As we ponder what to do with our investments in 2022, there are lots to worry about. Omicron is sweeping the world. Restrictions are being reimposed in many countries but government support is limited. Indeed, fiscal policy is being tightened and central banks are preparing to tighten policy. Surging input costs, supply disruptions and labour shortages all threaten corporate profitability.
After one of the longest and strongest bull markets in history, are equities due for a major correction? Is this the time to take the chips off the table and bank gains already made?
Reasons to be cheerful
Whilst I do think we’re in for a bumpy January, looking further ahead there are reasons why risk assets should continue to perform.
Company profitability is high and balance sheets are strong
Household finances are also exceptionally strong in aggregate
Economic growth may have suffered a setback over the winter due to Omicron, but it should recover as the year unfolds.
Equities may have had a good run, but valuations have improved and are far from being excessive prevail financial conditions.
Let’s look at these issues in more detail.
Company and consumer finances – spending power intact
First, the companies have taken advantage of supportive financial conditions to strengthen their balance sheets. They are cash rich and prepared to buyback shares, raise dividends and boost capital expenditure. Fiscal policy is being tightened and the failure of the latest Biden fiscal package in the US means that the child tax credit has expired which will hurt consumer spending in the next few months. The UK government has announced £1bn of support for the hospitality industry but that seems a small amount alongside the expiry of the £20 per week additional universal credit, the increases in VAT and prospective rise in National Insurance contributions. Surging energy and other costs are squeezing incomes in every country. Despite all this, consumers have plenty of spending power with much of the enormous fiscal support over the last two years unspent. Even if only part of this is spent over the new few years, consumer spending will remain strong despite the squeeze on real incomes.
Tighter central bank policy – the shift is modest
Second, although central banks are tightening policy, they are taking very small steps. Tapering by the Federal Reserve is just slowing the pace of easing. Federal funds lift off will follow but interest rates will remain low in both nominal and real terms. Experience suggests equities perform well even after the Federal Reserve starts tightening. Bear markets typically set in when the economy turns down or there is a financial squeeze. Neither of these looks imminent.
Supply disruption – set to ease
Third, the supply shortage and disruptions that have been such a feature of the pandemic recovery are easing. Exports of semi conductors from Korea and Taiwan are strong and the benefits are being seen in increased output in many areas, notably autos. With Christmas behind us, pressures on shipping and air freight have eased considerably. And, as the weather improves in the Northern Hemisphere – one forecast we can rely on – energy prices will ease too.
Our take on valuations – not expensive
Finally, let’s look at valuations. Although equities rallied strongly last year, earnings grew even faster so valuations improved. Even though official interest rates are set to rise in the UK and US in 2022 and bond buying programmes end, yields remain at record lows when set against inflation. The fundamental value of a company is the path of future earnings discounted to present value, and that discount rate is very low. So while equities are not cheap, they are far from being expensive.
In summary, yes, there are headwinds and I do not expect a super strong year for equities but returns of 5-10% seem a reasonable expectation.
Emerging market equities look more challenged
While we are upbeat on the prospects for developed markets, we are less positive on their developing counterparts. The financial ability to cope with Covid is more limited and interest rates have been rising in many EM countries for a year or more. China has not suffered higher interest rates, but it has bigger problems. The over-indebted property sector is struggling, and this will likely handicap the economy for years to come.
Pricing power to help larger companies
In terms of sectors, large cap companies might continue to outperform their smaller counterparts. They have greater pricing power in general and should be better able to cope with labour shortages. There is pent up demand for travel and leisure but I’m not sure how rapidly consumer confidence will recover in the face of fear around new variants.
Over the last few years have seen a plethora of unprecedented forces. Yet governments, businesses and society as a whole have coped remarkably well, helped by amazing medical support. Financial markets have benefitted from this and should continue to deliver solid returns.
Past performance is not a guide to future performance. The value of investments and any income derived from them can go down as well as up and investors may not get back the original amount invested.
The information, opinions, estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.
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