Good opportunities but pitfalls along the way

• Strong growth prospects and modest earnings estimates should support markets
• Persistent inflation due to increasingly divided central banks has created significant volatility risk
• There are opportunities on both bond and equity markets

The recent emergence of the Omicron variant is a timely reminder that the epidemic still represents a risk factor. It is still too early to measure its exact impact. The speed with which ARN messenger vaccines can adapt and the likelihood that new treatments will also work against the variant should mean, in a worst case scenario, that the recovery is merely postponed.

STRONG GROWTH, LOW EXPECTATIONS

Even before Omicron emerged, analysts had pencilled in cautious EPS growth of 7% for leading indices in 2022. They were not worried about falling margins but expected only moderate top-line growth. This is not our preferred economic scenario nor that of economists. With global growth likely to remain robust, investors will have to find a stable anchor and that should help private assets perform.

INFLATION AND CENTRAL BANKS ARE LIKE MOVING TECTONIC PLATES

The earnings outlook is reassuring but the main worry now is investor inflation expectations. There has been no inflation for so long that most investors only know the term. And its DNA is still a mystery. Is inflation a monetary phenomenon? It was particularly low following the Lehman Brothers bankruptcy when massive liquidity was injected. Or is inflation linked to unemployment levels as the Phillips curve suggests? True, it remained low two years ago when US unemployment bottomed at 3.6% but it surged in the1960s with the same jobless rate. Arguably, markets are happy to accept the notion of temporary inflation because they have spent 10 years being sceptical about the possibility of prices really being able to take off. Hence today's market valuations. However, the longer short term inflation lasts, the higher the risk that this particular investor conviction will come under attack. The current debate is between the idea that inflation is linked to global production chains being temporarily disrupted (short-term inflation) and the opposing view that it is essentially the result of excess demand. The latter might be the case in the US and it would mean an increase in structural inflation requiring more restrictive policy. If inflation were to remain high in 2022 despite supply chains gradually returning to normal, investor expectations of central bank action would also be upturned. Both the Fed and the ECB have reacted by looking for more optionality. They want to be able to tighten more rapidly if needed and possibly speed up tapering. However, Jerome Powell is now talking about persistent rather than temporary inflation. The system of balances is becoming unstable and there is not as much leeway. Is it reasonable for investors to expect the Fed to hike by 0.5% in 2022 if inflation is a problem? Our core scenario is that both central banks will somehow manage to do the absolute minimum to stop inflation expectations drifting. However, there is a strong probability that markets will test their determination to curb inflation, fuelling volatility across markets. 

THE POLITICAL ENVIRONMENT IS TROUBLED

2022 will see a number of political events. Mounting tensions over Taiwan and Ukraine will need to be watched closely. In Europe, persistent post-Brexit disagreements between the United Kingdom and the European Union over the Northern Ireland protocol and fishing quotas might, at the very worst, end up unravelling the entire Brexit agreement. And in France, we will need to monitor the presidential election even if market risks have abated since the Frexit theme disappeared from campaigns. In Brazil, the highly charged atmosphere ahead of the presidential elections is one reason to be cautious even if investors have already adapted.

INFLATION, A FOCUS ON THE US AND A PROBLEM FOR ALL ASSET CLASSES

Any jolt to inflation expectations would hit both bond and equity markets. In our view, asset class diversification in portfolios risks being flawed until inflation expectations have stabilised. Consequently, we prefer to take risks on equity markets as, unlike bond markets, they have more obvious upside in a recovery. Similarly, emerging market assets are trading at relatively attractive valuations and appear at first view to offer opportunities. But we believe that the best time to take advantage of this is when there is better visibility on inflation and central bank expectations.

A BALANCED GEOGRAPHICAL AND FACTOR APPROACH 

On equity markets, we are focusing on a finely-balanced geographical and factor approach. Japanese equities have underperformed in 2021 and therefore stand a better chance of rebounding as Japanese companies are more highly leveraged to the global recovery continuing and will also benefit from a stimulus package. Japanese inflation is also very low so markets are unlikely to be hit by monetary tightening if global inflation continued rising. European equities should also be interesting in 2022 thanks to accommodating monetary policy and the ability of companies to capture the global recovery story. In China, we will have more information on the real state of the property sector in the first quarter when promoters are due to pay coupons and reimburse debt, but the real issue is what role the private sector will play after an avalanche of highly restrictive regulatory measures. Beijing will most likely have to clarify matters before investors get their confidence in the market back and help boost indices. India was the revelation of 2021. Indices made significant gains in spite of soaring commodity prices, normally a negative influence on this market. India’s status has changed. Reforms in recent years have sent the country shooting up “ease-of-doing-business” rankings and there is now considerable upside as total debt is low and the demographic outlook is upbeat. The property boom is in no way speculative but a reflection of an emerging middle class with new requirements. A wave of new economy IPOs has been transforming the market’s fundamental nature. India has, in fact, turned into a growth theme just as China's visibility has become blurred.

Looking beyond geographical issues, we are still focusing on mid-term themes that the Covid-19 crisis has made even more interesting: Big Data and accelerating digitisation, human capital amid strong labour market mobility, healthcare and energy transition which will benefit from huge investment flows.

On fixed income markets, reduced visibility on the direction central banks will end up taking suggests we should be cautious on corporate debt and even more so on government bonds. We prefer a flexible approach in today's fluid environment and are focusing on shorter duration instruments and subordinated financial debt.