Investement Outlook January 2022

While 2021 has left us with a number of fears, there are many reasons for optimism, too. As far as the pandemic is concerned, it was clearly better than 2020, and we are encouraged by the progress that has been made around the world at protecting people from COVID-19 – although there are still some questions about the recent spread of the Omicron variant.

Risky assets have generally performed well, and portfolios has benefitted from that. But the longer-term investment outlook seem to have deteriorated: equity market multiples remain extremely elevated, government debt loads are still extraordinarily high, and we have finally seen a surge in inflation – which have been of concern for several years now.

Nevertheless, we see good reasons why 2022 will likely be a good year for risky assets. In this publication we will elaborate on our arguments, specifically focusing on the inflation theme, which is currently the most discussed topic at markets. As a format for our first annual publication, we will answer the questions of a fictional client couple, Mr Romeo and Mrs Juliet.

The pandemic in 2022

Mrs Juliet: There has been enormous progress made this year towards ending the pandemic, but it is not yet over – as evidenced both by Europe’s recent 5th wave, as well as this highly concerning Omicron variant. I understand that you are not medical professionals, but what is your base case view of what is likely to happen next year?

BENDURA: When we discussed last year’s outlook, it was certainly our hope that we would have declared a decisive victory in the war against COVID-19 by this point. That has not occurred, due to three major factors.

The first was the emergence of the Delta variant of COVID-19 in the middle of the year. Delta’s transmission and serious illness rate is higher than the original SARS-COV-2 virus and its Alpha variant, which rendered the goal of true herd immunity unachievable. The Delta variant of SARS-COV-2 has accounted for all new confirmed cases of COVID-19 around the world (until very recently), meaning that the bar for ending the pandemic has risen this year.

Vaccine hesitancy and a slow approval process for vaccinating children is the second factor that has prolonged the end of the COVID-19 pandemic. While vaccine penetration has generally been high in most countries, a combination of hesitancy and the inability to vaccinate children under the age of 12 has left 1/4th to 1/3rd of the population of advanced economies unprotected against COVID-19. That might have been enough to prevent rising transmission of the original SARS-COV-2 virus, but it has proven to be too low to durably stop the ongoing spread of the Delta variant once disease control measures are relaxed or eliminated (Chart 1). In fact, as you noted, Chart 1 highlights that a 5th wave of the pandemic is in the process of occurring, especially within Europe.

The vaccination of children has already begun in the United States and a few other countries, and many countries will likely follow suit in the weeks and months ahead. However, vaccination rates are likely to be lower among children given the considerably lower risk of severe illness, and it is clear that vaccine hesitancy among adults is sticky. The extent of vaccine hesitancy is most visible in the United States, where it has taken on a political dimension. Chart 2 highlights that US state vaccination rates are strongly predicted by the 2020 US Presidential election results, with states that voted for Donald Trump having on average a 12% lower vaccination rate than those that voted for Joe Biden.

The third factor that has prolonged the pandemic, which seems to be linked to the emergence of the Omicron variant, is the fact that poorer parts of the world have not been able to make as much progress in vaccinating their populations, at least in part due to vaccine nationalism. We do not pass judgement on the governments of richer economies for prioritizing their own citizens, and indeed it would be hypocritical for us to do so as most of us have personally benefitted from that. But the consequence of those decisions is that some parts of the world, especially in Africa, have been left as de-facto breeding grounds for new variants. While the Omicron variant only came to light in the days leading up to the publication of this report, it does appear based on the available data that the variant emerged in Africa.

Given all of this, we would be considerably more cautious in our outlook for the global economy next year if the progression of the pandemic were only dependent on the vaccination rate, especially now given the emergence of Omicron. However, two other factors will strongly influence the evolution of the pandemic and its impact on economic activity over the coming 12 months. First, in the US, states with a comparatively low vaccination rates likely have higher acquired immunity levels from previous infections, given that these states have recorded higher confirmed cases on a per capita basis.

Second, and much more important, is the fact that anti-viral drug treatments with the ability to significantly reduce hospitalization and death have been discovered and are already under production. Molnupiravir, developed/produced by Merck and Ridgeback Biotherapeutics, has been shown to reduce the risk of hospitalization by 30%, and Merck is projecting that 10 million courses of treatment will be available by the end of December 2021, with at least 20 million courses to be produced next year. 1.7 million courses of treatments are set to be delivered to the US upon FDA approval, which compares with approximately 2 million COVID-related hospitalizations in the US over the past year. Chart 3 highlights that US ICU bed occupancy has already lessened, and the imminent deployment of effective drugs should lower ICU utilization even further over the winter months.

