United Kingdom, Intermediaries

'22

2022 Multi-Asset Outlook

Multi-asset insights: Nanette Abuhoff Jacobson, Global Investment and Multi-Asset Strategist; Daniel Cook, CFA, Investment Strategy Analyst

Thematic insights: Nick Samouilhan, PhD, CFA, FRM, Multi-Asset Strategist; Andrew Sharp-Paul, Investment Director

 

Views expressed are those of the authors and are subject to change. Other teams may hold different views and make different investment decisions. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional or institutional investors only.

MULTI-ASSET INSIGHTS

Key points

We expect COVID concerns to fade, consumer spending to persist, and the economic recovery to continue but with higher inflation and less policy stimulus. On balance, we favor equities over bonds.

Within equities, we prefer developed over emerging markets (EM) given China’s slowdown and the hardships EM countries face post-pandemic, including slower growth, high inflation, worse fiscal deficits, and greater political volatility.

We are most positive on commodities, given that inflation pressures are likely to persist longer than the market thinks.

Interest rates are vulnerable to a broader reopening, inflation, and reductions in central bank support.

Downside risks include a surge in inflation that forces faster-than-expected central bank tightening or a severe China slowdown. Upside risks include a “Goldilocks” scenario (just the right amount of monetary tightening) that extends the cycle or a lift in inflation-capping productivity.

2022 asset allocation outlook: Multi-asset views

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.

FIGURE 1

2022 asset allocation outlook: Recent high consumer savings imply strong consumption

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.

FIGURE 2

2022 asset allocation outlook: Japanese consumers bullish despite rising prices

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.

FIGURE 3

2022 asset allocation outlook: Could equity volatility pick up with higher rate volatility?

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.

THEMATIC INSIGHTS

Five investment essentials for a post-pandemic world

With some luck, and a bit of hope, we are cautiously optimistic that 2022 should be the year in which most of the world begins to move towards a post-pandemic era — albeit after many fits and starts along the way. From a public health perspective, COVID vaccination rates and other telling numbers (including case counts, hospitalisations and virus-related deaths) suggest that the life-altering global pandemic may finally be poised to start winding down. In addition, many world economies are growing and appear to be on a path to recovery from the unprecedented COVID shock.      

To be clear, we are not out of the woods just yet. The virus, with its multiple potential variants and its ability to “break through” vaccine-induced immunity in some cases, has proven difficult to entirely vanquish. And even if (as we expect) next year does bring meaningful progress, it’s critical to stress that it will not be a truly “post-COVID” world in 2022, as the virus will most likely remain in global circulation for years to come. Nor will the economic and other improvements we anticipate be sudden or universal. Many countries still lack adequate vaccine coverage, whether due to ongoing supply issues or vaccine hesitancy among their populations. And lingering challenges around international travel and other activities we took for granted pre-COVID may well persist for the foreseeable future, making a full reversion to completely “normal” conditions an uncertain prospect anytime soon.

Nevertheless, barring a virus mutation that renders the vaccines ineffective, or some other unexpected plot twist, 2022 will hopefully mark the start of a long-overdue global rebuilding process.

The big picture: shifting tectonic plates

One of the overarching questions we keep hearing is: what exactly are we rebuilding towards? COVID has undeniably re