2022 Multi-Asset Outlook

Can central banks nail the landing?

We expect 2022 to be a year of transition, with the market’s focus shifting from COVID to the state of growth and inflation and the central bank response. Developed markets are close to moving from pandemic to endemic, with higher vaccination rates and better treatments reducing the risk of further lockdowns. Liquidity remains plentiful for consumers and companies. Consumers have bolstered their savings stockpiles significantly in recent quarters, wages should continue to increase, and spending should rise (Figure 1). Companies, for their part, are benefiting from ideal financing conditions, COVID-driven restructuring, and strong nominal growth, all of which should continue and support earnings next year.

On the other hand, central banks now acknowledge that they underestimated inflation — both the level and persistence — and find themselves having to “nail the landing” by tightening policy just enough to tame inflation without derailing the cycle. In the end, we think the result will be reflation rather than stagflation, with the recovery from COVID underpinning stronger demand, especially in the service economy.

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While the economic backdrop may not be quite as supportive for the market in 2022 as it was in 2021, we maintain a pro-risk stance and prefer to be moderately overweight equities relative to bonds, moderately underweight EM equities, and overweight commodities. As the global cycle improves, we think regions that suffered more from deflationary forces before the pandemic will benefit more from higher inflation. Thus, within equities, we favor  Japan over Europe, the US and EM. Within commodities, we remain bullish on energy and industrial metals, in light of both cyclical and structural dynamics.

Turning to fixed income, we see more upside for yields in the US and Europe, and we think strong demand technicals will continue to offset rich valuations in spread markets. We also favor the relative value of EM debt spreads, particularly in corporates.

Equities: Focusing on the benefits of inflation

While Europe has flirted with deflation for several years,  in Japan the struggle has lasted even longer. Higher inflation should incent consumers and businesses to spend and invest, rather than wait for cheaper prices ahead. On the flip side, higher inflation may be a headwind for the US, where, despite recent struggles to generate inflation, it has now moved above target, and for EM, where inflation is already much higher than target.

Japan should also benefit from a highly vaccinated population, a potential fiscal policy boost, and cheap valuations. The same arguments are true in Europe, but to a lesser extent, especially since inflation now exceeds the central bank’s target. Meanwhile, the Bank of Japan faces less inflationary pressure than other central banks and, despite some early hiccups, new Prime Minister Kishida is likely to continue reflationary policies. We are encouraged that Japanese consumer confidence has shifted higher despite inflation expectations picking up, which we see as evidence that real incomes are perceived to be rising (Figure 2). We also think the country remains a rich hunting ground for bottom-up alpha.

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We maintain our neutral view on US equities. Despite valuation and inflation concerns, the economy is robust and supported by pent-up savings and rising wages. Our focus is on high-quality companies in value-oriented or cyclical sectors.

We are moderately bearish on EM, taking into account their vaccination challenges and lack of access to antivirals, potential for aggressive rate hikes to address double-digit inflation, poor fiscal dynamics, and political volatility — conditions that set the stage for a stagflationary environment. China has slowed, but there are signs of modest policy easing. However, we are concerned that until China drops its “zero-COVID” policy, a robust recovery is unlikely. Within EM, we favor commodity exporters, which should benefit from our base case of higher inflation and commodity prices.

Commodities: An unloved asset class no more

While commodities have already enjoyed a strong run-up, we maintain our bullish view, given the global inflation picture and the historical sensitivity of the asset class to rising prices. We expect supply/demand imbalances in energy, metals, and agriculture to persist as recent underinvestment (in response to shareholder pressure) collides with increased demand. In addition, the growing effort to decarbonize the economy is helping to drive up the costs of a variety of commodities.

Against this backdrop, we encorage allocators to consider having commodities exposure, either through commodities futures, energy companies, or miners. Given ESG concerns, we favor companies that have clear plans and have made meaningful progress transitioning their business toward renewables and reducing their carbon footprint.

Fixed income: Navigating unattractive valuations

We see a tumultuous period for rates in the months ahead as markets try to divine how central banks will respond to inflation pressures. We may be entering a paradigm shift for many central banks’ reaction functions — one that, given higher inflation, is less focused on easing to address slower growth (Figure 3). As we have seen in the dollar bloc regions, markets could test central banks by pushing up the short end and flattening yield curves. That said, market expectations in the US have moved up the first rate hike to mid-year 2022, in line with the Fed forecast, so while we remain moderately bearish on US and European rates, we don’t see much scope for a big rate rise.