Paxlovid, Pfizer’s oral anti-viral treatment for COVID-19, has been shown to be even more effective at reducing hospitalization, and news reports suggest the US government will order enough Paxlovid to treat 10 million Americans. Pfizer expects to produce roughly 50 million courses of treatment in 2022, and recently agreed to allow 95 developing countries to produce Paxlovid locally, suggesting that the impact of COVID-19 on the global medical system will be greatly reduced next year. This seems likely to be true even given the emergence of Omicron, as Paxlovid works by stopping the virus from replicating, by blocking an enzyme that does not appear to have mutated since the onset of the pandemic. Paxlovid does not target the spike protein, unlike monoclonal antibody treatments.

Mrs Juliet: The development of anti-viral treatments was seen as a very positive announcement because it had the strong potential to reduce or eliminate the impact of vaccine hesitancy on the medical system. But this new variant appears to be vaccine-resistant; doesn’t that mean that we might need far more of these drugs than we originally thought?

BENDURA: Indeed. The fact that Omicron appears to be even more contagious than Delta and at least partially vaccine-resistant is legitimately concerning, because it could mean that many more courses of treatment of Molnupiravir and Paxlovid will be needed than will be available in the coming weeks and months to prevent a sharp rise in hospitalizations and deaths.

At the same time, increasing evidence is suggests that the Omicron variant may produce milder symptoms – which would be associated with a lower hospitalization rate. If Omicron outcompetes the Delta variant of the virus, but produces less severe disease, that could ironically prove to be a positive development. The fact that Omicron could render monoclonal antibody treatments useless could further reduce vaccine hesitancy in advanced economies and encourage the vaccination of children. That would further reduce the total incidence of severe illnesses even if Omicron is partially vaccine-resistant, and thus would be positive from the perspective of reducing the burden on the health care system.

Still, South Africa’s population is considerably younger than those of advanced economies, and we will not know for some time whether a reduction in severe illness, if that proves to be true, applies also to those who are older. If Omicron threatens a significant hospitalization or fatality rate among the elderly who have been fully vaccinated, Omicron-specific booster shots for that age cohort will likely be required – which could take 3-4 months to become available. If that proves to be the path forward, the widespread reintroduction of “non-pharmaceutical interventions” (NPIs) – the policymaker codeword for travel bans, school closures, and lockdowns – is certainly a possible outcome in the first quarter. Omicron will have at least some impact on global travel over the coming month, as countries around the world decide to err on the side of caution and impose travel restrictions while more information is gathered about this new variant.

Overall, due to the many questions surrounding the Virus and its mutations, there is more uncertainty concerning our 2022 outlook than would normally be the case.

Prior to the emergence of Omicron, our base case view was that the pandemic would meaningfully recede in importance this year, which would lay the groundwork for a more normal labor market, prices, and the supply of both goods and services. For the reasons that we have laid out, we have not yet seen enough information to change that view for 2022 as a whole, although the opposite will likely be true for the next few weeks at a minimum. We may have to have you both back for another discussion in the first half of the year to revisit our outlook, but for now it is not our expectation that we are back to square one on the pandemic front.

Inflation: A temporary problem?

Mr. Romeo: Thank you for your insights. Although this is clearly a concerning development, I suppose that there is no use panicking yet, as we do not have the information that we need to make an informed judgement. Perhaps we can turn to the question of inflation, given that seems likely to be an important economic and policy factor next year regardless of whether Omicron extends the duration of the pandemic. The last year’s rise in consumer prices was extreme, at least by the standard of the past three decades. As you know, I have my own views about why this has occurred, and I suspect that you do not fully agree with me. But for the sake of our discussion, please outline your views about what has occurred this year, and what that implies for policy and financial markets.

BENDURA: As you noted, in both the US and euro area economies, headline consumer price inflation rose this year to their highest levels since the early-1990s (Chart 4). The rise in core inflation has been less extreme in the euro area, but it is also back to early-1990s levels in the US (panel 2).

It is understandable that investors are worried about inflation remaining very elevated, and we agree that US inflation will likely be both above the Fed’s target as well as its forecast next year. However, our base case view is that investors are currently overestimating the magnitude of inflation over the coming 12 months, and that actual inflation will come in lower next year than what short-maturity inflation expectations are currently suggesting.
As such, we do not expect that inflation next year will lead to a major shift in the monetary policy outlook, and we would continue to recommend that global investors stay overweight stocks versus bonds in 2022.

