- We remain constructive on equities despite high valuations due to the strong likelihood of earnings upgrades to come. However, we do not expect a repeat of high beta returns next year and place more emphasis on alpha from companies that are improving their market positions.
- A multi-year capex cycle is just beginning, with enormous investments needed in renewables, automation, and equipment upgrades amid the push for sustainability and net-zero carbon commitments for both countries and individual firms, and as companies adjust to pandemic-related shifts in how consumers live, work, and spend.
- Companies that seize the opportunity to make their businesses more efficient, sustainable, and “future-proof” are likely paving the path to sustained alpha and are where we see the most compelling opportunities. Spending on digitalization, along with automation, artificial intelligence, and cloud technology, is a critical driver of competitive advantages that could upend companies that fail to keep up.
- China’s reform announcements since early 2021 have driven up risk premia in China’s equity market, which has created attractive entry points for high-quality companies with strong business models that add social value and bring economic growth to China.
- While “pandemic inflation” has persisted longer than expected, we believe the nuances of the price increases are encouraging; rather than a multi-year period of elevated readings, we think a one-year hiccup arising from recent extraordinary conditions is more likely.
The strength and length of the economic cycle ahead along with the path of corporate earnings will be critical factors as we gauge where equity markets are headed in 2022. The tremendous investment needed to address widespread obsolescence up and down supply chains, alongside an increasing push among many companies and industries to meet net-zero targets – which could cost in excess of $60 trillion to achieve, by some estimates – augur for a massive replacement cycle ahead.
Also critical are the tremendous wealth accumulation and strong spending patterns we have observed, at the same time that the six-decade trend of declining interest rates is now moving into the rearview mirror. Against this backdrop, equity beta returns will likely be more modest going forward and take a backseat to a decidedly more alpha-driven market. This means determining where and how to look for that alpha amid increasing market dispersion will be critical heading into 2022.
What has led to where we are today? Entering last year, we believed the breadth of the market was going to improve; it has. We also thought analysts had been too hasty and mechanical in their cuts to earnings estimates; they were. Now, we believe that while a number of cross-currents are roiling markets – including ongoing pandemic-related issues with supply chains, labor, and pricing – these too will pass, if not as quickly as hoped. The sources of these problems are known and are set to recede, though they may well linger into next year.
Meanwhile, “pandemic inflation” has persisted, but likely will not significantly move inflation expectations. The Federal Reserve appears to be paying close attention to the distinction between “good” (demand-driven) and “bad” (bottleneck-driven) inflation and looking carefully at the causes of price elevation. We believe the nuances of price increases are already encouraging, and while inflation appears likely to run higher for longer than many expected, we do not expect a multi-year period of elevated readings – rather, we anticipate closer to a one-year hiccup arising from the extraordinary pandemic-related conditions we have seen. Indeed, prices for many commodities, such as iron ore, are already topping out, and original equipment manufacturers are starting to indicate that semiconductor chip shortages are abating.
Perhaps most remarkable is the confluence of the strength of demand, the pricing power that companies have demonstrated going into 2022, strong hiring, and capex intentions – all at the same time that balance sheets of the major central banks will still continue to expand well into 2022. Yes, there will always be unforeseen cross-currents, but we have rarely experienced such a positive backdrop for equities before.
Perhaps surprisingly to some, we may be entering a period of greater certainty on many fronts in 2022 – and this means that barring a major exogenous event, companies may be willing to make some big spending decisions in a way that they have not done for more than a decade. Over the past 10-plus years, major disruptions have cropped up nearly annually, from the eurozone crisis, to the taper tantrum, to trade wars, to fears of a China hard landing, and of course the Covid-19 pandemic. If the runway stays relatively clear, we envision a multi-year period of investment spending with the potential to spur robust job creation.
On the back of this, we believe the alpha potential ahead is tremendous. With the massive disruptions we are seeing in everything from work and purchasing patterns to supply chains to light-speed advances in technology, companies that seize the opportunity to make their businesses more efficient, sustainable, and “future-proof” are likely paving the path to sustained alpha.
The capex story has only just begun
The release of pent-up capex was a big theme in 2021, and could be even bigger in the coming year and well beyond. We believe an enormous amount of investment spending lies ahead, with capex intentions for many companies skyrocketing. Company sentiment remains strong, and qualms about policy uncertainties and financing conditions that had long hamstrung companies’ investment decisions have eased at a time when the need to upgrade or replace obsolete or inefficient equipment has grown more urgent amid pandemic-related shifts and the global push for sustainability.
