With equity markets on a knife-edge heading into 2022, we tasked Border to Coast’s Ryan Boothroyd and Anthony Petalas, to set out plausible bull and bear cases over the next 12 months.
The Bull Case
Ryan Boothroyd
While the prevailing narrative heading into 2022 is one of investor caution, the near-term economic outlook is the most positive that we’ve seen since the start of the pandemic.
Vaccination rates continue to rise, and this is enabling a resumption in global economic activity. Moreover, data from major transport and logistics hubs suggests that the worst of the supply chain disruptions are beginning to abate.
The normalisation of international trade removes a major headwind to company earnings, particularly for industrials or those with complex cross-border supply chains. While the Omicron variant is clearly concerning in the short term, the global economy has tended to rebound following the emergence of previous variants, supported by vaccination programmes, fiscal support and pent-up consumer demand.
The bullish view is that the global economy is likely to be in significantly better shape at the end of 2022 than it is today, and this should be a supportive force for equity markets.
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Peak
An under-appreciated side effect of improving trade flows is the impact on inflation. As central banks and economists have highlighted, the driving force behind the recent inflationary uptick has been supply disruptions.
With backlogs clearing, developed market inflation will likely peak in the first half of 2022. Moderating inflation would be positive for equity markets as it reduces the likelihood of aggressive central bank policy action and the potential for a major policy mistake.
A continuation of accommodative monetary policy, combined with a renewed appetite for government spending, means that liquidity is likely to remain abundant for the near future.
The net impact of economic normalisation and continued supportive policy is that analyst forecasts of 2022 company earnings appear overly conservative.
Companies could surprise to the upside, setting the foundation for another 12 months of solid equity market returns. Moreover, from a technical perspective, investors still face the same conundrum. Do they lock in guaranteed negative real returns in the bond market or accept more risk to achieve positive real returns from the equity market? As unsettling as the implications may be, there are few available alternatives to moving more deeply into global equities.
Room151 Roundtable: LGPS Valuations and Risk 2022
Next year sees the English and Welsh LGPS funds go through the next triennial valuation process, likely to reveal large surpluses across the scheme. Room151 convened a special roundtable to explore the valuations, inflation, data quality and the impact on strategy.
Download a PDF version of this article here.
The Bear Case for Equity Markets
Anthony Petalas
The equity bear market that began with the onset of Covid-19 quickly gave way to one of the fastest recoveries on record. Indeed, despite lacklustre economic growth in developed economies—not to mention one of the worst humanitarian crises in our recent history—global equity markets have delivered a 13% annualised return over the past decade.
It is clear that there is a fundamental disconnect between markets and economic reality. Signs of excess are everywhere, with some retail traders driving unprofitable businesses to billion dollar valuations and investors increasingly willing to pay record high prices for future earnings.
This sounds awfully familiar, especially to those that have experienced the true impact of market corrections.
Equity bulls might point to strong and improving business fundamentals to justify their position. However, not all is as it seems. A significant proportion of the growth in earnings per share is not attributable to real growth but to financial engineering via share buybacks—reducing the number of shares outstanding.
In other words, investors get a bigger slice of the same pie. In addition, over half of the returns that equity markets have generated over the past 10 years can be attributed to valuation expansion, which is driven purely by sentiment not company fundamentals.
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Liquidity
A key factor driving this phenomenon is the provision of central bank liquidity. Years of interventions have reinforced the speculative notion of unlimited support, propping up companies that should otherwise have failed.
Indeed, record low interest rates and the “TINA effect” (there is no alternative) have pushed investors to the few asset classes that can deliver positive real returns regardless of price.
However, with record low unemployment and inflation raging, it could be time for central banks to start pulling back support. A hawkish tone has certainly entered the rhetoric.
The implication of higher interest rates is that future cash flows become less valuable, reducing the present value of equity markets. The impact will be particularly pronounced for companies whose valuations are anchored to distant cash flow expectations (i.e., long duration assets).
Irrespective of the liquidity outcome, one thing is certain, a bear might say that the extraordinary equity returns over the last 10 years are unlikely to be replicated in the next 10 years and, as the old saying goes, whilst a rising tide raises all boats – only when it goes out do you discover who is swimming naked.
Critical juncture
Global equity markets are at a critical juncture. Analyst forecasts show record levels of disagreement about future returns, and no one knows what the impact of the pandemic and associated policy action will be on capital markets, companies and society in the short, medium or long term. And let us not forget other big issues, such as climate change – which for investor can bring opportunities as well as challenges given the need for investment to support the carbon transition.
While the market environment over 2022 is likely to fall somewhere between two extremes outlines above, one thing is clear. For long-term investors, a fundamental and stock-driven approach to equities should remain a critical component of strategic asset allocation and have an important role to play in a well-diversified portfolio regardless of the short-term outlook.
Ryan Boothroyd and Anthony Petalas are portfolio managers with Border to Coast.
Photo: nosheep / Pixabay
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