Omicron: volatility is expected to remain

Even Europe, by the MSCI index, has come to trade at pre-pandemic levels. But we are not like in April 2020. We know much more about the coronavirus and society is more prepared to deal with it.
Luca Paolini

Chief Strategist

Pictet AM

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“No need for pandemic panic”. The appearance of the Omicron variant shows the pandemic has not disappeared.  It could evade current vaccines, though it’s unclear how severe the disease it can cause.  Meanwhile, governments have imposed travel restrictions.  

Even Europe, by the MSCI index, has come to trade at pre-pandemic levels.  But we are not like in April 2020.  We know much more about the coronavirus and society is more prepared to deal with it.  There is no need for pandemic panic.  Covid has caused distortions and bottlenecks in supply, but economies in general have adapted well.   In addition, vaccines can be modified relatively quickly for the new variant.  Although it is necessary to see if it affects the reopening of economies, it is probably possible to manage the new variant.

In fact, the new variant is not likely to dictate the course of the business cycle, although may influence it.  The global direction remains one of reopening and normalizing economies.  At the moment, we don’t see any big changes due to the new variant. We expect growth and recovery in services, although volatility in financial markets is expected to remain.

2022: a global economy in strong growth

At the moment we have seen some weaknesses in leading indicators globally, as industrial production and services, but investment and construction remain strong. Overall, by 2022 we expect a recovering global economy with services around the world gaining momentum.  In fact, we expect higher growth and inflation than consensus, with less dispersion across regions and sectors than by 2021. Thus, we forecast 4.8% global GDP growth in 2022, above potential, in virtually all regions, especially the US (whose growth may surpass China for the first time), Europe and Japan.

Although declining liquidity and upward pressure on real debt yields may reduce equity price-to-earnings ratios, we expect corporate earnings to increase globally 16% in 2022, compared to 7% of the consensus and basically in all regions, most likely in the Eurozone and Japan (where economic recovery is incomplete).

The biggest risk is inflation and that central banks do nothing about it, that is, a scenario of high inflation with low growth.

Higher inflation

Higher inflation is foreseeable. In the US has reached 30-year highs and is up in Europe and Asia, and expected to remain so.  It should be borne in mind that wages account for 60 to 70% of the GDP deflator and there is a lack of labour, together with low level of inventories, attributable to supply bottlenecks, although with certain indications that freight prices have peaked.  With this, the increase in wages in the US is approaching 5%, above historical trend.  Contributing to this situation is the largest known monetary and fiscal stimulus, which has reached 10% of US GDP.  Although this year it is expected to be reduced globally, it will remain positive.

But there are signs that supply constraints are starting to ease and inflationary pressures may peak in coming months, before moderating for the rest of 2022.  In fact, our liquidity indicators show a significant contraction in credit supply this quarter with the withdrawal of stimulus from central banks, although there are signs that grows in the private sector, especially in the US and that the Chinese authorities are beginning to relax their adjustment. So less monetary stimulus should not affect growth.

On the other hand, after emerging markets have led monetary tightening cycle this year, we expect developed market central banks to do so. In any case, even if the Federal Reserve increases its interest rates by 0.25% three times in 2022, they would still be between 2 and 3% below inflation.  That state of affairs is positive for risk assets.  Moreover, there are macroeconomic and market events that typically need to take place for a bull market to end and one of them is an increase in real interest rates by the Federal Reserve and an inversion of the yield curve at maturity of US debt, which we do not foresee in 2022.  Also, historically, stocks tend to perform well while the U.S. economy creates jobs, as is the case.

Up to 10% return in equities

Most asset classes remain expensive by historical standards.  The riskiest are trading at or near highs, especially in the US, although for good reasons. Consumer and industrial demand is robust, supply bottlenecks appear to be diminishing and corporate profits and margins remain healthy. This bodes well for equities.  At the same time, valuations of Covid-sensitive stocks suggest that investors have been largely sceptical of a smooth reopening and risk appetite has returned to neutral levels.

