Following the pandemic-related upheavals of 2020, subsequent supply bottlenecks, and China’s policy pivot in 2021, investors might be looking forward to a return to some form of normal in 2022. But don’t count on it: Disruptions appear more likely to dissipate than to disappear, causing asset markets to move in waves as the year progresses.
A rapid loosening of supply constraints that in turn helps bring core inflation back toward 2% is unlikely, and the big change in 2022 will be the visible hand of monetary excess slowly pulling back. Many will shake their heads, recalling all such prior attempts in the last decade. Yet the post-financial-crisis period was fragile, featuring private sector deleveraging at the same time that governments – instead of taking the other side with fiscal stimulus – actually piled on with fiscal drags, ensuring a slow expansion. Such perverse policy created a fragile backdrop that monetary policymakers sought to offset with their own excesses. Inflation targets still undershot as this excess liquidity found no economic takers in a world attempting to deleverage. Instead, it flowed into financial markets.
That fragile backdrop is gone. Rising inequality and a ticking clock on climate change have shifted the narrative. Fiscal actors can no longer drag their feet, which is one reason growth looks firmer outside of China. Consumers, instead of needing to deleverage, now have strong balance sheets. Breakthrough Energy (Bill Gates’ venture to accelerate new climate technologies) sees US$50 trillion of need in the next decade to beat climate change. If so, this would be the largest replacement cycle in history – and what better way to put today’s global savings glut back to work?
What a change from the decade after the global financial crisis (GFC), when business investment barely registered a pulse. And while all eyes look to governments to solve climate change, don’t overlook growing investor engagement, which now equates to $130 trillion of assets that have pledged to develop concrete plans and timelines to decarbonize. Welcome to the “Climate of Change.”
Monetary excess is as responsible for boosting demand in this new backdrop as supply issues are in constraining its fulfillment, with the imbalance between the two accounting for today’s inflation overshoot. So it’s time to rethink monetary policymakers’ willingness and ability to step back from policies put in place for a different era. Of course, this would mark quite a change to the investment landscape. Yes, faster economic growth usually foreshadows faster cash flow growth outside of fixed income. Yet markets involve not only cash flows but also discount rates. The latter have been falling not only due to debt, demographics, and technology (which created the global savings glut), but also from a surge in developed market central banks’ balance sheets at rates far exceeding nominal GDP growth, in an attempt to offset the fiscal foot-dragging.
This whole picture has flip-flopped. We see a choppy flatness ahead, at least for the first half of 2022, a standoff between positive (albeit slowing) cash flow growth and reduced monetary excess, and its impact on capitalization rates. This standoff as 2022 unfolds looks poised to be quite exciting, with bigger winners and bigger losers.
Inflation noses north
While we are more concerned about where inflation will be three to five years out, we can’t ignore what is happening now: If 4%-5% inflation (or higher) morphs from transitory to self-sustaining, it will bring down financial assets – and while not our base case, this risk keeps rising. Inflationary trends that will march into the new year include broadening sources of supply-chain bottlenecks (even as earlier ones clear), a growing energy shortage, and wage-price spirals as developed market central banks sit and wait for earlier supply pressures to abate.
What started as manageable supply-oriented bottlenecks have been exacerbated by fiscal and monetary policies that are boosting demand. This has delayed a rebalancing long enough that constraints are leaching into other areas – chief among them labor shortages as many workers remain unwilling to return unless terms are much more favorable. Wage pressures will increasingly need to keep pace with, if not exceed, inflationary pressures.
At the same time, long-gestating negative interest rates have created a situation in which home price increases, initially spurred by work-from-home migrations, are now expected to exceed the rate of interest on mortgages. This is creating a self-perpetuating dynamic that is bringing about a re-leveraging of homes and a rise in home prices relative to income growth. Resulting rent increases are now beginning to feed inflation in a more enduring manner.
Meanwhile, rising energy prices are challenging the maxim in commodities that “the cure for high prices is high prices.” After burning cash for over a decade with investments in shale, buyers are now more wary, with capital and supply not responding meaningfully to higher prices. Active ownership is dissuading Big Oil from investing in anything other than new-energy sources, which are not coming online quickly or reliably enough to keep up with Covid reopenings and the resultant boost in demand for energy.