Mr Romeo: I am surprised that you have a sanguine inflation outlook given how sharply consumer prices have risen this year. It sounds like you are blindly accepting the “transitory” narrative that central banks themselves are now questioning!

This year’s surge in consumer prices has several causes, and a review of these factors is necessary to predict how future prices are likely to evolve. Fundamentally, any change in price can be traced to changes in supply and demand, and both of those effects worked in the direction of higher consumer prices this year.

Chart 5 outlines the clear evidence of demand-side effects. The US fiscal response to the pandemic was more forceful than in the euro area, and US core consumer prices have correspondingly risen much more than in Europe. The chart highlights that US durable goods prices have been responsible for more of the surge in prices this year than has been the case for services, reflecting strong goods demand from US consumers. Chart 6 highlights that US real goods spending is 9.8% above its pre-pandemic trend, whereas it is 4.5% below for services. Extremely strong goods demand partially reflects the impact of fiscal and monetary stimulus, but also a shift in spending from services to goods owing to the nature of the pandemic and the type of activity that it has restricted. We expect that another shift in spending mix will occur next year in the opposite direction, barring a major extension of the pandemic from Omicron.

You referenced the “transitory” debate in your question, and the answer to whether above-target inflation is likely to be transitory is both yes and no. Many of the supply-side effects that are driving prices are transitory, in the sense that they will not last beyond the pandemic. That view should not be controversial. But, some of the demand-side effects lifting prices are not.

In the US, supply effects are seen by observing services prices. Services prices in the US have risen despite a collapse in demand, pointing to supply-side effects as the dominant driver of higher prices. A significant decline in labour force participation has caused a shortage of workers, which is driving up wages for the first quartile of wage earners (the lowest paid) who often work in service-providing industries (Chart 7). Faced with higher labour costs alongside low operating margins and the expectation that demand will continue to recover, service providers have raised prices to stay afloat.

The specific causes of the ongoing labour market shortage in the US are multifaceted, but most relate directly to the pandemic:

  • There has been a surge in the number of retirees, mainly driven by a sharp slowdown in the number of older Americans (who are more vulnerable to COVID-19) shifting from “retired” to “in the labour force”.
  • Workers in some sectors of the economy that experienced a surge in demand during the pandemic (technology, health care, food products, transportation, and manufacturing) have experienced burnout and have quit their jobs. Some service-sector workers have complained of difficult working conditions during the pandemic (the need to wear masks, the policing of masks and vaccination passports, overwork due to short-staffed conditions, negative interactions with customers, etc.) and have instead chosen not to work until these conditions improve.
  • Some parents have been unable or unwilling to re-enter the labour force due to increased childcare requirements resulting from day-care/school/classroom closures.
  • Chart 8 highlights that legal immigration to the US collapsed during the pandemic following a restriction in worker visas last year, which has also likely exacerbated worker shortages in some industries. Illegal immigration has surged over the past year, but illegal workers do not necessarily immediately enter the labour market and are often employed in a narrow set of industries.

Mr Romeo: But if these supply-side effects that you are pointing to are mostly on the services side, does that not imply that goods inflation will remain very elevated next year due to excessive demand?

BENDURA: No. As we mentioned, some of this goods spending is being funded by income that would normally go towards services spending. We doubt that a services spending deficit will be sustained if the pandemic recedes next year, meaning that some spending will naturally be diverted away from goods.

In addition, other supply-side factors are also impacting consumer prices for both goods and services, and on both sides of the Atlantic:

  • Global shipping costs have surged, particularly for cargo containers traveling from China / East Asia to the west coast of the US. US demand for goods has certainly boosted shipping prices, but Chart 9 highlights that supply-side effects have also been present. The large rise in China/US shipping costs since late-June appears to have been caused by the one-month closure of the Port of Yantian that began in late-May, in response to an outbreak of COVID-19 in Guangdong province.
  • Semiconductor shortages have limited automotive production, thereby significantly boosting US vehicle prices. These shortages have occurred, in part, due to a global surge in semiconductor demand stemming from work-from-home policies, but also demand/supply coordination failures last year (auto producers initially cut chip orders on the expectation of collapsing car sales) and COVID-driven plant shutdowns in some Asian countries such as Malaysia.
  • Energy prices have risen this year, partially due to supply-side / policy decisions. In the case of oil & gasoline prices, OPEC’s production decisions clearly reflect a desire to maintain oil prices at roughly $80/bbl., 30% above the level that prevailed prior to the pandemic. US shale producers have focused on repairing their balance sheets over the past year, and have not been able to take advantage of higher prices to boost output.
  • In Europe, the impact of higher energy prices has occurred mainly though a spike in the price of natural gas, mostly due to weather, carbon pricing, Russian supply issues, and a surge in China’s natural gas demand. Chinese natural gas demand has surged in response to very strong manufacturing activity / export demand, but also previous decisions by Beijing to shift towards cleaner energy sources and the limitation of coal imports from certain countries (which has contributed to a collapse in Chinese coal inventories).

