Bonds are no longer providing a hedge to equities. A combination of monetary tightening and stubbornly high inflation means returns on traditional government bonds are likely to be negative over the next two to three years at least.
Hence our large Underweight in this asset class. We favour the High Yield segment, the short duration segment in particular, as credit fundamentals remain positive and the default rate for 2022 remains low by historical standards. We remain cautious about the Emerging Debt as the asset class is typically negatively impacted by US rising yields and a strong dollar. We expect inflation linked bonds to fare better than nominal bonds, but the asset class may not be spared of negative returns due to its long duration. We therefore prefer short duration inflation linkers. We will consider buying the emerging debt later in the year once the outlook on US rates becomes clearer.
Equity return look set to deliver much lower returns than in 2021. The earnings cycle is maturing. Profit growth has started to slow, fuelling the risk of earnings/outlook disappointment. The path to a greener and more sustainable economy will require huge investments to progress towards a carbon neutral economy, which may weigh on corporate profit for some time. According to IBES data from Refinitiv, earnings of S&P 500 companies are expected to grow 8.4% in 2022, a still decent pace of growth but a significant deceleration from 50.8% seen in 2021. In the longer term, a supply-driven inflation may erode households’ real spending power and weigh on demand.
Valuations look elevated with regard to higher inflation and rising yields. Over the past two years, PE above long-term average were justified by low interest rates. In a context of slowing earnings growth and rising interest rates further PE contraction looks inevitable. Even after the recent market correction, some individual stocks still look too expensive. Trading at a forward PE of 20.3x, the S&P500 has little room for price appreciation. Earnings of STOXX 600 are forecast to grow 71.4% in 2021 and c10% in 2022. Trading at a forward PE of 15x, the STOXX600 looks more attractive than the S&P500, although some individual stocks (mainly growth and tech stocks) look pricy as well.
Volatility will complicate the job. Policymakers will have to navigate the fine line between taking action to contain inflation but not tightening too fast to avoid the risk of putting a quick end to the economic recovery that would disrupt equity markets, damage the wealth effect and hence final consumption. Considerable uncertainty about the degree of strength in global economies and the resultant inflation and interest rate expectations has the potential to trigger regular bouts of risk aversion. Sector and style rotation could be violent and difficult to capture. The Fed will need to communication clearly about its policy to prevent a messy correction in financial markets. The pace of monetary policy tightening will be key to equity returns which we expect to be modest this year.
Against this challenging backdrop, we favour asset managers with a flexible investment strategy, without a particular bias on value or growth, but with a focus on good quality companies and sustainable earnings over the long run at a reasonable price. Companies with pricing power will be better placed to weather rising costs arising from supply chain crunch and higher commodity prices and to protect their profit margins by passing costs along to customers. Companies that display attributes such as high barriers to entry, low availability of substitute products, industry leadership, better-than-average profitability, consistent cash flow generation, will continue to benefit on the long run. Dividend strategies will likely be a good hedge against rising interest rates.
ESG/Thematic/Impact funds will continue to attract large inflows as the pandemic has exacerbated investor willingness to address environment, social, and governance issues. Crowded trades however have led to price bubbles in some places like renewable energy, innovative healthcare and technology. Multiples contraction may still be needed in a context of rising rates. That being said the quest for a “greener” and a more sustainable economy requires huge investment in infrastructure like electrification grids, renewable energy, electric vehicles, sustainable food and water treatment and recycling.
Secular growth trend companies fueling the acceleration of digital disruption (cloud computing, e-commerce, digital payments, robotics, internet security, media and entertainment, data centers, semiconductors and semiconductor equipment manufacturers, biotechnology should also remain supported on the longer term.
We remain cautious about China as a shift in the government development strategy is putting pressure on the growth outlook. After pursuing a path of aggressive economic growth for decades, China’s government now wants to develop a more egalitarian society. This shift from “growth first” to “common prosperity” has the potential to weigh on growth as the government intensifies its punitive measures to reduce poverty and social inequality.
In Asia, we have a preference for India where the government will step up spending to 39.45 trillion rupees ($529.7 billion) in the coming fiscal year to build public infrastructure and drive economic growth.