However, in two years there has been an improvement in stock valuation multiples that would normally take a full cycle. In 2002, increases in stock prices will have to be moved by increased profits.  On the other hand, we expect a 5 to 10% reduction in valuation multiples. The result can be a return of 5 to 10% in equities in 2022.

In addition, developed markets may perform better in the first part of the year, followed by a recovery in emerging markets the second half.  The behaviour of the latter is closely related to weakness of the dollar, growth differential with the US and price/book value relative to developed markets and it is foreseeable that US growth, strong in real and nominal terms, will slow down throughout 2022 while that of China improves, without worries about an increase in real interest rates of the Federal Reserve, as there are structural factors that keep them low, so the yield on ten-year US bond should not exceed 2% in 2022, positive for emerging economies. In addition, a significant slowdown in the pace of monetary adjustment in emerging markets is expected the second half of the year.  Even Latin America may be a region to look at the second part of the year, as its equity markets are cheap even in absolute terms.

Cyclical value stocks

Consumer discretionary stocks are starting to look as expensive as tech stocks. Cyclicals have outpaced defensives as inflation expectations have risen; with a near-cycle highs of 16%.

But cyclical value stocks must perform better with the reopening of economies.  If inflation protection capacity is added, banks from developed markets, energy and mining sectors, Japanese stocks, small and medium-sized US capitalization companies, real estate assets, Chinese technology and Russian stocks are suitable.  The finance sector, despite its strong rebound this year, remains attractively valued and banks’ profitability will improve as bond yields rise and obstacles to the distribution of their dividends are largely removed.  For its part, the real estate sector is one of the cheapest in 20 years and can serve as a partial hedge against inflation.  In addition, supply constraints affecting the automotive sector should begin to ease and improvements in its profit forecast are likely in the coming months.

But we are more cautious with defensive sectors, whose good relative performance in recent months make them vulnerable to a rebound in economic growth.  We have reduced public services and consumption staples to underweight. They behave like bonds and may struggle as yields to maturity on fixed income rise.   In addition, utilities may come under increased pressure from governments seeking to contain energy prices.

The riskiest assets are bonds

The persistence of inflation and efforts by central banks to withdraw monetary stimulus should lead to increased yields of bonds, generating volatility in fixed income markets.  In fact, we expect the yield curve to maturity to flatten next year, especially in the US.  So investors have no prospect of profit through higher-maturity sovereign bonds, which we underweight.   In addition, the rising inflation outlook has triggered a flight to U.S. inflation-linked bonds, whose yields are below minus 1% and are overbought.

In fact, the riskiest asset is bonds.  Although emerging market sovereign debt shows positive yield, while developed markets negative, we must be selective and take into account political uncertainty, which includes elections, as those in Brazil and Colombia.  However, we overweight Chinese government bonds. It offers attractive yields and has demonstrated diversification benefits.  Inflationary pressures in China are relatively moderate and its currency may appreciate over the long term.

At the same time, corporate debt shows oversupply. We have downgraded U.S. investment-grade corporate debt to underweight. Its yield spread against U.S. Treasury debt is near an all-time low of 0.96%, offering limited protection against any unforeseen economic weakness.  In addition, this debt is more sensitive to changes in interest rates than its European peers. The outlook is equally negative for high-yield U.S. debt.

Abut, after the recent liquidation, we see opportunities in emerging markets corporate debt, especially in Asia and China, as well as bonds Russia, which has a credible central bank.  We also consider U.S. leveraged credit with floating interest. These assets are favoured by value and low sensitivity to changes in interest rates.

As for the dollar, it may continue to rise in the short term, but devaluate in the second half of 2022, given excessively bullish positions and a higher growth in the US that may moderates, with divergence of policies between the Federal Reserve and the ECB.  In addition, the US, shows excessive double deficit to GDP.  For its part, gold is a strategic asset that in the medium term can benefit from the weakness of the dollar and negative real rates.

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Omicron: volatility is expected to remain