To be sure, 2022 looks to be full of uncertainty and shifts as the global economy continues to normalize from the initial Covid shock nearly two years ago. However, growth appears set to remain robust and could keep powering markets up that ever-growing Wall of Worry.
Wider Plateau of Elevated Growth
Let’s start with the growth backdrop. The defining characteristic of the recovery has been a persistent underappreciation of economic and earnings growth. Quarter after quarter, some of the largest and most heavily followed companies have shattered expectations while economic growth surprised to the upside. Even as investors braced for a disappointing 3Q21 earnings season, name after name cited managing rising cost pressures and supply chain disruptions that were more than offset by robust top-line growth. We didn’t witness the dreaded margin compression investors broadly feared. With those strong earnings came strong guidance and a growing sense of peak supply chain disruptions. We expect more of the same in the year ahead as investors underestimate the operating leverage gains achieved during the pandemic through cost management and optimization.
We stressed throughout 2021 that growth was unlikely to rapidly revert to pre-crisis trend levels. Supply chain bottlenecks and labor supply shortages all but assured the growth peak in 2021 would be lower than what we otherwise might have enjoyed. But that growth was likely pushed into 2022. So we are trading a lower peak for a wider plateau of elevated growth. Also, lost within the raging inflation debate is the fact that robust demand is bleeding into price gains. We think this is muddying the picture of true economic growth.
While we would all prefer modest inflation and higher real growth, the nominal growth picture remains robust. We think consensus estimates of 7% nominal gross domestic product (GDP) growth are likely still too low. Continued normalization of consumption patterns from goods back towards services should help shift the composition of nominal growth away from inflation and back towards real growth. Also, corporates’ book revenues in nominal terms, and well above trend growth, should continue to support the corporate earnings engine.
Catalysts for Growth
While many investors continue to fear the fiscal cliff, the effects of the fiscal impulse will continue to be felt in 2022 as the growth engine shifts from the public to the private sector. Consumer balance sheets have never been stronger, with over $2.7T in excess savings built up through the crisis and plenty of room to re-lever. Corporations are equally flush with cash and looking for ways to deploy that capital as companies signal intentions to increase capital expenditures (CapEx).1 Many firms are already doing just that. In both instances, much of that cash makes its way either to the bottom line through spending or into multiple expansion as savings and corporate buybacks. This should be a win-win for equity markets.
Much maligned supply chain disruptions have continued to weigh on inventory levels which will need to be rebuilt, providing a further tailwind to growth. And a robust housing market that is likely to remain strong into 2022 – being supported by the Millennial demographic bulge – should serve as yet another upside catalyst for growth. Putting these forces together, it’s not hard to envision another year of strong economic growth supporting further earnings growth and multiple expansion. After all, while we constantly hear that valuations are extended, equities look cheap amidst that backdrop, particularly when compared to fixed income valuations and deeply negative real rates.
Favorability of US Equities
So how does one position for this backdrop in 2022? Much the same as is currently appropriate. We favor equities, more specifically US over international, and barbelling between tech and cyclical sectors. After what felt like an endless consolidation through much of 2021, small-caps could benefit from a year-end rally into early 2022. That said, any allocation there should likely be viewed as a short-term rental. Tech should continue to be supported by a healthy consumer. Cyclical components, such as semiconductors, we think should benefit from the emerging CapEx cycle. The broader cyclical complex, including industrials, materials, financials, and energy, could continue to post upside surprises as nominal growth delivers upside beats, as well.
US Dollar Dominance
King Dollar looks set to remain stubbornly strong. We also think strong US growth should support a bid for US assets, limiting the attractiveness of international developed and emerging markets (EM) – despite what is quickly becoming a consensus overweight in 2022. Continued headwinds from slowing Chinese growth pose clear risks to EM equities, as well as European growth through the critical export channel for trade-reliant European economies. Oil prices that are likely to remain supported into 2022 pose another medium-term threat to demand recovery in Europe.
Resynchronization of Global Growth
That said, 2022 may indeed be a year of two halves. In the second half of the year, US leadership could give way to an international catch-up trade on the back of a true resynchronization of global growth. What has thus far been a fragmented and rolling pandemic recovery should synchronize as vaccination programs continue to push back Covid-19 and global economies adapt to a coexistence strategy. That resynchronization and acceleration of global growth is the key to unlocking a weaker dollar and ushering in outperformance from international developed and EM equities.
While there’s no shortage of topics to worry about in 2022 – including inflation, policy tightening, new variants, and stretched valuations – the catalysts to scale the Wall of Worry continue to build. For example, policy and financial conditions appear to be accommodative for some time. Combine that with the private sector driving robust growth to deliver earnings upside and valuation support, and it’s not hard to imagine another year of double-digit equity market gains ahead, which could broaden as 2022 progresses. Not your typical 5%–7% year after all?
Fixed Income Hurdles Ahead
On the fixed income side, bonds will continue to be challenged throughout 2022. It’s not hard to see interest rates drifting higher, with solid corporate earnings and a continued global economic recovery that should see monetary policy begin the year highly accommodative. Combine this backdrop with historically low yields and tight spreads and you get an uninspiring time for fixed income. To add to the headwinds, bond market duration continues to extend, offering up even less reward for each incremental unit of risk one takes to earn extra income.
