January has seen strong gyrations in markets, with nominal and real yields rising sharply, driving a strong shift from growth to value in equities. The reassessment of the inflation premium in the wake of demanding valuations has driven a strong repricing of risk premia. Going forward, we are likely to see continuation of this more uncertain and volatile environment as the market assesses four themes:
- evolution of the Omicron variant, which could impact growth negatively and further exacerbate supply bottlenecks;
- uncertainty over CBs’ reactions to high inflation numbers (US and Europe), in a context of growth slowing somewhat and the psychological dimension of inflation resurfacing, with the possible spiraling of wage/growth inflation;
- geopolitical risk is back, with Kazakhstan and Ukraine in the news and role of Russia and China in the region. Energy and commodity markets are tight, volatile and extremely exposed to political risk. In Europe, the political agenda is getting crowded with Italian and French elections at a time when new fiscal rules unfold and the Next Generation EU plan is implemented;
- ongoing troubles in the Chinese real estate sector. Policies are turning supportive but investors should forget the high GDP growth figures of the past.
Against this backdrop, we see three main themes for investors:
- A confirmation of a cautious risk allocation stance over the short term. This is not a time to add risk, but to stick to the core convictions (defensive on duration, preference for value, protection against inflation). It is too early to consider the recent repricing as an entry point. With a strategic perspective, in a world of low expected returns, it is paramount that investors enhance their diversification, include appropriate allocations to, for example, Asian markets such as China and India and real assets which could benefit from an inflationary environment. Low correlated strategies targeting absolute returns or real returns should be favoured as well, as with rising rates and inflation, the traditional bond-equity correlation dynamics tend to fade. Liquid alternative strategies could also help diversify portfolios while cost-efficient solutions will become even more important in a world of low yields. Tactical allocation will also be vital in capturing opportunities. Moving towards H2, we should see a mild slowdown for inflation and improvement in growth momentum (more positive for equities).
- Equity volatility is on the rise and will stay higher as markets reassess the inflation path and central banks’ response. However, decent economic growth and reasonably accommodative financial conditions should be able to prevent a major market crash. Single-digit equity returns in 2022 is our base case. Regionally, we prefer Europe/Japan and selective EM, such as India and China where valuations are more appealing. The US market could end the year almost flat, but with great divides that will provide relative value opportunities. Structurally high inflation is not yet priced in and the market is pricing the cost of capital remaining low for a long time. A modest repricing of inflation risk – and rates – could have a big impact on equities in terms of performance and composition (S&500 is broadly a growth market). The great rotation inside the indices and among value/growth markets is going to be the main theme for equity investors this year. Therefore, investors should favour value over growth in the US market and even more so at the global level. Higher inflation and higher rates will take a bite out of equity earnings and will be barely sustainable for expensive growth names. Value will be favoured vs technology growth. We are also more cautious on the large-sized overvalued names and prefer companies with high pricing power.
- In bonds, flexibility and a short duration bias are recommended. Traditional bond benchmarks face the challenges of high duration risk and low yields. If rates rise, these indices will experience losses. Investors should therefore favour flexible approaches in FI to exploit opportunities from the asynchrony among CBs and FX dynamics. Bonds are not dead, but relative value will be the name of the game. Opportunities across curves and geographies and in higher-yielding assets such as EM bonds will be crucial to extracting additional value in a negative real yield environment. Investors could benefit from dislocations by adding exposure to fixed income once some of the repricing in yields is behind us. In credit there are still opportunities, for example, in HY, but here investors should avoid over-indebted names that could suffer from lower liquidity.
After decades on the backburner, the great inflation comeback will mean investors need to shift their mindsets from nominal to real returns. Playing ongoing market gyrations will be paramount for generating returns and real yields will be the key driver of these.