February 08, 2022
2022 Global Multi-Asset Team Outlook: A Review of the Key Macroeconomic Issues and Investment Themes in 2022
February 08, 2022
2022 Global Multi-Asset Team Outlook: A Review of the Key Macroeconomic Issues and Investment Themes in 2022
February 08, 2022
Key 2022 Macroeconomic Issues
COVID-19 Transition From Pandemic to Endemic
Our base case is that COVID-19 will transition from pandemic to endemic in 2022, with 2023 likely the first full normal year since 2019.
Two years after the first cases of COVID-19, the world still faces tsunamis of new infections with no apparent end in sight. And while COVID-19 continues to have an outsized impact on financial assets—for example, bond market performance in the past nine months has been better explained by infection numbers than inflation, growth, or the Fed—countries, populations and governments are reacting more moderately to new waves of infections, with targeted measures such as vaccination campaigns and mandates, with masking and selective quarantines thus reducing the economic impacts of each successive wave. Indeed, current data suggests Omicron is twice as infectious as Delta, though its deadliness is lower. And though 2022 may see a few more waves, each could be of lessening severity given the improvement in the availability of medical tools in the developed world such as triple-dose vaccines, antiviral therapeutics and treatment, as well as the protection afforded by prior natural infection. Of course, the uncertainty around this base case remains enormous and, as such, well reflected in the prices of direct plays on an end to COVID, Working from Home and on full re-opening of the global economy.
From Overheating to Stagflation
While we still expect above-trend growth for most of 2022, by the end of 2022, the economy will likely slow to or below trend.
We believe the economy entered the Overheating phase of the economic cycle in mid-2021. The GMA Team defines Overheating as above-trend growth, a closed output gap and rising inflation. The global economy grew at 5.8% in 2021,1 more than double its trend growth rate, and the output gap is now nearly closed with labor markets in many countries within the range of NAIRU (Non-Accelerating Inflation Rate of Unemployment). Inflation is now above central bank targets virtually everywhere. We expect Overheating to persist before the Stagflationary phase takes over in the second half. We define Stagflation as an environment where growth has decelerated to or below potential, but where inflation is above target and rising. For the U.S., sub-2% growth and 2.5%-3.0% inflation—which we expect by year-end 2022 - qualifies as Stagflation.
Why the shift from Overheating in the first half to Stagflation by year-end 2022? In the first half of the year, contributors to growth will win the tug-of-war against detractors, but by the end of the year detractors will gain the upper hand. The main boosts to economic growth include: continued re-opening; the public to private sector hand-off as fiscal stimulus fades; still-easy monetary policy, with negative real rates everywhere in the developed world; easing supply shortages; and consumption, as approximately 15% of the $2.5 trillion of U.S. household excess savings will be spent in 2022 (with similarly large magnitudes across the world).2 Offsetting these growth boosts the following are likely to detract from growth in the latter part of 2022: The U.S. fiscal cliff, which could detract -250 basis points from U.S. GDP; the latest COVID variant, Omicron, which will hit growth in the first quarter and may delay the eventual economic normalization we expect over 2022 and into 2023; and the end of free money which will likely slow economic activity with a lag.
Inflation: Partially Transitory, Partially Structural
After taking two steps forward in 2021, inflation will take a step back in 2022 as the prices of core goods normalize. However structural forces have likely ended the disinflation cycle of the past forty years as the world enters a more inflationary regime akin to the late 1960s (but not like the 1970s).
Core inflation has accelerated to 5%. But a very high proportion of current inflation is supply-shortage driven and thus likely to be temporary. For example, over half the acceleration in core inflation has been driven by car prices. On the other hand, inflation has broadened: median inflation, the best measure of the breadth of inflation, now points to an underlying trend in core CPI of 3.0% (from a low of 1.5% just a year ago).
Many structural trends support a regime shift to higher inflation. Unlike in the prior cycle where printed money accumulated as commercial banks’ excess reserves at the Fed, in this cycle, the money printed was spent. In addition, improved bargaining power for workers, as well as changes in attitudes and demands of workers, point to higher inflation. There is also building evidence of “greenflation,” with decarbonization (net-zero emissions by 2050) adding as much 80-100 basis points to developed markets’ consumer price inflation in each the next ten years by some estimates. Importantly, unlike in the decade following the Global Financial Crisis (GFC), no deleveraging in the banking, household and corporate sectors is occurring, removing a significant source of deflation.
The End of Free Money
Over the past two years, the Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England collectively printed over US$11 trillion (about 26% of their GDP), more than double the amount which was printed after the GFC in half of the time.3 At the same time, these four central banks cut rates to (or below) zero. Money became literally free and enormous quantities of it were (and still are) floating around. Governments availed themselves of this free money and spent more in 2020-21 than at any time since World War II.4 The combination has been explosive for economies and markets, particularly because the Fed can print money, but cannot control where it goes. All this is now reversing. Most central banks are already tapering their bond purchases or are about to. A few have started raising rates – most recently the Bank of England. For its part, the Fed has started tapering quantitative easing (QE) purchases, expects to raise rates three times in 2022, and is even starting to discuss QT (quantitative tightening, i.e. shrinking its enormous nearly $9 trillion balance sheet). Free money has been an elixir for markets. What happens when money is no longer free?