Inflation’s Transitory Path
Inflation is very much expected to end up at a level higher than pre-Covid levels. But we are at odds with any expectations for a significant increase. Inflation could very well end up as a one-time step up in prices rather than a persistent and steady march higher. Supply chain and bottlenecking-related issues should prove transitory – or not permanent.
If you get Covid under control, we believe people will eventually return to the labor markets and pressures will ease. Sure, some of those job losses will be gone forever and some of those workers will not return as they permanently retired. But there is still labor market slack and productivity gains that should limit the wage-price spiral fears that we are hearing about. In addition, consumers are balking at higher prices, not stockpiling because expectations are for those price advances to remain elevated. In this sense, the cure for higher prices is higher prices, providing a self-governing mechanism that should prevent a wage-price spiral scenario from unfolding.
Absolute Dollar Gains Matter More
We also caution about reading into the wage gains that we are witnessing. The markets are laser focused on these increases from a percentage perspective. But looking at the absolute dollar gains tells a different story. We believe this matters more because this is the actual dollars in our pockets that we spend. The largest percentage gains in wages are accruing to the segment of the market that has the lowest average hourly earnings. For example, a 15% increase on someone earning $10 an hour is very different in cumulative dollar terms from someone seeing a 15% increase making $50 an hour. The gains accruing to the lowest average hourly earnings cohort are simply not enough to sustain a demand push higher in prices.
Modest Interest Rate Drift Higher
While wage increases do not appear as the persistent inflationary catalyst, interest rates will likely drift modestly higher. They could, however, end lower than many expect. Why? Demographics and demand. Simply put, the number of economically insensitive buyers in the world are fast outpacing the growth in assets that throw off any positive nominal yield. Adjust this for real yields and that pool becomes even less. Think pension funds and insurance companies. Consider life insurance companies in Japan, Taiwan and Europe where their domestic bond markets are too small to absorb the demand – and are offering very little yield. These buyers are forced to find liquidity and yield in the US bond market. This should help keep rates from pushing aggressively higher.
Also, while rates may end up drifting higher, curve flattening is likely to persist. We expect inflation to remain contained and long-term expectations remain very well anchored…so far. As a result, the long end of the curve should remain fairly well behaved with the front end moving higher in step with Fed hike expectations. We do caution that we think the market may be getting ahead of itself with current expectations for three hikes in the back half of 2022. This seems a bit aggressive to us.
Supportive Backdrop for Credit Markets
Shifting to credit, take note of several historical data points. Default cycles tend to turn some four to five years after the initial Fed hike within a tightening cycle. And defaults accelerate roughly one to two years after the peak in the fed funds rate. That puts the default cycle years away. And recall, equity markets tend to rally into the first few Fed hikes as growth is often increasing. Risk on.
In addition, default activity usually lags tighter financial conditions. Based on metrics that reflect financial conditions like the Fed’s Senior Loan Officer Survey, signs of tightening from commercial banks regarding lending standards are far from raising any red flags. The proverbial Wall of Maturities for credit remains well managed as corporates have continued to extend maturities well into 2025. Within Corporate America, companies continue to pass along higher costs. Also, in many cases the rise of input prices has been slower than the increase in top-line revenues. Profit margins have surprised to the upside. We believe above-trend growth coupled with modest inflation should prove to be highly supportive for credit fundamentals as revenues expand. Firms have shown the ability thus far to retain pricing power and with many funded via fixed rate debt, the credit backdrop looks well supported for 2022.
Despite this, the headwinds to the fixed income market remain its lack of cushion: little spread compression opportunity that may absorb any move higher in the risk-free rate. So where does that leave us? US Treasuries still offer the traditional equity risk offset. However, rising rates could prove to be the catalyst for an equity market shakeout at some point in 2022. Investment grade bonds could prove even more challenging given that spreads have marginal room to tighten and will likely widen in a risk-off scenario. In addition, yields will likely move in tandem with any Treasury re-pricing. That leaves us favoring more spread-related products: high yield, emerging market debt, and loans.
Given the economic backdrop and limited prospects for defaults, we see loans as the more attractive play relative to high yield due to the duration component. And emerging markets? We’ll see if we get a resynchronized global growth story in the second half. Should that manifest, emerging market debt could have its time to shine. But for now, a barbell between Treasuries and loans may serve a portfolio well.
Overall, fixed income will probably once again provide endless headaches for investors. The generic and uninspiring 2022 outlook also rings loudly: expect spread volatility with the accompanying monetary policy uncertainty along with a modest drift higher in interest rates. Yawn.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed are as of November 24, 2021 and may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted, and actual results may vary.
All investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided.
Commodity-related investments, including derivatives, may be affected by a number of factors including commodity prices, world events, import controls, and economic conditions and therefore may involve substantial risk of loss.
Below investment grade fixed income securities may be subject to greater risks (including the risk of default) than other fixed income securities.
Credit risk is the risk that the issuer of a fixed income security may fail to make timely payments of interest or principal or to otherwise honor its obligations.
Currency exchange rates between the US dollar and foreign currencies may cause the value of the fund's investments to decline.
Foreign and emerging market securities may be subject to greater political, economic, environmental, credit, currency and information risks. Foreign securities may be subject to higher volatility than US securities, due to varying degrees of regulation and limited liquidity. These risks are magnified in emerging markets.
Interest rate risk is a major risk to all bondholders. As rates rise, existing bonds that offer a lower rate of return decline in value because newly issued bonds that pay higher rates are more attractive to investors.