclays Private Bank.

Dorothee, great to have you with us today. Can you start by taking us through your outlook for equity markets next year, and perhaps outline how you think investors should be positioned from a portfolio perspective in 2022?

Dorothee Deck (DD):  Thanks a lot Henk, and good to be with you. As you mentioned earlier, we have recently published our investment outlook for 2022, and the key message for equities is that we remain constructive on the asset class in absolute terms, and relative to bonds. But we do expect returns to be more muted next year as the growth inflation mix deteriorates.

I guess it is fair to say that the post COVID recovery has been exceptional, both in terms of speed and magnitude, so the returns that we’ve seen in the past few months are unlikely to be replicated.

Going into next year, we think markets should continue to be supported by strong earnings growth, albeit at a slower pace, partially offset by multiple contraction as growth moderates, while inflation remains sticky.

Consensus is currently going for 7% earnings growth globally, which we feel is reasonable. We think it will come primarily from top-line growth, as profit margins are now at a 13-year high, and the room for further expansion looks limited.

We do recognise that equity valuation looks stretched in absolute terms, but they’re in line with history when compared with bonds. So, in our view, valuations are not a constraint, and equities should continue to benefit from the lack of alternatives.

So, all in all, we expect equities to generate mid-to-high single digit total returns in 2022, including dividends.

We also expect next year to be characterised by increased volatility, and we see the potential for continuing rotations across sectors, regions, and style.

Now, this environment of above-trend growth, combined with lower rates and accommodative policies, should continue to support risk assets in 2022, and in our view it warrants a modest pro-cyclical stance in portfolios, as well as a value tilt.

HP: So let’s pick up on some of those points that you’ve mentioned there. You mention a preference for cyclicality and for value. Which sectors would you highlight as being particularly attractive?

DD: So, for the next six months, we would favour areas of the markets that are most sensitive to an economic rebound, benefit from higher yields and inflation, and enjoy superior pricing power. So that would include financials, energy, industrials, and basic materials.

Among those sectors, we particularly like banks, which we feel are especially well positioned in the current environment. The broadening recovery should continue to 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. It should also place upward pressure on bond yields and help manage interest margins.

In addition, banks are one of the main beneficiaries of higher yields, so historically there has been a very tight correlation between their relative performance, and changes in yields. And finally, valuations are very compelling, with this sector trading on a substantial discount to the market versus history, despite a strong outperformance in the past year.

Now, the flattening of the yield curve is often cited as a key risk for banks, but our view is that it is actually the level of yields, and the level of economic growth, that matter the most for banks’ earnings, and relative price performance.

We also like industrials, which would benefit from an increase in capex spending, fuelled by the economic recovery, and the digitisation of manufacturing processes. The sector is very heterogeneous, but tends to enjoy strong pricing power, which is obviously important in times of rising input costs.

And finally, energy and basic materials should continue to benefit from the ongoing recovery, and high commodity prices across the board.

HP: So you’ve highlighted some sectors where you think there are some opportunities, but clearly there’ll be some risks as we look out to next year. Which sectors should be avoided by investors?

DD: Yeah, so over the next six months we would be cautious on the more defensive, long-duration parts of the market, such as consumer staples, healthcare, utilities, telecoms, as well as the broad technology index. And this is due to their lower sensitivity to the cycle, and also their vulnerability to higher yields and inflation.

Among those sectors, we think consumer staples look particularly vulnerable. Historically, there has been a strong inverse correlation between the relative performance, and changes in bond yields. They also tend to lack pricing power, especially compared with the more cyclical sectors.

Now, with regards to the technology sector, we think it is important to differentiate between software, hardware, and semiconductors. During the pandemic, the technology sector was a place to hide, given the visibility of its earnings, but the sector has now become very expensive trading at two standard deviations above its 15-year average, based on forward PEs.

It is worth flagging that this premium is mainly driven by the software segment, which represents 60% of the overall market cap, and is now trading at three standard deviations above its long-term average.

Now, this comes at a time when we think the sector will face increased headwinds, in the form of greater regulatory oversight of large-cap technology names, as well as tax reforms. And tax reforms could hurt those names disproportionately more, because they often benefit from the lower tax rates.

So, while we continue to see attractive long-term opportunities within this sector, we believe those headwinds could actually weigh on sentiment, and penalise part of the industry in the short term. And this is why we think stock selection will be key in the tech sector in the next few months.

HP: OK. So let’s finish off with some regional preferences. Where do you think investors should be focusing their financial firepower?

DD: Yeah, so given the regional market composition, our sector views actually translate into a preference for non-US equities over their US peers, in the first half of next year, and more specifically for Europe, including the UK, followed by Japan, and emerging markets.

To be more specific, financials are over-represented in Europe and emerging markets. Cyclicals, ex-technology, are more heavily weighted in Europe and Japan, and, to a lower extent, in EM, and the US market is dominated by tech and healthcare.

So, those regional preferences are also consistent with our macro views. We expect growth momentum to shift from the US to the rest of the world next year, supported by the reopening of economies, further progress on the vaccination front, and continued accommodative monetary and fiscal policies.

And finally, our regional preferences are also supported by valuations which have become quite extreme in recent months. So, to give you some numbers: European equities are now trading at a 30% PE discount to US equities, versus a 15% discount, on average, over the past 20 years. That’s 2.4 standard deviation below average. And if you look at non-US equities more broadly, they are now on a 34% PE discount to the US, versus a 15% discount on average over the past 15 years. That’s 2.7 standard deviation below their long-term average, so that’s quite extreme.

All those factors should support non-US equities in the first half of next year in our view.

HP: Well, thank you, Dorothee, for your insight today. If listeners are interested in getting more information about the prospects for the global economy and financial markets in 2022, they can find our outlook document on the Barclays Private Bank website.

Let’s turn to the week ahead. Oil prices will be in focus, with the OPEC+ meeting taking place on Thursday. It looks set to be an interesting meeting, given the renewed concerns over future demand, and the recent releasing of the strategic reserves.

OPEC+ are expected to maintain a conservative approach around increasing production. OPEC+, to remind you, introduced aggressive cuts at the start of the pandemic, 10 million barrels per day in April 2020. They’re still holding back somewhere around about 3.8 million barrels per day.

The group of producers appear reluctant to increase output levels beyond the 400,000 barrels per day per month, given the risks around the new restrictions infringing upon travel. Industrial production is struggling with supply constraints, further evidence of the Chinese economy slowing down, and, as has been mentioned, countries, including the United States, announcing plans to release oil from their strategic reserve.

On the data front, we forecast that euro inflation will accelerate to 4.5% year on year, driven by energy prices, supply and demand imbalances, and low base effects. We anticipate this will mark the peak in terms of euro area inflation.

In the US, the focus will be on the employment report on Friday. We expect the US economy created 500,000 jobs during the course of last month. We look to the unemployment rate to fall to 4.5%.

With that, I’d like to thank you once again for joining us. We will, of course, be back next week with our latest instalment, but for now may I wish you every success in the trading week ahead.