The End of China’s Exceptionalism
China has grown at an extraordinary pace of 9% for four decades.5 In fact, many predicted China would overtake the U.S. as the largest economy in the world by 2020. Though China has had an outsized impact on the global economy, driving approximately 28% of global growth in the past decade, its economy is still 23% smaller than that of the U.S. and its growth is likely to severely downshift to 4% or less for the following three reasons: 1) China has “gotten old before getting rich,” with its working age population estimated to have peaked in 2010, and its total population likely starting to shrink outright in 2023;6 2) China has already built out its infrastructure and housing and thus cannot keep investing at the same pace. Further capital deepening will become debt-funded malinvestment, as the property sector’s recent troubles show; and 3) President Xi Jinping, in consolidating power around himself, is in the process strangling the golden goose responsible for the Chinese growth miracle of the past forty years.
Key 2022 Investment Themes
Speculative Mania Bursts
In the ten years before COVID-19 hit, U.S. and global stocks rose in one of the biggest and longest bull markets of the past century.7 But interestingly stocks did not show signs of generalized frothiness usually associated with long bull markets. Then in the eighteen months following the COVID-19 low in March 2020, from a near standstill, most market participants caught the bit in their teeth and pushed almost every measure of speculative enthusiasm to record levels: IPO funds raised went from $32 billion annually from 2009 to 2019 to a record $262 billion in 2021 (nearly four times the 2000 record of $65bn).8 M&A activity went from $1.25 trillion annually in the last decade to $2.75 trillion in 2021.9 Inflows into equity mutual funds and ETFs reached $1 trillion in 2021, more than the past twenty years combined and significantly exceeding 2000’s $312 billion.10 Margin debt has doubled from the average of the past five years to reach more than 2% of GDP, much higher than the 2000’s when it was 1.4% of GDP.11 The meme stock craze of early 2020 has ebbed with many stocks down -50% from their peaks, but their market caps are still 10 to 20 times higher than pre-COVID-19 levels in 2019 despite revenues down 20 to 50% and no profits.12
History shows that these speculative manias tend not to last much more than eighteen months, and are followed by market corrections greater than -40%, unwinding almost all of the bubble’s gains. Highly speculative and expensive assets are most at risk: the crypto ecosystem, retail/ meme stocks, no-profits stocks, hypergrowth high-multiple stocks and probably growth stocks in general.
There are already indications that some of the bubbliest areas in the market have burst, though the overall market continues to make new highs, powered by an increasingly small number of mega-cap stocks. Possible catalysts for a more generalized market correction include The End of Free Money, the fiscal cliff and Stagflation. Or it may just be that stock market optimism and expectations are so high that they are very unlikely to ever be met.
The Value Bull Market Is Only Getting Started
Value stocks in the U.S. and globally have entered a structural bull market, in which they could outperform growth stocks by as much as 100% over the next five to seven years.
If one properly defines Value (the way the Global Multi-Asset team believes it does: by removing sector/industry bias, equal weighting each stock, and focusing on the cheapest quintile of stocks), Value has outperformed Anti-Value (i.e. the most expensive quintile of stocks) by +26% since April 2020. We believe this marks the beginning of an uptrend, which is mirrored by our global measures of Value: Value outside the U.S. has outperformed Anti-Value by +28% since its low in 2020.13
Nonetheless, Value remains nearly the cheapest it has ever been. Today, U.S. Value stocks trade at 11x forward earnings, with Anti-Value stocks at 37x. This is well below the average historical relative discount of Value stocks to Anti-Value. If relative multiples returned to historical averages the result would be a 69% re-rating for Value stocks. The likely catalyst for this normalization would be higher inflation and the end of quantitative easing and zero interest rates, which would be favorable for Value stocks’ fundamentals as well as their valuations relative to longer-duration Anti-Value stocks.
The Rise of the Rest (of the World)
For the past ten years, the U.S. stock market benefited from the best of all worlds compared to its foreign peers and, as a result, has spectacularly outperformed. U.S. stocks rallied +428% cumulatively since 2010 with non-U.S. stocks up only +96% in USD terms, a +332% outperformance.14 Non-U.S. developed equities are now trading at a record -30% discount to U.S. equities, and emerging markets ex-China equities are trading at a -43% discount (approaching the Asian Crisis low of 47%), on relative forward P/E.15 Many factors supported U.S. outperformance, most of which are likely in the process of reversing.
