There's still reason to be positive

On 24 January, we recommended trimming some equity risk in portfolios. While we believe the economic outlook remains very positive, events over our summer, including the acceleration of central bank action, more persistent inflation, and heightened geo-political risk, suggest our unchanged preference for equity over fixed income returns should be outworked from a more neutral position.

The changes we made still resonate with the key messages contained in Outlook 2022…there may come a time to pivot, published in early December. In particular, our belief is that:

  • Returns will be more moderate and volatility elevated, 
  • Rising bond yields will favour a rotation within equities from growth to value and tech to non-tech,
  • Active management will outperform passive.

While we were away central banks ‘blinked’

We continue to favour equity over fixed income returns. However, from 24 January we chose to reduce our equity overweight to neutral. In our early December 2022 outlook piece, we noted that “dissipating slack and tighter policy could demand a more neutral—or even defensive—stance as H2 2022 gets underway”, and that it would be key to assess whether that pivot may arrive “sooner and faster” than expected. Over the summer, inflation has proved stickier than expected and geo-political risks have risen somewhat.

Most importantly, central banks, including the US Federal Reserve (Fed), have blinked. From collectively signalling rate hikes and a staged withdrawal of liquidity from 2023 or 2024, pressure from elevated inflation and their current near-zero interest rates’ starting positions have brought this forward to H1 2022. While we remain constructive on the outlook, we have chosen to adopt a more neutral risk position. We anticipate that once the tightening phase begins and inflation pressures more clearly recede (likely through Q2 2022), a more risk-on position may be warranted in H2 2022.

Staying constructive on economic growth

We remain constructive on the economic outlook, and we are arguably more comfortable now that 2022 growth will be above trend than we were when we published our outlook in early December. At that time, the Omicron variant had just emerged and neither the efficacy of current vaccines nor its mortality rate was known. Moreover, inflation was continuing to surprise higher and the likely response of central banks to inflation surprising was less clear.

As we have emerged in 2022, Omicron cases now look to be peaking, mobility restrictions have been modest and are now expected to ease through Q1, while the impact on economic activity has been relatively limited. We also have a clearer view of central banks, which have lost patience with elevated inflation and decided to begin removing liquidity much sooner than they initially flagged through most of 2021.

It is also important not to confuse early central bank action with sharply faster and higher rates. We only view the earlier timing as adding modest incremental tightening in 2022 that will leave interest rates still quite accommodative. We still view inflation pressures as ‘on the cusp’ of easing (even if this process is somewhat delayed again) as surveys point to easing pressures in early 2022.

Global inflation reaches new highs in late 2021

Other drivers of a strong 2022 growth outlook remain intact, from:

  • global consumers flush with cash;
  • pent-up demand for consumer services;
  • cycle-low inventories, likely underpinning a production upswing; and
  • capex intentions globally at their highest level for years.

The decision by central banks globally to normalise rates somewhat earlier should also limit the extent to which the abundance of consumer purchasing power leaks into global consumer inflation.

Prior to the evident disruption of the Omicron variant in early 2022, global growth forecasts for 2022 were in the range of 4-5%. However, we expect this to trend closer to 4% now (after 6.1% in 2021), a still strong and above-trend pace. Relatively, the outlook appears strongest across Europe and Australia (both aided by more dovish central banks), the UK and then the US. China appears to be a game of two halves, with H1 2022 likely to remain weak before the recent easing in policy fosters stronger H2 2022 growth.

Rising bond yields suggest the rotation from tech will continue

Near-term uncertainty warrants a more neutral risk stance

Despite a positive macro outlook, a number of additional cautionary factors have played into our decision to trim risk:

  • The months preceding the first hike in a cycle have typically led to volatility and, in many cases, meaningful drawdowns in risk. The recent history of quantitative tightening (QT) has also proved an initial head-wind for markets. Prior to Christmas, what was signalled as the end of bond-buying in mid-2022, then hikes in late 2022, followed by balance sheet run-off somewhere in 2023, is now expected to be compressed into the coming six months by the US Federal Reserve (Fed). Our own Reserve Bank of Australia (RBA) is also likely to have to move quicker than it’s signalled. Of course, we also note that equities have typically rallied strongly in the year following the first Fed rate hike.
  • While we believe that recent data point to an ebbing and move lower in inflation through 2022 as the transitory aspects pass through, there is unlikely to be any meaningful disinflation until the March month data is released in mid-April, still several months ahead.
  • Over recent weeks, geo-political tensions have risen, providing additional risks for markets to absorb. Risks of a Russian incursion into the Ukraine have risen sharply. A number of countries (including the US and Australia) are evacuating non-essential personnel. Tensions with China over Taiwan have also not dissipated.

