What can investors expect after a year marked by new phases of the pandemic and given the prospect of another year that could see further outbreaks, renewed restrictions on mobility and activity? What is the macroeconomic outlook for 2022? What can we expect from the markets?
While we expect the dogged supply chain and production constraints of 2021 to fade eventually, labour markets may well not return to where they were before the pandemic. A smaller labour force implies less output and perhaps more wage pressure. While businesses will eventually substitute capital for labour, and productivity should improve, this will not happen immediately.
US equities could lag the rest of the world
Apart from historical patterns, there are other reasons to foresee US equity returns falling behind other parts of the world. As the US opened up earlier than most of the rest of the world, much of the recovery from lockdowns has taken place and GDP growth has already surpassed pre-pandemic levels. As reopening progresses in Europe and spreads through emerging markets, economic momentum should follow.
Monetary policy, though, will tighten more in the US than in the eurozone, partly because inflationary pressures are higher as a result of the fiscal stimulus. To the degree that higher inflation crimps demand, the US may see household consumption rise at a slower rate than in Europe.
In absolute terms, US equity valuations are high, but in our view, they do not pose a threat to market returns. Multiples have been boosted by central bank quantitative easing (QE) purchases and as long as those bonds remain on bank balance sheets and yields low, we believe multiples will be supported.
On a relative basis, however, valuations for European equities versus US equities have reached historic lows. This discount is not merely because multiples for mega-cap US technology stocks are high; most European sectors are trading at a discount to their US counterpart.
The rising premium awarded to US equities is not obviously warranted given that European equity market earnings growth and performance kept pace with the US in 2021 and profit expectations for 2022 are similar, and equally modest.
Fixed income – Inflation focus
We believe that inflationary pressures will ultimately prove to be ‘transitory’, but they will be strong enough and persistent enough to force the US Federal Reserve (Fed) to tighten policy sooner than it has projected.
Longer-term inflation expectations remain well-anchored, reflecting one of two things: either the ‘transitory’ inflation narrative, or a belief in the credibility of the major central banks.
If inflation looks to be spreading and becoming more entrenched than currently forecast, the belief is that central banks will react to it (albeit belatedly) to bring inflation back down to target. The key concern for investors then would not be medium-term inflation per se but the path for policy rates.
Central bank policy rates
So much of what has happened in the last 15 years has been unprecedented, from the Global Financial Crisis and quantitative easing, to pandemics and lockdowns. Uncertainty about how quickly and smoothly the global economy reaches the next ‘new normal’ is reflected in interest rate volatility and divergent policy prescriptions.
We believe market expectations will be fulfilled and that the Fed will be forced to moderate its transitory inflation narrative. The US labour market looks set to reach full employment sooner than expected thanks to participation rates remaining below pre-pandemic levels, and wage pressures will rise as a result.
The increase in government bond yields will be more notable out to five years than later, as near-term policy rate expectations rise more than the terminal rate. The increase in longer-term Treasury yields will be limited by capped inflation expectations and the size of the Fed’s balance sheet keeping real yields low.