With OPEC seeing the long-elusive peak in demand actually materializing amid the drive to decarbonize, we don’t expect capacity additions from this source. However, prior agreements are still curbing production, which could be trickled back into the market to keep crude from going much above $85. OPEC will recall how $100 oil threatened its hold on this market, and the quadrupling of prices from the 20s over the last 18 months is still flowing through, with the downstream impacts working their way into the pricing of other products and services.
All told, inflation sources are still broadening. A year ago we wrote that inflation looked poised to persist, even if it ultimately proved transitory, and that familiar tune still rings true. We may need to wait until 2023 for a period akin to the post-World War II era, when supplies eventually rebounded from wartime shortages as economic conditions became more balanced.
Until then, an era of new technology and disruption should lead to a step-up of business investment – not into greenfield capacity, yet aimed at removing bottlenecks to boost throughput and help boost supply to meet today’s stagflationary challenges.
While not hitting the brakes, developed market central banks will gradually be forced to take their feet off the accelerator as 2022 unfolds. While fiscal drags are a thing of the past, incremental fiscal packages are now on their last legs. Overall, we remain confident that a regime shift toward reflation is underway over the next several years, particularly in the US and Europe. Tangible signs should become move evident as we exit 2022.
China’s ‘Climate of Change’
China is 2022’s biggest wild card. Having achieved its growth and poverty-reduction targets over the last 40 years, policymakers are making a big strategy pivot. A shift toward a policy mix lying between Deng Xiaoping’s more free-market approach and Mao’s planned economy, which has characterized President Xi’s tenure, took a giant leap forward in 2021 with the push for “common prosperity,” which seeks to cap the excesses of capitalism to nurture a larger middle class.
While a growing middle class is often associated with more stable political regimes and economic success, this particular push is also characterized by far more centralized control. While we do not anticipate a return to a planned economy, the impact of 2021’s regulatory ratcheting on the private sector’s confidence and willingness to invest bears close watching. China’s private sector reinvestment has been shrinking since 2014’s centralized actions to effect abrupt supply-side cuts and then again after 2018’s shadow bank reforms to help centralize the flow of capital within China. This global growth champion cannot grow faster than the rest of the world if China’s private sector remains reluctant to invest.
Rapid-fire regulatory changes in 2021 reached all the way into the previously untouchable real estate sector, which exemplifies accumulated wealth in China and accounts for upwards of 25% of its growth. This sector’s hoarding of the nation’s huge savings and its history of widening and entrenching inequities through not only wealth but also the school system is now policymakers’ top target. Resources will be redirected conspicuously away from property and toward strategic initiatives like semiconductor production. Such transitions, even when successful, take time.
The economic impact of China’s societal course correction will ripple through much of the global economy in 2022 and beyond. Countries and sectors that rely on China’s unmatched demand for commodities to feed their real estate appetite will feel it most acutely. However, it could also become a broad disinflationary force if China’s consumption doesn’t climb as an offset. That too hinges on private sector confidence as the government increases its reach. And given the inflation heating up through the West, China’s cooling influence may not be such a bad thing.
While export growth has held stronger for longer, it will likely cool in 2022 as countries like Vietnam reopen and the West slowly gets a grip on many of its own supply issues in satisfying current demand. Into that, we do not expect President Xi to step back from his societal reset as growth slows and spills over elsewhere, as China has done in the past. The wild card in 2022’s outlook is whether, as the risks inherent in disassembling property giant (and red line crosser) Evergrande recede, policies aimed toward societal rebalancing pick up again.
More government, not just more spending – with decarbonization a driving force
In the geopolitical realm, two key trends will shape the cycle ahead: the rise of economic nationalism, and an intensifying rivalry between democratic and more centralized models, as exemplified by today’s US-China relations.
While Presidents Biden and Xi will make gestures toward greater multinationalism, nations are already developing “national strategic plans” to address weaknesses in their domestic capabilities exposed by pandemic-related product shortages. “Resilience,” rather than simply economic efficiency, is now the watchword for supply chains. All told, the growth gap between emerging and developed markets marches in step with the growth of global trade – and the cresting we’re seeing bodes poorly for most emerging countries unless activity within China and US trading blocks offsets the declines between them.