Ultimately, once markets have absorbed the ‘shock’ of the Fed and other central banks starting what we believe to be a modest rate hike cycle (and announcing their QT policies), we expect equity markets should be in a better position to advance, likely through H2 2022.

The bears are getting noisy…is a valuation correction afoot?

Of course, given our constructive view on growth and ebbing inflation, why not just maintain our existing moderate risk-on position, which has served us well since the pandemic unfolded? As has been the case since valuations post the pandemic moved multiple price/earnings (P/E) points above their pre-pandemic averages, there has been a persistent concern that, at some point in the future, valuations would need to mean-revert.

Our central case has been to look for a ‘bullish derating’ of equity markets—as has been unfolding—where strong earnings allow valuations to slowly glide back to pre-pandemic levels over several years, even as markets grind higher.

Can global P/Es continue to correct to pre-pandemic levels gradually?

European equities look attractive, given positive cyclical outlook

However, at this point in the cycle, we are confronted with 30-year high inflation (in the US and UK) and very high inflation elsewhere. And from the position of near-zero policy rates with central banks removing liquidity, there must be non-zero risk that a valuation correction comes more quickly. A more neutral stance, as central banks normalise rates, is more warranted than being moderately risk-on, particularly given a reset to pre-pandemic valuations would still require a further material correction from market’s current valuations (see the chart on the next page).

Again, more positively, we note that economic growth is likely to be slowing through H2 2022 as inflation ebbs. Being early in the tightening cycle, this should caution central banks about being overly aggressive, leading them to limit the pace and magnitude of future rate hikes.

We, therefore, prefer to reflect our preference for equity over fixed income returns from a more neutral risk position. While we typically target 6-12 months for our tactical positioning, this likely reflects a stance closer to 3-6 months. We anticipate embracing a more risk-on position in the period ahead as our macro views of strong growth and easing inflation become more evident and after markets have digested the first steps towards higher rates.

Key tactical changes we have made

Overall, many of the changes we made should resonate with key messages contained in our 2022 outlook. In particular, our expectation that returns would be more moderate in the year ahead and volatility elevated. Rising bond yields (our target is 2.25%-2.50% on US 10-year bond yields) would favour equities over fixed income, and an ongoing rotation within equities from growth to value and tech to non-tech (see the chart on page 5). Heightened volatility and more moderate returns should also significantly favour active management (alpha over beta).

We also continue to favour full allocations to alternative assets. We now see real assets as our preferred alternative asset, while hedge funds should benefit from the renewed level of volatility (previously tactically underweight).

Finally, for those implementing new capital, we continue to believe the best way to preserve capital is through a (largely) implemented and globally diversified portfolio. In this regard, the much higher level of bond yields and more attractive equity valuations provide little headwind to implementing a significant share of any new capital.

In terms of our key changes (24 January 2022):

  • We are maintaining our overweight equities position relative to government bonds. But we have trimmed the size of that position (from 5 points to 2 points), mostly by reducing our equity overweight (+2) to zero.
  • Regionally, we continue to favour European and UK markets from both a valuation and style perspective, with sectoral composition (being heavier financials, resources and industrials) favouring strong growth and rising bond yields. We have trimmed the domestic equity overweight to zero (where we are constructive on the upcoming earnings season), while also delaying our telegraphed transition of emerging markets back to neutral from underweight. For the US, we have trimmed to a slightly underweight position to reflect the tech-heavy compositional challenges and more aggressive central bank. In thinking about our valuation risk scenario, while the US market has experienced the more significant correction year-to-date, its prior strong performance leaves it vulnerable if real rates rise and valuations correct (see the chart below).
  • We have continued the process of trimming our government bond underweight. Having moved from -4 points to -3 points in November 2021, the recent sharp sell-off in yields (from 1.40% to 1.80% in the US) supports another move to a less underweight position (-2).
  • Reflecting our constructive outlook and potentially shorter tactical timing of 3-6 months, we have shifted the overweight equity position to cash.

Our modest US underweight reflects ongoing valuation risks

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Scott Haslem
Chief Investment Officer

Scott has more than 20 years’ experience in global financial markets and investment banking, providing extensive economics research and investment strategy across equity and fixed income markets.

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