At the same time

At the same time as the end-of-year review, the French President aptly describes the situation of the markets:

Fund Commentary
10 Jan 2022

At the same time as the end-of-year review, the French President aptly describes the situation of the markets:

  • The variant is mutating, the effectiveness of vaccines seems very limited in the long term… and at the same time, the emerging Omicron variant has only moderately impacted markets.
  • Equities have risen strongly… and at the same time, they are less expensive than last year.
  • Inflation is high and less transitory than expected… and at the same time, the US 10-year bond yield is quietly hovering around 1.5%.

Can these simultaneous situations persist in 2022? Are they, to the contrary, an alert at a time of relative market exuberance?

Insofar as concerns surrounding the variant, we will not venture to make a forecast: it seems that Omicron is highly contagious and not very deadly, but it is too soon to conclude… and then what about the variants that follow? We are in the realm of “known unknowns”: we know that which we do not know…

There is more to be said about the rest. Concerning the stock market indices, earnings growth in Europe and the United States has been outstanding in 2021. Around 70% on this side of the Atlantic, and around 50% for US equities: spectacular figures which make the increases, in local currencies, of 26.9% for the S&P500 and 21.0% for the EURO STOXX 50 more reasonable than they might seem. This trend will fade as base effects disappear, and the earnings growth figures for 2022 will undoubtedly fluctuate more sensibly around the consensus of 8%.

With a forward PE of 15.5 in Europe and 21.1 in the United States, the markets are expensive, but we do not share certain alarmist comments which compare the current situation with that of the year 2000 dot-com bubble. This applies to developed markets.

In China, which is the only “major market” to be in the red in 2021, the situation remains very different. Under pressure from a less accommodative central bank and a government in an intrusive and regulatory mode, valuations have compressed significantly. If monetary policy eases (which is what seems to be on the horizon) and the government reduces its pressure, then there will be a clear entry point.

_____
With a forward PE of 15.5 in Europe and 21.1 in the United States, the markets are expensive, but we do not share certain alarmist comments which compare the current situation with that of the 2000 dot-com bubble.

There remains a key question: the inflation dynamic and the FED policy. With regard to the price dynamic, we remain clearly in the “inflationary” camp at least for the first part of the year. Given the trend in the producer price index (exceeding 10%), there is no doubt that consumer prices will continue to rise. Jerome Powell’s recent hawkish policy turnaround, bringing forward the tapering in an uncertain health context, confirms this hypothesis.

The US 10-year rate will likely be impacted by this, and the recent multiple contractions of the most expensive technology stocks on the market will probably continue. That said, if the 10-year interest rate stays within a range between 1.5% and 2.5%, markets as a whole will get by nicely with this situation of negative real rates. The release of inflationary figures will nevertheless cause market corrections and raise doubts, and they will determine short-term movements in equity markets.

This price regime – new compared with previous years – also brings back into the spotlight some of the stock market’s worst-performing sectors of the past decade: banks and mining stocks (especially those that are likely to benefit from the energy transition!).

Following the “growth only” years post-2008, portfolios must now reflect a greater disparity of styles. The main winners in Europe in 2021 already belong to very different universes: The high growth universe (ASML and Hermès gained more than 70% this year!), but also the cyclical or value universe (SG also rose 77.5% in the year!).

For 2022, these eclectic styles are likely to persist, probably with a less powerful underlying trend for the indices than in 2021. An open environment could be beneficial!

 

Macro Review – and Now?

This is the question many market participants are asking themselves at the start of this year. The extreme recessionary shock experienced in 2020 was mirrored in 2021 by a post-COVID rebound that was equally extraordinary.

A health situation still generating uncertainty

The recent emergence of the Omicron variant reminds us how tricky and difficult economic forecasting is in a still precarious health context. In light of the previous waves, we can only assume that the impact will again be noteworthy on sectors with major social interactions (leisure, tourism, restaurants) and less significant on the others for which working from home is widespread and which should benefit from the learning experience of the previous waves.

The script for 2022 also risks being disrupted by a weaker-than-expected Q1 and a catch-up effect in the following quarters. The example of Omicron shows us that the pandemic is far from over and that the risk also comes from regions where the widespread virus circulation and low vaccination coverage favour the emergence of more resistant and contagious variants. Countries with a high vaccination rate will probably have a slight advantage again in 2022.