Back in 2010, U.S. equities stood near 15-year lows relative to the Rest of the World on price-to-book valuations.16 In addition, the U.S. dollar was the cheapest it had been since the early 1970s. During the 2010s, U.S. economic growth was double that of emerging markets ex-China (in real US$ terms) and 50% faster than that of other developed economies (in real terms). Partially as a result, U.S. listed company profits were up +376%, massively outpacing Rest of the World profits of +123% (in U.S. dollar terms).17 Non-U.S. regions were buffeted by economic and political crises such as the eurozone peripheral crisis, the Fragile Five18 emerging economies in 2013, the Oil Collapse of 2014, the China Devaluation in 2015, and Brexit in 2016, as well as various political crises in Brazil and other emerging markets, while the U.S. remained relatively stable. U.S. companies benefited from a corporate tax cut as well as its sector mix. U.S. tech and internet stocks made up of 19% of U.S. benchmarks in 2010 and ended at 40% in 2021.19 Meanwhile, in the rest of the world, tech and internet stocks were just 7% of market cap (in 2010 and now). This benefited U.S. stocks as tech and internet outperformed the rest of the U.S. market by +448%.20
Looking forward, most of the above factors are no longer as favorable: U.S. equities have the highest relative valuations in history vs. the Rest of the World and the U.S. dollar is expensive (though not extreme). From their current record-high levels, U.S. corporate margins are more likely to suffer downside pressure from labor costs, taxes, regulation and the possible re-shoring of supply chains. Lastly, a high tech and internet index weighting was very helpful in one of the biggest Growth bull markets in history, but these sectors are likely to suffer from the end of the pandemic boost to digital and virtual activities, high valuations and excessive profits expectations, greater regulation and anti-trust enforcement, and the incipient signs of potential excessive capital investment. Economic prospects still may favor the U.S. over the rest of developed markets but even there, the U.S. is starting to face many of the same problems as its peers (e.g. increasing size of government, expansion of the welfare safety net, slower population growth etc.).
Commodities Still Beat Stocks and Bonds
Commodities had a very strong year in 2021—as is typical during the Overheating phase of the cycle—rallying 33%.21 As mentioned, we expect to remain in the Overheating phase for a few more quarters before transitioning to Stagflation. Historically commodities have been the best performing asset class during Stagflation.
While commodities’ financialization in the past two decades mean they are more sensitive to a risk-off environment even if fundamentals remain strong, and China (where growth is slowing) has become a bigger source of demand for most commodities than the U.S. except for oil, two structural factors should keep commodities well-supported. First, severe underinvestment in oil & gas, as well as in most other industrial metals and bulks. Oil investment globally peaked at $779 billion in 2014 and in 2020 fell as low as $328 billion, and global mining capex peaked at roughly $160 billion annually in 2012-2013 and has averaged roughly $80 billion annually from 2016-2020.22 Second, decarbonization might require enormous quantities of some commodities which current production (and future production at current investment levels) would be incapable of meeting, thus causing “greenflation” (inflation in commodities required for the electrification and greening of the global economy).
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In addition to the Portfolio's fees and expenses, the Portfolio generally would bear its share of the investment company's fees and expenses. Subsidiary and tax risk the Portfolio may seek to gain exposure to the commodity markets through investments in the Subsidiary or commodity index-linked structured notes. The Subsidiary is not registered under the 1940 Act and is not subject to all the investor protections of the 1940 Act. Historically, the Internal Revenue Service ("IRS") has issued private letter rulings in which the IRS speciﬁcally concluded that income and gains from investments in commodity index-linked structured notes or a wholly-owned foreign subsidiary that invests in commodity-linked instruments are "qualifying income" for purposes of compliance with Subchapter M of the Internal Revenue Code of 1986, as amended (the "Code"). The Portfolio has not received such a private letter ruling, and is not able to rely on private letter rulings issued to other taxpayers. If the Portfolio failed to qualify as a regulated investment company, it would be subject to federal and state income tax on all of its taxable income at regular corporate tax rates with no deduction for any distributions paid to shareholders, which would signiﬁcantly adversely affect the returns to, and could cause substantial losses for, Portfolio shareholders. Cryptocurrency (notably, Bitcoin) operates as a decentralized, peer-to-peer financial exchange and value storage that is used like money. It is not backed by any government. Federal, state or foreign governments may restrict the use and exchange of cryptocurrency. Cryptocurrency may experience very high volatility. LIBOR Discontinuance or Unavailability Risk. The regulatory authority that oversees financial services firms and financial markets in the U.K. has announced that, after the end of 2021, it would no longer persuade or compel contributing banks to make rate submissions for purposes of determining the LIBOR rate. As a result, it is possible that commencing in 2022 , LIBOR may no longer be available or no longer deemed an appropriate reference rate upon which to determine the interest rate on or impacting certain derivatives and other instruments or investments comprising some of the Fund’s portfolio.