While the world maintains its focus on the battle against COVID-19, there are reasons for optimism in the months ahead. We believe that the current economic recovery will continue to deliver above-potential global growth; markets are indeed “Continuing the Climb.” But as we move past peak momentum and peak accommodation, the recovery that follows will likely be uneven and multi-layered. Many risks to our outlook remain, including uncertainty about the nature of inflation.
Other urgent issues are returning to the fore. The search for yield in a relatively low-rate environment is causing investors to rethink their fixed income strategies. The climate crisis — one of the defining challenges of our era — is causing investors to search for ways to express their views on climate and related topics. And because the macro rationale for China investment remains intact, investors are searching for the most appropriate ways to access that market. We’ll explore these themes and more in this year’s Global Market Outlook.
From a macroeconomic perspective, 2021 was an extraordinary year. Economists and investors alike are now pondering what the new year will bring. As the recovery continues to deliver above-potential growth globally, we believe it will do so with a bit of a rotation tilt that allows, for example, the eurozone to narrow — and perhaps even close — the growth gap with the US.
The global growth narrative is far from uniform. In emerging markets (EM), growth headwinds persist as lagging vaccination levels, rising interest rates, electoral uncertainties, and other domestic policy considerations take their toll. In China, we have downgraded 2022 growth expectations to just 5.0% and still see near-term risks skewed to the downside.
The pandemic remains an important driver of performance; the COVID battle has not been won just yet. One cannot overstate the importance of vigilance in continuing the COVID fight at this stage of the business cycle. This is because the lowest-hanging “re-opening” fruit has already been harvested, and the gains that come next will be harder-won and more modest. In light of the stellar returns of the past year, this is even more true in financial markets than in the real economy. In addition, because financial markets are notoriously forward-looking, the concerns that will accompany the removal of fiscal and (especially) monetary policy accommodation will become more prominent by the middle of 2022.
In many ways, the twin dynamics of high growth and high inflation that dominated the macro narrative in 2021 will extend into 2022. However, while inflation steadily built over the course of 2021, it should steadily decline from mid-2022 onward. The current annual average rate of inflation remains elevated by virtue of arithmetic, but by the middle of 2022 the acute inflation worries that currently dominate headlines should markedly subside. After all, base effects are likely to become serious headwinds a year from now. That said, we do not expect inflation to suddenly disappear. Rather, we expect to see a degree of “inflation rotation” take hold — particularly in the US — as shelter-cost inflation intensifies and offsets easing inflation pressures in other areas. Moreover, though worries around cyclical inflation will subside, the intense debate over possible structural changes to inflation is likely to persist. The two key indicators that we watch in this regard remain business/consumer inflation expectations and wage inflation. Both have moved sharply higher in 2021 to touch multi-year highs, but we would need to see current levels persist before a convincing argument for structurally higher inflation can be made.
We also think that it is worth considering more broadly whether a combination of highly accommodative macro policy, rising production costs in a scenario of “peak globalization,” new costs associated with the green energy transition, and renewed global focus on equitable growth and income redistribution will create a fertile ground where persistently higher rates of inflation might take root. Investors might consider some protection against such a scenario.
Fiscal and Monetary Policy
We are past the moment of peak monetary policy accommodation. EM central banks have clearly led the move toward higher interest rates so far. Given EM’s higher sensitivity to food price inflation, and that in general inflation expectations are less well anchored in EM than in developed markets (DM), this is a reasonable dynamic. Expect DM central banks to jump on the rate-hike bandwagon in increasing numbers over the course of 2022.
For the Fed, the immediate focus is on tapering and then ending asset purchases. The Fed may well accelerate the pace of its quantitative-easing taper in the first quarter as a precautionary step toward creating more optionality around the timing of its first rate hike. Even so, many uncertainties remain regarding the pace of tightening. Recently, markets have swung violently, buffeted by more aggressive pricing-in of tightening expectations, followed by central-bank pushback against those same expectations.
Our view is that much of the inflation we are experiencing today is “baked into the system” — i.e., caused by past fiscal stimulus and current supply chain challenges that central banks are powerless to resolve. Therefore, central-bank efforts to fight inflation with aggressive rate hikes might not only be detrimental to growth, but also ineffectual in taming inflation quickly. Fortunately, central banks know this and will seek to regain control of market and investor expectations. With a bit of luck, the task of central banks should become easier in coming months, allowing for a policy of steady but gradual normalization over 2022 to 2023.
Tactical Portfolio Positioning
Against this macroeconomic backdrop, State Street’s latest monthly tactical portfolio positioning, summarized in Figure 1, remains supportive of risk assets — although we are conscious of near-term risks to the outlook.
Highlights from, and recent changes to, our tactical portfolio positioning include:
We continue to build a position in European equities, which score well across most of the factors we monitor. Valuation, price momentum, and quality are favorable, and sales and earnings estimates have been significantly upgraded.
US equities look reasonable, as buoyant macro factors offset negative valuations. Price momentum, particularly longer-term measures, aid the outlook, but sentiment has moderated and is now neutral. We are overweight both US small caps and US large caps.
Slowing China growth and expectations for further weakening helped to drive the deterioration in our EM outlook. Appreciation of the US dollar is negative for EM, as are low sentiment scores for cyclical sectors.
Within fixed income, we have increased our allocation to high yield bonds, which allows us to improve our expected return while picking up additional yield.
From a sector perspective, we have maintained our allocations to technology and financials, and a partial allocation to energy. We rotated out of consumer staples and initiated a partial allocation in materials.
The recovery will continue to deliver above-potential global growth, but recovery will also be uneven.
The eurozone has a chance to narrow — or even close — the growth gap with the United States.
The lowest-hanging fruit from the re-opening trade has already been harvested; future gains will be more modest.
High growth and high inflation will extend into 2022; however, we think inflation will steadily decline from Q2 2022 onward.
Conditions for structurally higher inflation could be set by highly accommodative macro policy, rising production costs, new costs associated with the switch to green energy, and renewed global focus on equitable growth and income redistribution.
Central-bank efforts may prove ineffectual and could also hurt growth prospects — but central banks are aware of this possibility and will seek to regain control of market and investor expectations.
We remain overweight to risk assets in our tactical portfolio and have continued to build our position in European equities, which are attractively valued and score well on most of the attributes we monitor.
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