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In growth fixed income (credit), valuations are rich, with most spreads well inside of median levels. However, we think defaults are likely to stay very low and demand technicals are strong, as foreign demand for yield persists, and currency-hedged US credit yields are attractive to many non-US investors. Within credit, we prefer EM debt to US high yield as EM spreads are considerably wider. Credit valuations have been a reliable indicator of forward excess returns, a dynamic we continue to trust. We think Mexico, Russia, and various countries in Central and Eastern Europe are attractive.

We also prefer bank loans, which offer attractive valuations versus US high yield and could benefit from Fed tightening. Within securitized credit, we favor floating-rate structures in CLOs and CMBS. New risk-based capital factors being adopted by the National Association of Insurance Commissioners are likely to increase demand for AAA-rated and AA-rated bonds.

Risks

Our base case is that the economic recovery will continue and demand will overtake the risks of higher inflation. Specifically, we think a high stock of savings and rising wages position consumers well to deal with higher prices. A policy mistake is a key risk if central banks are slow to react to inflation and inflation expectations de-anchor, leading to a rapid and significant rise in rates. Alternatively, if central banks are perceived to be too hawkish in their inflation policy, that could also derail the cycle. We think central banks can successfully thread the needle, but we are wary of a policy mistake.

COVID remains a risk as part of the world moves toward the indoor winter months and about five billion people remain unvaccinated, which could give rise to new variants. Unfortunately, the COVID overhang is likely to last for years in EM countries.

China’s path is difficult to discern with its opaque system. If the country’s credit clampdown and energy shortage become more severe or, as noted, there’s no relaxation in the country’s zero-COVID policy, we could see a more dramatic slowdown than expected, which could impact the global cycle.

On the upside, central banks may hit a perfect landing with their tightening decisions — a scenario that would justify a more bullish view on risk assets. In addition, our inflation concerns may be ameliorated by a pickup in productivity, though that is not likely in the near future.

Another upside risk is that antivirals, in combination with vaccines and warmer weather early next year, put an end to the scourge of COVID in developed markets, unleashing stronger consumer spending. 

Investment implications

Stick with developed market equities — We think developed market equities will continue to do well, but that Japan will outperform the US and Europe. Japan is likely to experience more of the benefits of inflation, given its prior struggles with deflation, and its government is more likely to pursue reflationary policies.

Get more selective within equities — We continue to favor a value tilt in energy and financials and prefer cyclical sectors such as materials and some industrials. However, we think asset allocators should be more judicious about valuations in cyclicals as many stocks are fully priced for a recovery. Travel and leisure is one area where valuations do not yet reflect recovery in the services sector. A key attribute to look for in any company in an inflationary environment, regardless of sector, is its pricing power.

Remain cautious on EM — China is key to the EM outlook and the government’s credit clampdown has been engineered to wring excess risk out of the financial system, especially in the property market. Until that changes, continued sluggishness seems likely. Outside of China, countries will face major economic pressures from COVID as well as political volatility. Despite the grim overall picture, we see opportunities in commodity exporters and Central and Eastern European countries.

Given the risks of inflation, pursue protection with commodities — Inflation may reach higher levels or be more persistent than many asset allocators expect. While value-oriented equities may provide some protection, commodities (excluding precious metals) have historically been the most inflation-sensitive asset class. Real assets and inflation-linked government bonds may also play a role.

Focus growth fixed income in shorter duration — Central banks are on a tightening path, so we favor shortening duration and we prefer floating-rate structures, especially in CLOs and bank loans. Most spreads are rich, but we don’t see a catalyst for them widening much. We think EM sovereign and EM corporate debt offer better upside potential from a spread perspective than US corporates and high yield.

Maintain defensive fixed income for diversification — While our views tilt toward an economic recovery, we think it is still prudent to consider an allocation to high-quality bonds in case of a sharp equity sell-off. A global fixed income universe gives investors more opportunity to add value, and we think Japan’s central bank can support their market the longest. We think municipal bonds can play a strategic role for taxable investors, especially given the trend toward larger federal deficits. Precious metals and option strategies may provide additional ways to supplement bond exposure.

The big picture: shifting tectonic plates

One of the overarching questions we keep hearing is: what exactly are we rebuilding towards? COVID has undeniably reshaped the global landscape in many ways, accelerating some long-range trends, blunting or stalling others, and indeed ushering in wholesale, lasting changes to how we live, work and travel. Could these changes cause a return to the type of slow-growth world we experienced after the 2008 global financial crisis, or are we instead pivoting to a period of sustained stronger growth? Will inflation stay stubbornly high and if so, for how long? These are some of the vexing “head scratchers” that are coming to the fore as we enter 2022, but which will take time to fully answer.