Our analysis of numerous earnings call transcripts each quarter using natural language processing shows that sentiment among senior management of listed companies turned positive on their businesses very quickly after the depth of the pandemic, in contrast to the negative sentiment that persisted long after the global financial crisis in 2008. Particularly interesting is that the sentiment is even more positive in the unscripted “questions and answers” part of earnings calls than in the prepared remarks. This is an indication of upward bias to earnings guidance heading into 2022, which should translate into a “buy the dip” type of equity market supported by positive revisions to earnings estimates.
Company Sentiment Is Positive
Digital transformation remains a key investment theme driving fundamental shifts in business models in almost every industry. We view spending on digitalization, along with automation, artificial intelligence, and cloud technology, as a critical driver of competitive advantages that could unleash tremendous disruptive forces on companies that fail to keep up. Businesses are looking to reduce production costs substantially while becoming ever more customized, aiming to deliver higher levels of service and added value to customers.
Digital transformation: the great disruptor and a tremendous alpha driver
Our framework for digital transformation includes two major axes – the consumer and industrial – for each major region of the world.
On the consumer axis, the US and China stand out in terms of ecommerce penetration, infrastructure maturity, and sophistication of payment systems to enable efficient customer fulfillment. This has led to a steady gain in market share relative to traditional formats, but at a slower pace than the heady rates of even five years ago. Companies in the consumer discretionary and consumer staples industries that have been slow to adapt their business models to digital channels have already come under tremendous pressure, and if they are still in business, are now in a game of catchup to the industry leaders.
At the other end of the spectrum are large regions like India and Latin America, with their young populations, regional diversity, and geographic size, which make the early adopters of digital business models the clear winners – at the cost of entrenched traditional businesses whose stocks are, very often, the most heavily weighted in equity indices. As globally connected equity investors, we view this as a case of déjà vu: It is critical to determine with a high degree of confidence which business models are the likely winners if digital adoption in India and Latin America were to follow in the footsteps of China or the US. Notably, digital consumer platforms present a class of investment opportunity that is product-agnostic and does not force the active investor into narrow stock selection decisions based on analyzing market segments or brand strength.
On the industrial axis, we see exciting developments ahead with the convergence of hardware and software that will enable a host of new applications – from connected factories, to continuous data capture for predictive maintenance and optimization, to 3D visualization techniques in manufacturing that speed the time to market for products, to high levels of industrial automation. This evolution is at a much earlier stage than the consumer axis, even in advanced manufacturing, such as in the US or China, and the investment spending needed to deliver a significant increase in productivity is likely to run for many years.
Climate initiatives open a new capex category
An entirely new category of capex has opened up as both countries and individual firms make commitments to help move the world toward carbon neutrality, or “net zero.” The roughly $60 trillion in investment needed to achieve net zero, an enormous sum, could go even higher given the likelihood of project cost overruns.
A powerful force for ensuring that companies meet their climate and social commitments is coming from none other than the asset management industry, where active management through company engagement is designed to use the cost of capital as a potent instrument to improve corporate behavior and operating practices. New fund-level reporting requirements such as Europe’s Sustainable Finance Disclosure Regulation (SFDR) are prompting far greater disclosure by companies, which is a powerful incentive for executive management to make the necessary investments. In all markets, but especially in emerging markets such as China and India for which fossil fuels are still the main source of energy, technological innovations in clean energy, battery storage, and electric vehicles open up many equity investment opportunities.
Supporting this vast range of capex are the tech and industrial companies at the cutting edge of innovation. Here again, only a small group of companies are the winners given that pricing power has a notoriously small lead time without continuous innovation. This means that while selectivity is always key, it has become much more so among tech and industrial stocks.
The cost of capital is also a key driver of capex, and we agree with the market consensus that the US, as the global rate-setter, will likely ensure that global financing conditions remain accommodative for some time. In addition to the high levels of liquidity in the banking sector, the propensity for asset owners to seek returns through equity and equity-like parts of the capital markets has lowered the cost of capital for companies. For example, private equity and strategic investors seeking growth investments have enabled companies in India to obtain reasonably priced capital. This has given rise to several “unicorns” that will no doubt come to market with initial public offerings (IPOs) in due course, in addition to a possible swath of privatizations, thereby changing the composition of that market.
Bottlenecks and supply constraints are problematic, but the market will look past them
Meanwhile, bottlenecks and supply shocks are persisting longer than many had hoped, and could push out some investment spending. Supply chain disruptions that appeared to be opening up in the middle of 2021 have since headed backward again, and many companies we have spoken with have confirmed ongoing disruptions.
One good indicator of the state of reopening is daily aircraft departures data, which is generally accurate and has been highly indicative of a resumption of precautions in China, with only the US, India, Brazil, and parts of Europe getting closer to normal levels. While vaccination rates are slowly increasing around the world, the release of the two new Covid-19 antiviral drugs in pill form promises to be a game-changer for the pandemic in 2022.