These developments are concurrent with the drive to decarbonize. Most major governments are vowing to shrink or eliminate their carbon footprints in the coming decades. Accomplishing this will require governments to be far more prescriptive about the private sector’s emissions practices and the framework in which many industries operate. While stepped-up infrastructure projects to add renewable energy assets and electrify transportation are a net positive for growth, we can’t lose sight of the many current jobs and industries that will be lost in the net gain. A widening gap between winners and losers is almost certain given the huge scale of this undertaking. Pressures to chase targets may also lead to inefficient allocation of capital, although active ownership that spurs the business sector to take the lead, instead of waiting for governments, could alleviate such pressures.
Catching the wave: where we see opportunity in 2022
How will the mix of regions and assets in our portfolios change in 2022? Much like previous years, we’ll be constantly on the hunt, seeking to own the full gamut of asset classes over time, yet only about 20% at any given time, when their valuations are attractive and their fundamentals are improving rapidly.
When bubble scares were making headlines a little over a year ago, we were moving our portfolio into early-cyclical beneficiaries, such as US financials, European small caps, and short-dated Treasury Inflation-Protected Securities (TIPS). Today, Japan is our new cyclical darling. Japan will soon be among the most vaccinated countries, from one of the least vaccinated just months ago. Reopening and recovery should soon follow, especially as chipmakers crank up supplies to the auto sector, which we’re already seeing. These developments, along with a new prime minister and the potential for policy changes early on in his term (if history is a guide), signal better days ahead.
While boosting exposure to a global cyclical like Japan, our bigger thrusts are to prune other early-cycle positions in an effort to balance cyclicality with more sustainable growth allocations, including new-energy assets and allocations to a “quality” basket. This is a rapidly evolving cycle, and such movements embrace the fast-approaching midpoint of this new cycle.
Our Capital Market Line still has a moderately positive slope, yet with a high degree of dispersion (see chart below), signaling an average reward for broad-based risk-taking but the enhanced potential to significantly improve upon this with more selectivity.
Capital Market Line as of 30 September 2021 (Local Currency)
While China A-share exposure lies below our CML and has little broad-based appeal (given that new industries have yet to be re-regulated and regulatory ratcheting in others is not yet fully reflected in financials), we do see plenty of selective opportunities. We don’t expect a return to a planned economy, and thus disagree with those who assert that this market is “uninvestable.” President Xi’s aim to build a “dual circulation” economy that puts domestic consumption first but remains open to international trade and investment, while bolstering sectors like supply chains that didn’t receive much support before, will be conducive to investors who understand the nuances and are comfortable with a more targeted approach. For those new to China, however, we think it’s not a place to try a blanket, index-based approach.
Overall, across developed market (DM) equities, select cyclical and high-quality equities can both still benefit to some degree from slowing growth and firm pricing conditions throughout 2022, even though the best moves are behind us. More “bond-like” defensive equities will likely be clear underperformers.
In emerging market equity, our lukewarm outlook for EM growth, given the drag from China and deglobalization, makes EM equities relatively unattractive. The EM index today is overwhelmingly composed of broad-based exposure to China, Taiwan, and Korea. The latter two are dominated by semiconductors, where bottlenecks should begin to clear in 2022 and could dent those stock markets.
The challenge for risk-free bonds in developed markets is stark: Even without the drag from rising yields, the starting point of negative real yields implies that large parts of most institutional portfolios will be losing purchasing power. We expect core DM investment grade bonds to lose share in capital conservation allocations to absolute-return types of multi-strategy hedge funds or liquid alternatives, like absolute return multi-asset products.
Emerging market debt should be a bright spot, offering an attractive yield pickup. As recent default situations in China show, an active investor can position for the winners, who will benefit as those who crossed the “three red lines” on asset-liability and debt ratios fade away. At some point in 2022, we expect local-currency fixed income, where EM central banks have spent a good portion of 2021 raising policy rates, will start to look very appealing.
Real estate has become extremely bifurcated. While the single-family market may pause in 2022, many years of strong appreciation lie ahead if mortgage rates remain low. Digital infrastructure and industrial assets serving e-commerce remain compelling. Selectivity is key to avoid assets whose utility is becoming less relevant as work and living centers repot themselves, with segments of the “old core” real estate now in decline.
While most of 2022 may be choppy, the first asset class likely to catch a wave will be equities, especially in developed markets, when bottlenecks start to clear toward the end of the year.
For more economic and asset class insights, see our full 2022 Investment Outlook: Opportunities in a Climate of Change.