Monthly View December 2021

by
Leo Wealth

A Christmas Rally?

Despite the risks posed by the Omicron variant, global growth should remain solid in 2022. Inflation is likely to cool off early next year as goods prices come off the boil. However, the longer-term trend for inflation is to the upside, especially in the US. Continued economic growth will support fundamental business growth, which makes us still positive on risk assets. 
 
We remain positive on global equities, although we could see sector rotation from mega cap growth stocks to more cyclical stocks. We also think non-US equities could perform well. We think the risk of a severe economic growth slowdown (recession) in 2022 is low and we also think inflation will not be a problem next year. One or both of these are more likely to become a problem in the years ahead.

Omicron

Just as the world was looking forward to “life as normal,” a new variant of the virus has surfaced. While still little is known about the Omicron variant, preliminary indications suggest that it is more transmissible than Delta but the symptoms seem to be milder. This would fit in the natural development of viruses. As viruses mutate, they tend to become milder. 
 
The natural evolution of pandemics is that as a virus mutates, it becomes more contagious, but less deadly because the virus is primordially programmed to survive rather than kill its host. Therefore, we think it is unlikely that this new variant will lead to renewed widespread economic shutdowns around the world, as occurred in the first half of 2020. No government has an appetite for that kind of policy.

Global Growth Surprising to the Upside 

Assuming the vaccines and antiviral drugs can keep the new strain at bay, global growth should remain solidly above trend in 2022. Consensus GDP growth projections for G7 countries predict growth to tick up to 4.5% in Q4 of 2021. Next year growth is set to cool to 4.1% in Q1 and gradually decrease to 2.3% by the end of the year. Thus, while growth in developed economies will slow next year, it is unlikely to return to the long-term average of 1.7% until 2023.
 
Emerging markets face a more daunting outlook. The Chinese property market is weakening, and the recent collapse of the Turkish lira highlights the structural problems that some emerging markets face. Nevertheless, the combination of higher commodity prices, probably more Chinese stimulus, and potentially a weaker US dollar next year should support EM growth. Relative to consensus, we think the risks to growth in both developed and emerging markets are tilted to the upside in 2022. This would be positive for equity markets.

The Long-Term Inflation Outlook

We expect inflation in the U.S. to follow a “two steps up, one step down” path. The US is currently near the top of those two steps. Inflation should dip over the next 6-to-9 months as the demand for goods moderates and supply-chain disruptions abate.
 
For example, container shipping costs have started to come down. The number of ships anchored off the ports of Los Angeles and Long Beach is falling. US semiconductor firms are working overtime. Chip production in Japan and Korea is rising swiftly. DRAM chip prices have already started to decline. Reflecting the easing of supply-chain bottlenecks, both the “prices paid” and “supplier delivery” components of the manufacturing ISM declined in November. As headline inflation numbers are 12-months backward looking, we will see some components of the inflation data come down early next year. For example, energy prices rose sharply in early 2021. That means that energy price inflation is currently very high compared to late 2020 but early next year the year-on-year rise will be a lot less. And this is true for several components of the Consumer Price Inflation Index (CPI). These are some of the key reasons that make us believe inflation will cool down in 2022.
 
The respite from inflation will not last long, however. The US labor market is heating up. So far, most of the wage growth has been at the bottom end of the income distribution. Wage growth will broaden out over the course of 2022, pushing up price inflation in 2023.

Fed Policy is Key

Under mounting political pressure to “do something” about rising inflation, Fed Chair Jay Powell has capitulated to the hawkish thesis. By abandoning the Fed’s prior characterization of inflation as “transitory,” the FOMC will likely speed up balance sheet tapering either this week or in early 2022, paving the way to potentially begin raising rates much earlier than the market had anticipated just two or three months ago.

Monetary policy transitions will likely take place in the US and China, the world’s two largest economies. Interestingly, the transitions could unfold in opposite directions. To put it plainly, the Federal Reserve will likely accelerate balance-sheet tapering, and likely raise interest rates in 2022. On the other hand, the People’s Bank of China (PBoC) is ending its monetary austerity and will continue to ease policy next year. 

China: Economic Crosswinds

The Chinese economy faces a different kind of crosswinds going into 2022. On the one hand, the energy crisis should abate, helping to boost growth. China has reopened 170 coal mines and will probably begin re-importing Australian coal. This will help manufacturers to catch up on production. The US may also soon trim tariffs on Chinese goods. This will also help Chinese manufacturers.
 
On the other hand, the property market remains under stress. The proportion of households planning to buy a home has plummeted. Loan growth to real estate developers has fallen to the lowest level on record. 
 
The authorities have taken steps to stabilize the property market. They have relaxed restrictions on mortgage lending and land sales, cut mortgage rates in some cities, and have allowed some developers to issue asset-backed securities to repay outstanding debt.