So while it is clear that there is a strong underlying demand component that has boosted goods prices, supply-side factors have magnified the acceleration in consumer prices this year. Most of these supply-side factors (except for oil) have been directly linked to the pandemic, and thus are likely to wane in 2022 if the pandemic recedes (as we currently expect).

In the case of oil, our view is that spot prices in 2022 are likely to average the price that prevailed prior to the Omicron-driven collapse in prices, meaning that the energy component that has been boosting headline price indexes this year will likely disappear next year even if recent travel bans are not long lasting and oil prices fully recover.

The economic outlook

Ms Juliet: Thank you. Let’s turn now to the outlook for growth next year. Starting first with developed markets, what do you expect in terms of the pace of economic growth, and how does that expectation differ from consensus market expectations?

BENDURA: While we are less concerned about short-term inflation than most investors, we generally agree with consensus expectations for growth next year. Chart 10 shows that both official and private forecasts for real GDP growth in the US and euro area are well above trend, and that the US and euro area output gaps are likely to turn positive next year.

In Q4 2021 and Q1 2022, it is possible that the Omicron variant will negatively impact economic growth. But assuming that the pandemic does recede in importance for the year as a whole, the basis for expecting above-trend growth in advanced economies next year is straightforward: we expect that monetary policy will remain extremely accommodative in the US and euro area, and will likely remain so even if the Fed begins to raise interest rates. In addition, the collapse in spending that occurred last year, arrayed against stable-to-higher income, has caused households to accumulate a massive amount of savings that will support consumption.

Chart 11 highlights that this has occurred in both the US and the euro area. In the euro area, income was relatively stable, and spending has yet to fully recover – supporting the view that a catch-up in European consumption will boost euro area growth to above-trend levels. In the US, personal income rose during the pandemic, because the US government issued stimulus checks to Americans who did not lose their job. Some of these excess savings have been spent or used to pay down debt, but a sizeable portion remains to support spending. Chart 12 highlights that US household net worth has exploded higher over the past 7 quarters, by a magnitude that far exceeds any other instance since the Second World War.

It is true that fiscal policy will subtract from growth in both the US and euro area next year, although it remains an open question how much drag will occur in the US. Chart 13 presents the Hutchins Center Fiscal Impact Measure from the Brookings Institution, which suggests that US fiscal drag will be significant in 2022. This measure does not include the recent infrastructure bill, or the Build Back Better plan. However, Chart 14 presents the IMF’s projections for the US and euro area cyclically-adjusted budget balance, which suggest meaningfully less drag next year for the US.

In the case of the euro area, Chart 14 highlights that the IMF is forecasting considerable fiscal drag next year, which seemingly contradicts optimistic expectations for euro area growth. There are two reasons to believe that euro area growth will be meaningfully above-trend in 2022, despite fiscal retrenchment.

First, the IMF’s projected reduction in the euro area’s cyclically-adjusted primary deficit reflects the expiry of employment support programs such as the “Kurzarbeit” scheme in Germany, a social insurance program that incentivizes employers to reduce employee hours rather than laying off workers. The expiry of these types of programs is politically tied to a continued recovery in domestic consumption and further gains in service-sector employment, meaning that some of the fiscal drag projected in Chart 14 is necessarily linked to a growth impulse from the private sector. Certainly, these programs will be renewed or extended if the Omicron variant significantly weakens near-term economic growth in the euro area.

Second, while the positive contribution to euro area growth from goods exports will likely wane over the coming year as spending in advanced economies shifts from goods to services, European services exports will eventually improve. Chart 15 highlights that the recovery in foreign tourist visits to the euro area is in its very early innings, and a normalization of tourist travel will eventually act as a significant contributor to income and employment growth in the region. According to the World Travel & Tourism Council, Europe was the third most impacted region globally from the decline in travel, after the Caribbean and Asia Pacific. It is clear that tourist travel will not pick up as long as Omicron-related travel bans are in effect, but Europe’s peak tourist season typically runs from June to August, which is beyond the range of time supposedly needed by vaccine manufacturers to produce Omicron-specific booster shots (should they be required).

