Despite the COVID-19 pandemic and the volatility of asset prices associated with it, 2021 turned out to be the third year in a row of good equity returns. Since the virus escaped China, economies and asset prices have been supported by extraordinary fiscal and monetary policy. From an investment perspective, the good news of successful vaccines, new anti-viral drugs and the possibility that the Omicron variant might be a steppingstone towards a less harmful endemic disease needs to be tempered by the knowledge that policy makers have started to take the inevitable first small steps towards policy normalisation.
Year on year growth in government spending is forecast to drop from current elevated levels in the Eurozone and United States, whilst these countries’ central banks are likely to stop supporting asset prices and start raising interest rates. In January, investors started to pay attention to consequences of policy normalisation and highly rated growth stocks sold off sharply.
The reason that central banks, and the Federal Reserve in particular, are now pivoting to a more cautious stance is that there is evidence that both housing and labour markets are running hot. In the United States, house prices have risen strongly, whilst the labour market is tight with many companies reporting that it is now exceptionally difficult, relative to history, to fill job openings and there are signs of wages being increased to attract staff.
The COVID-19 related supply shocks increased costs for companies, however these have been successfully pushed on to end customers via price rises and we have seen a spike in core inflation to levels not seen since the early 1990s. Core inflation is expected to subside as the year progresses, however additional inflationary factors are now coming into play. Corporate investment, to re- or near-shore production assets (to improve supply chain security) and to mitigate climate change impacts, is set to accelerate appreciably.
The positive news, from an asset class perspective, is that equities, in general, can cope with higher inflation as companies live in a ‘nominal’ world. A company’s sales are a function of both volume and price and in an environment where price rises can be put through to the end customer and demand isn’t impacted then companies, in aggregate, can manage inflationary pressures fairly well.
The MSCI World Net Total Return Index reached a new high at the beginning of January 2022 (in US Dollar terms) aided both by upgrades to earnings growth forecasts and the willingness of investors to ascribe record valuation multiples on companies’ future cashflows and earnings. Indeed, the Price/Sales multiple for US equities has never been higher. Equity markets can (and often) do well in a rising interest rate environment as it usually signals economic and earnings growth. However, the high starting point for valuations this time round is problematic and signs of over-exuberance are not difficult to find.
From an asset price perspective, central banks’ attempts to wean investors off quantitative easing is likely to increase asset price volatility. As interest rates rise, albeit modestly, some pressure on valuation multiples may occur as the rate at which future forecast cash flows are discounted back to the present will rise.
Of the G7 nations’ central banks, the Bank of England has been the first to raise interest rates, with a 0.40% rise (taking the Bank Rate to 0.50%). Others are forecast to follow. Investors are anticipating rising short term interest rates but there has been little change to longer term interest rate expectations. This suggests investors do not believe that the current high inflation rates will persist and that the marked increase in government debt is likely to deaden any medium term economic recovery.
Whilst shorter maturity Government debt yields have moved to levels where it could be argued there is some value, the yields on longer dated maturities remain unappealing in our view. The ‘risk-on’ period has resulted in the spread between the yield on higher risk corporate debt and lower risk ‘investment grade’ corporate debt narrowing to such an extent that high yield corporate debt does not look compelling relative to investment grade debt. With slowing economic growth, less liquidity, and the prospect of rising real interest rates, risk is tilted towards a further widening of corporate credit spreads.
An important counterpoint to the rather pessimistic tone in this commentary so far is that the Chinese authorities are beginning to get a grip of the debt crisis within the outsized Chinese property development sector. Visibility, when it comes, of the policy approaches to be taken, to rescue those companies within the sector that are struggling is likely to be taken well, particularly if measures to reinvigorate overall economic growth are enacted at the same time.
In summary, the outlook for asset prices in 2022 is challenged given the starting point of high valuations. Ultimately, the interplay between tightening policy conditions in developed economies and easing conditions in China may ensure a reasonable outcome, but it will only be when pandemic distortions fade and post COVID-19 policy goals from governments and central banks start to emerge that a degree of clarity can be formed.