At the other end of the spectrum, China’s zero-COVID policy will inevitably have serious repercussions on economic activity. Remember that the Chinese authorities did not hesitate to shut down the Ningbo-Zhoushan harbour, the third-largest shipping port in the world this summer, for a single COVID case detected among its employees, in so doing accelerating the supply chain disruption and price inflation for certain goods and services.

In 2022, therefore, China could continue to blow hot and cold either by remaining the destabilising factor or by helping to alleviate some of the pressure on supply chains thanks to a less uncompromising health policy.

The economic slowdown and greater dispersion

Not surprisingly, the global economy can be expected to slow in 2022, from 5.8% to 4.4%. Nearly every region of the world will probably be affected (see Table 1 below). This slowdown will most likely be especially pronounced in certain large emerging countries such as Brazil and Turkey which, in addition to the health crisis, are faced with a resurgence of political risk (elections in Brazil) and more restrictive financial conditions represented by the rising US dollar and required by the inflationary context (Turkey).

China should not be an exception to this slowdown but at the same time could possibly do reasonably well. After a lacklustre year in 2021 due to regulatory pressures and repressive measures meant to rebalance economic growth, the Chinese authorities, always with a view to maintaining social stability and consolidating their leadership, will probably be more flexible on both the monetary level (with the PBoC running against the tide of the Fed) and the fiscal level (selective stimulus measures).

The United States can be expected to remain in overdrive and continue to remain above-potential with close to 4% growth expected in 2022. The landing in 2023 could be more complicated with a modest increase of 2.5% expected…

Table 1: Growth and Inflation Forecasts

Table 1

Source: FMI, Consensus Bloomberg, Banque Eric Sturdza.

However, the environment is becoming less favourable at the margin. To deal with higher inflation and a less transitory period than expected, the Fed could raise its benchmark rate three times as early as 2022. After its drastic fiscal effort in 2021, the federal government is also expected to be less generous in 2022 with the federal deficit to be reduced from 3.0 trio to 1.3 trio according to the latest CBO estimates.

The Eurozone’s usual lag could benefit its economy in 2022 with a much less pressured ECB to raise rates and with a concentrated effect of the EU Next Generation stimulus plan over the period 2021-2022.

With supportive forces still present, the macro environment is expected to remain favourable in 2022 and call for more selectivity and decoupling between zones, with health risk as a potentially destabilising factor. An interesting macro framework, but one that will call for more vigilance…
 

Fixed-Income Markets: COVID, Inflation and Central Banks

 

Pandemic and rising prices make the headlines in 2021 and 2022

2021 was marked by emerging inflation fears, putting pressure on government interest rates. Credit markets moved in line with equities: as they say, “high risk, high performance” (except for Chinese high-yield offshore bonds issued in USD).

At this year-end, COVID remains a subject of concern since the appearance of the Omicron variant. Major central banks, with the exception of the Fed, will probably be reluctant to thoroughly change their monetary policies so long as the health situation is a threat to the global economy.

Inflation is expected to fall back gradually in 2022. In our opinion, markets assign too much importance to inflation and not enough to the economic slowdown. A risk of a widespread slowdown, dominated by a threat of a poorly controlled slowdown in China, is among our major sources of concern for 2022.

Powell declares war on inflation

The risk of a monetary policy error by the Fed is increasing. Jerome Powell was probably confirmed in his position by Joe Biden on the condition that he adopt a more hawkish stance on inflation in order to stamp it out before the mid-term elections. The Fed has therefore changed its policy and attitude on the agenda: tapering completed by end-March, three Fed Funds rate hikes in 2022 and then three in 2023 and three more in 2024!

In Europe, the ECB will probably remain ultra-accommodative despite surging inflation which annoys the Germans. The acronyms may change, but all in all the total amount of the ECB’s quantitative easing programme will probably not change much. We have always considered the asset purchasing policies of the central banks from a global perspective.

In China, in order to fend off the economic slowdown and deal with the ripple effects of corporate bankruptcies, the PBoC will keep the taps wide open. This means that the total amounts of asset purchases by central banks will not decrease in 2022, but are even likely to increase.