While the third-quarter results season was relatively noisy due to supply shortages and rising raw materials costs, the market looked through the quarter to generally positive guidance for the year ahead, with strong order books and the deferral of production into subsequent quarters. After a flattening of sell-side earnings estimates at midyear, we expect estimates to trend up in the context of improving guidance from strong investment and consumer spending.
China’s policy pivot and the impact on growth and investment
We think the market has misinterpreted China’s policy reform agenda, which some view as a retrograde step for the government in its intent to rein in the private sector. In our view, China’s government cares deeply about the health of the private sector, which accounts for roughly 50% of tax revenues, 60% of GDP, 70% of all innovation, and 80% of employment creation.
China’s rapid growth has meant that its institutional development has not kept pace, especially with regard to data security and privacy or anti-competitive practices, with companies in certain consumer technology industries obtaining dominant scale almost in a flash. We see the recent raft of policy reforms as a continuation of the reform agenda over the past decade, notably that of the shadow banking industry back in 2018, when an alarmingly high 30% of banking assets were held off banks’ balance sheets. China’s economic size, expected to overtake the US in the next few years, requires developed market monetary and fiscal tools that work in tandem; to the equity market’s relief, China has used these tools adroitly of late without once resorting to credit stimulus or market-distorting subsidies. In that sense, China has come of age in the management of its economy, which has positive implications for equity valuation multiples due to lower risk expectations.
Macroprudential risk management has been an important part of the toolkit in developed markets, as it now is in China. The country’s shadow banking and property market reforms are linked in that they both seek to ensure a reduction of excessive leverage in the sector as well as systemic risks in the banking system. While China’s policy announcements may seem abrupt through the lens of democratic markets, the excesses in the property sector have been building over several years and have been visible to investors. Also critical is that from the market’s perspective, China’s steps to reduce its historical reliance on property and land sales, both as an important source of local authority taxation and as a driver of the economy, are laudable.
We believe that over the near term, China’s ability to manage the flow of liquidity to the property sector, either through asset sales, capital markets, or selectively through the banks, can avoid a systemic problem, although a temporary weakening in property prices cannot be ruled out. China’s reform timing has tended to be globally countercyclical; that is, it embarks on domestic reforms while the external economic environment is strong and can act as a buffer, and China’s strong export growth shows once again that it is better to fix the roof while the sun is shining.
China’s ambitions under the heading of “Common Prosperity” have also been misunderstood by some market participants. In our view, China has embarked on reducing the income gaps between segments of its population (such as urban versus rural) by increasing the size of the pie rather than slicing it differently through income redistribution by taxation or welfare. The objective is to increase the provision of social security and to improve affordability and access to education, housing, and healthcare – and the policy shift has resulted in a raft of regulations on these “Three Mountains” sectors.
If China is successful in its ambition to expand its middle-income population, increase its GDP per capita by 30% by 2025, and double its GDP by 2035, the investment opportunities in China and globally are extremely attractive. It is also noteworthy that China has significantly improved access for foreign capital in the past couple of years. The reform announcements since early 2021 have driven up risk premia in China’s equity market, which has created attractive entry points for high-quality companies with strong business models that add social value and bring economic growth to China.
Key investment takeaways
We believe the debate into 2022 should be about the length and strength of the economic cycle ahead. We are just at the start of a multi-year investment spending cycle, with enormous investments needed in renewables, electrification, automation, and equipment upgrades as sustainable operations become a more urgent priority and the pandemic shifts how consumers live, work, and spend.
We remain constructive on equities despite high valuations overall due to the strong likelihood of earnings upgrades to come. However, we unlikely to see a repeat of high beta returns next year as the Federal Reserve gradually removes liquidity while remaining highly accommodative. With the end of the multi-decade fall in interest rates and active equity managers embracing engagement as a driver of returns, we think the asset management industry is at an inflection point where the inexorable flow of assets into commoditized equity products should abate in favor of strategies that seek and own select stocks to leverage mispricings and the potential for positive fundamental change.
The year ahead is likely to be characterized by higher-than-average dispersion of returns among stocks and industries and between equity indices, which are a function of their weighted average composition of cyclical and stable stocks; stocks in the same industry are being valued similarly regardless of where they are listed, barring certain emerging markets where the political risk premium is still the driving force.
All told, we see compelling, selective investment opportunities arising from the secular themes of accelerating digital transformation and a strong capex cycle, and will continue to seek out those companies best positioned to benefit from the structural changes underway.
For more economic and asset class insights, see our full 2022 Investment Outlook: Opportunities in a Climate of Change.