But one thing seems fairly settled at this point: COVID has hastened the onset of “big picture” structural changes to how we operate and what we value. These types of secular changes, as opposed to the cyclical changes associated with the nature of business cycles, are like the shifting tectonic plates of the investment terrain: hard to see on a day-to-day basis, but powerful longer term and, ultimately, arguably more significant than anything else. Despite the many unknowns still facing the world, here are five themes that we think should play a more prominent role in investors’ toolkits as we march inexorably towards a brave new future.

Theme 1: Adapting to rising inflation

We think the supply-chain bottlenecks that are plaguing much of the world these days are unlikely to be resolved very quickly. In fact, next year could easily see mismatches between supplies of many goods and demand for said goods continue (or even worsen), as more countries reopen and global economic activity picks up. Since supply constraints have been a key driver of rising inflation, we believe the most likely outlook for inflation in 2022 is that it will remain above historical average and more elevated than it has been for years. This, in turn, would likely lead to higher bond yields, especially with major central banks preparing to taper their quantitative easing (QE) programmes and laying the groundwork for interest-rate hikes going forward.

The dual spectre of rising inflation and higher bond yields has potential implications for an array of asset classes (few will be unaffected), but will, in our view, offer opportunities for investors in more flexible fixed income funds, as well as global macro strategies and those with an explicit mandate to mitigate the effects of inflation (such as purpose-built multi-asset portfolios).

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Theme 2: Focusing on fundamentals and quality

While inflationary pressures are likely to influence almost all investments to some degree, an equally important dynamic that investors should not overlook is the potential reemergence of individual company factors and characteristics as a catalyst for asset prices in 2022. As COVID’s far-reaching, dominant impact gradually recedes in the period ahead, we expect to see growing divergences between well-managed companies that look positioned for robust growth on the one hand, and on the other, companies whose poor management and shaky fundamentals were largely obscured by COVID turmoil.

We believe that seeking out quality, fundamentally sound companies that are no longer being “drowned out”, so to speak, by the macro forces of COVID, economic lockdowns and government policy support, will be an increasingly desirable investment strategy next year and beyond (Figure 2). Investing in quality growth funds is one potential solution.

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Theme 3: Playing the “net-zero game”

One of the most pervasive investment themes in today’s environment is that of decarbonisation — the global energy transition. With more pronounced changes to the world’s weather patterns becoming evident over time, many governments are moving past mere verbal commitments towards concrete regulatory steps and investment programmes aimed at combatting climate risks. This so-called “green revolution”, to some extent a large-scale reimagining of how economies work, will obviously require capital investments in order to be successful, and we believe getting on the “right side” of what is likely to be a decades-long phenomenon with transformative global potential will become increasingly mainstream next year.

Climate mitigation/adaptation strategies are one way to play this theme, but investors should also not underestimate the value and potential benefits of ESG integration in general in the context of their overall investment portfolios.

Theme 4: Going long secular thematic trends

Particularly since the arrival of COVID, several secular thematic trends have broadened out and gained momentum, creating compelling new investable opportunities. These include, but are not limited to, financial technology (fintech), enterprise intelligence and innovation and a combination thereof that has recently helped to spawn the “metaverse” megatrend.

Not surprisingly, such trends reflect the global macroeconomic backdrop. For example, enterprise intelligence has been spurred on by mounting wage inflation and labour shortfalls that are pushing many companies towards automating more tasks where they can and making greater use of cloud-based computing capabilities. Such evolving corporate needs and decisions are becoming more apparent not only in developed market economies, but also in their emerging market (EM) counterparts, especially China. This will be worth watching next year.

Investors can target theme-/sector-specific strategies tied to the themes and trends that most interest them. Notably, however, thematic investing of this sort is not the same as index investing. You need to do your homework to ensure you’re buying what you really want. 

Theme 5: Taking a deeper dive into China

We think China’s extraordinary growth and development over the past few decades demand that it be both a topic of investment discussion and, where appropriate, perhaps a standalone portfolio allocation or the main component of an investor’s total EM exposure. Of course, this is often easier said than done, given the complexity of the Chinese economy and the systemic economic, societal and structural changes that are still going on in the country. The good news: with such seismic change comes numerous opportunities for discerning investors. However, China’s recent regulatory announcements and their well-publicised negative impact on some Chinese assets have highlighted the need for investors to properly understand and carefully evaluate these opportunities.

Thus, with the right approach, we believe investing in China should remain an attractive investment idea in 2022 and beyond, despite recent bouts of market volatility (Figure 3). Consider either a dedicated China fund or a more diversified EM strategy. 

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