Most Chinese property is bought “off-plan.” The government does not want angry buyers to be deprived of their property. Thus, the existing stock of planned projects will be built.
 
However, the longer-term outlook for the Chinese property market is not positive. Especially as prices are already very high relative to income. Paradoxically, this could be good news for the equity market. For the past two decades property was the key investment choice for Chinese households while equity ownership is still relatively low. This could change as investing in property becomes less attractive.

Equity Markets

2022 could turn out to be a year of two distinct phases for stocks. The first phase will be characterized by rising price volatility and periodic shakeouts in the key averages on increasing concerns over Fed policy, weakening growth, and sticky inflation, while at the same time we expect corporate fundamentals to stay strong.
 
This phase could be followed by another major leg up once the Fed turns more dovish again, as inflation will likely cool off and the US economic growth slows, while growth in the rest of the world improves. The current bull market in stocks has been tracking the pattern of the late 1990s closely. If history is any guide, the stock market could become more volatile in 2022. We should remember that from 1996 to 2000, there were seven stock market corrections of 9% or more, while the trend of the market was clearly up. The US equity market has not had a correction of 5% or more over the past 12 months. Market volatility is poised to rise heading into 2022 but we believe the trend will remain up.

Portfolio Strategy

A golden rule of investing is: don’t bet against stocks unless you think that there is a recession around the corner. Recessions and equity bear markets almost always overlap. A sustained decline in stock prices requires a sustained decline in corporate earnings; the latter normally only happens during economic downturns.
 
Admittedly, it is impossible to know for sure if a recession lies around the corner. If the Omicron variant is able to completely evade vaccines, growth will slow considerably over the coming months. Yet, even in that case, the global economy is unlikely to experience a sudden stop of the sort that occurred last March. 
 
Equity corrections can occur outside of recessionary periods. In fact, we experienced a market correction in late November. However, in the past week markets recouped almost all of the recent losses already. And if the Fed does not surprise the market this week, which we don’t expect, we could even hit new market highs before the end of the year. Also known as a Christmas, or Santa, rally.
 
If economic growth remains above trend, earnings will rise. S&P 500 companies on average generated $53.82 per share in profits in Q3. The bottom-up consensus is for these companies to generate an average of $54.01 in quarterly profits next year, implying almost no growth from this year’s level. This is a very low bar to clear. We expect corporate earnings to continue to grow next year, which should support further gains in the equity markets. The average valuation of equity markets is not low but it is also not overly high either. We are still far away from the valuation levels seen in 1999 and 2007.
 
The relative performance of value versus growth stocks has broadly followed the trajectory of the 30-year Treasury yield this year. Rising yields should support value stocks, with banks being the biggest beneficiaries. In contrast, rising yields will weigh on tech stocks.
 
One way to profit from this is to consider our Equity Income portfolios, which focus on combining quality with dividend yield, which could offer a cushion when markets become more volatile. The Global Equity Income portfolio currently yields 5.3% in annual dividends. For investors who prefer a US or UK only focus, the US Equity Income and UK Equity Income portfolios, equivalents of the global one, yield 3.9% and 5.9%, respectively.

Fixed Income Allocation

When bond yields are positively correlated with stock prices, bonds are a hedge against bad economic news. If the economy falls into recession equity prices will drop, the value of your home will go down, you may not get a bonus, or even worse you may lose your job. But at least the value of your bond portfolio will go up!
 
However, there is a catch. Bonds are a hedge against bad economic news only if that news is deflationary in nature. The 2001 and 2008 recessions all saw bond yields drop as the economy headed south. Both recessions were due to deflationary shocks: first the dotcom bust and later the housing bubble bursting.
 
In contrast, bond yields rose in the lead up to the recession in the 1970s and early 80s. Bonds were not a good hedge against falling stock prices back then because it was surging inflation and rising bond yields that caused stocks to fall in the first place.
 
This could mean that bonds will not offer much portfolio protection in the next recession. For next year we believe there is still money to be made in pockets of fixed income, such as in corporate credit and emerging market government bonds.
 
In the coming years, investors will have to consider alternative forms of portfolio protection than just holding bonds. Unfortunately, there is no simple answer to this problem as the nature of the next recession will determine what could be the right investment. However, portfolio diversification will likely become more important in the coming years.

Lastly, the whole team at Leo Wealth wishes you and your family Happy Holidays and a good start to the New Year.

DISCLAIMERS & DEFINITIONS 

This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.

Investments in emerging markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.

Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices do not account for any fees, commissions or other expenses that would be incurred. Returns do not include reinvested dividends.

The Consumer Price Index (CPI) is a measure of inflation compiled by the US Bureau of Labor Studies

The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value weighted index with each stock’s weight in the index proportionate to its market value.

Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.

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