Bond market prospects

Mrs Juliet: You noted earlier that you disagree with the bond market’s outlook for US rate hikes next year. What are the fixed-income portfolio implications of that view?

BENDURA: It is possible that the Fed may begin raising interest rates as early as next summer, but this is only likely to occur if jobs growth meaningfully accelerates, the surge in net retirements during the pandemic is durably sticky (beyond any potential impact from the Omicron variant), or long-dated inflation expectations become unanchored. It is not likely to occur simply because actual inflation, driven significantly by supply-side factors, is elevated.
Mrs Juliet: And what positioning would you recommend within a global fixed-income portfolio?

BENDURA: The likely sequencing of central bank rate hikes over the coming 12-18 months suggests that global fixed-income investors should maintain an underweight stance towards US, UK, Canada, and New Zealand, and an overweight stance towards Japan, Europe, and Australia.

Among our overweight recommendations, our view that the ECB will lag the Fed makes a clear case to be overweight euro area versus US bonds (both core and periphery), and Chart 16 highlights that rising US bond yields have been strongly correlated with the outperformance of euro area government bonds in US$ hedged terms over the past five years. For Japan, long-maturity JGB yields are likely to remain flat over the next year as they have been since 2016, underscoring that our allocation to JGBs is a strict function of our global duration call (with a short duration stance favouring Japan).

Equity market outlook

Mr. Romeo: Thank you for your bond market comments. My view that bond yields have potentially much further to rise over the coming few years suggests that we will earn very little in the way of returns from our fixed-income portfolio, but the equity market outlook is no better. In fact, the medium-to-long term equity outlook is probably the worst that I have seen in a long time. Next year’s outlook is arguably bad as well; equity valuation is extreme, and you are forecasting a rise in long-maturity bond yields next year. In addition, you acknowledge that the longer-term term risks of inflation have risen, and believe that the Fed and investors are underestimating the neutral rate of interest. All of that seems wildly bearish to me!

BENDURA: Let’s focus on what is likely to occur next year. Since the US equity market now accounts for 60% of global stock market capitalization, we will outline our US equity views first before turning to the rest of the world.

The starting point for any cyclical view of the stock market should be one’s earnings outlook, and based on our economic view we agree with analyst expectations that US revenue growth will remain elevated next year relative to what has prevailed on average over the past decade (Chart 17). Above-trend growth and consumer price inflation point to revenue growth in the high single-digits, and this would normally serve as a conservative estimate for earnings growth given that profit margins have been trending higher since the beginning of the 2009 economic recovery.

However, US profit margins have already risen to a new high both for the tech sector (broadly-defined) and ex-tech (Chart 18), and there are credible arguments in favour of an outright contraction in margins over the coming year.7 As such, we expect earnings growth to come in at or below revenue growth, which is currently expected to be about 7% next year.

You referenced extreme overvaluation of the equity market, and Chart 19 highlights that the S&P 500 12-month forward P/E ratio is indeed now as high as it was during the stock market bubble of the late-1990s. But panel 2 of Chart 19 highlights that our proxy for the US equity risk premium (ERP) is in line with its historical average, in stark contrast to the lows that were reached in the late-1990s.

These seemingly contradictory perspectives are resolved by the observation that real bond yields are extremely low today. It is reasonable to expect a structural decline in real bond yields over time given a structural decline in the potential growth rate of the economy, but Chart 20 highlights that real long-maturity yields are already substantially lower than estimates of trend growth.

If we believed that real US government bond yields were set to rise by 200 basis points over the coming year, we would be categorically bearish towards stocks as it would imply a substantially lower P/E ratio. That, however, is very unlikely to occur while the Fed and investors subscribe to the secular stagnation narrative. While R-star is probably higher than the Fed and investors think, we do not think that these expectations will change before the Fed begins to normalize monetary policy. As such, while equity multiples may fall over the coming year in response to somewhat higher bond yields, we expect the decline to be relatively modest.

Putting this all together, given our base case view that the pandemic will recede in importance next year, we expect mid-to-high single-digit returns from US equities in 2022 – the net result of robust revenue growth and some return compression from profit margins and equity multiples.

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