2022 Fixed-Income Strategy

With regard to our investment strategy for 2022, we believe that the US yield curve will flatten due to the growing risk of a monetary policy error by the Fed. To simplify, the more the short end of the curve rises, the more the long end will ease.

As far as emerging market debt in hard currencies is concerned, certain good-quality issuers could offer fine opportunities, but for the time being this asset class seems to us still risky and a source of uncertainties (China and Latin America in particular). Hybrid corporate debt is rather expensive, but already less so than in the autumn. We will hold our hybrid bonds from a carry perspective, but the slightest accident on Wall Street will have repercussions on spreads and will offer windows of opportunity to add to our positions.

We will stay positioned in dollar-denominated investment-grade bonds, which remain a good compromise. So we will start the year tactically with slightly less credit risk in favour of pure duration.
 

Equity Markets: Navigating through a normalised environment

This past year saw a number of existing dynamics persist, as the economy and financial markets today remain impacted, first and foremost, by the COVID virus and its ramifications.

Even as they evolve, the extraordinary disruptions brought about by this pandemic continue to dictate to a large degree the opportunities and risks in our societies and economies: The wave of digital adoption remains a key source of development across sectors and geographies, but the physical restraints impacting employment (travel, restaurants, entertainment, etc) and complex supply chains also persist.

Against the backdrop of a resurgent wave of COVID, the Federal Reserve’s December “hawkish pivot”, announcing an accelerated tapering and opening the door to three rate hikes brought uneasiness across equity markets still very much debating over the persistence of current inflationary pressures and their implications for the Fed.

While a normalising monetary policy certainly is called for given the stabilisation of financial markets post-March 2020, few question the significance of constant liquidity injections in supporting risk assets across the world. In this regard, a quicker normalisation and the perspective of higher rates likely challenges one of the key pillars of the current market dynamic.

Let us keep in perspective that according to Goldman Sachs, flows into global equity funds have surpassed $1trn in 2021, exceeding the combined totals of the past 19 years, putting a number of the now-infamous “TINA” effect – as in “There Is No Alternative”. Could some of these flows reverse, should rates actually increase?

We believe some of these adjustments have already been at work, especially in the fourth quarter, as evidenced by significant dispersion within equities and lack of support for anything but a select few groups, notably the FAANGs.

_____
Though many companies will surely deliver, the mood of “Mr Market” could quite easily become more volatile and offer investment opportunities for those in a position to transact.

For 2022, we do believe in the potential for more volatility, as a trend of normalisation affects both monetary policy and GDP growth. This could be the case especially if China’s current slowdown proves harder to resolve and Mr Biden’s massive “build back better” plan remains in limbo. Valuations still remain on the high side, or at the very least indicative of robust expectations and low-interest rates.

Though many companies will surely deliver, the mood of “Mr Market” could quite easily become more volatile and offer investment opportunities for those in a position to transact. Active managers should enjoy more dispersion and the opportunity to catch companies misunderstood companies or those on the wrong side of flows, and frankly, we believe a number of these already exist today after an eventful Q4.

Graph 1: The Mega Cap Dominance – Ratio of MSCI World Cap-Weighted to its Equi-Weighted Counterpart

GRAPH 1 : THE MEGA CAP DOMINANCE - RATIO OF MSCI WORLD CAP-WEIGHTED TO ITS EQUI-WEIGHTED COUNTERPART

Source: Bloomberg, Banque Eric Sturdza.

We remain broadly constructive on what the equity asset class has to offer in 2022, as we keep in mind that many of the challenges that are on top of our minds are also well-understood by the market, and likely partially “priced-in”. Focusing on the opportunities, we do believe upside risks could potentially be significant, especially if Omicron proves more benign or additional progress is made on the Coronavirus prevention front.

Another key source of upside could come from China, should increase stimulus and a soft landing of the real-estate sector counteract the US monetary policy headwind, all the while some more profound trends such as near-shoring and the need to resolve logistical challenges spur a Capex cycle lacking for many years in developed markets.

As always, we invite investors and prospective investors, to contact us should they wish to understand our views on the current situation and the positions held in the portfolio.

Adam TurbervilleAdam Turberville
Director
+44 1481 742380
a.turberville@ericsturdza.com

The views and statements contained herein are those of Banque Eric Sturdza SA as of 31/12/2021 and are based on internal research and modelling. Please click on Disclaimer Page to view full disclaimers.