Having said that, fundamentals remain solid and our base case sees above-average GDP growth of circa 4 per cent for 2022, largely driven by private sector gains, a strong consumer with savings to spend, and a solid environment for business investment. Companies flush with profits have every incentive to invest to meet demand and improve automation. Seeing through to 2022, earnings are expected to grow by an additional circa 9 per cent. This growth rate is in line with consensus forecasts for the market. According to Goldman Sachs data, for example, the US market has historically returned 8-9 per cent in environments of positive economic growth, even when interest rates were gently rising.
But there is a risk that inflation has the potential to dampen this growth and be less transitory than expected. Inflation can also cause corporate margins to deteriorate if companies cannot pass on these price increases. To combat inflation, the Fed and other central banks may be forced to taper (remove liquidity) and/or raise rates sooner than expected. Already, key central bankers have hinted at this possibility. History shows that if inflation is eroding future company cash flows that shares will be valued at lower P/E multiples. Indeed, share values tend to contract when inflation is persistently above 4 per cent.
There is also the risk to growth of ongoing COVID infections and mutations; as we write, a new variant of the coronavirus has been identified in South Africa, potentially complicating efforts underway to fully reopen economies.
To protect against these risks, we continue to recommend that portfolios are well diversified. Depending upon client risk and return appetite, exposure to investments such as dynamic bond, and absolute return strategies and real assets such as real estate and gold, are less market-sensitive and thus provide alternative sources of return. Within equities, we favour active management as it allows us to remain overweighted to quality companies, with high margins and cash-generative business models. These companies are most able to protect their pricing power and therefore offer a hedge against rising inflation. Typically, they continue to embrace trends in innovation and invest to maintain their competitive moat.
We also continue to remain positive on the outlook for private markets. We believe that powerful forces are at work in terms of innovation, automation, digitalisation and sustainable ‘green’ strategies, and that many of these opportunities are best accessed in private markets. Companies are staying private for longer, then coming public at valuations (some $10bn and beyond) where large value has already accrued to the private investors. We see opportunities to access this value earlier through private equity managers who also have the capital and skill to underpin growth and scale success. This also allows us to diversify exposure and benefit from these new secular growth trends, as franchise winners of tomorrow are created across a range of global sectors and industries.
In short, exposure to high-quality, capital-light, innovative companies in both public and private markets is the best way to grow wealth, while using portfolio diversification across other less market sensitive asset classes to dampen risk in the face of potentially rising inflation.
In the sections below, we outline:
- Near-term concerns around too much liquidity fuelling overexuberant market
- How recent strong earnings growth has supported valuations
- Solid fundamentals that still underpin a constructive outlook for 2022
- Mega-trends that continue to drive exceptional opportunities
- The risk of inflation that might lead to an earlier tightening cycle
We then offer our view of risk and opportunities in our market outlook ahead.
Near-term concerns around too much liquidity fuelling overexuberant markets
As we approach year end, there is a sense that investing has become easy, just buy the latest, hot stock and market returns will rise further. So called ‘fear of missing out’ and ample liquidity are fuelling recent market advances in a worrisome way.
To share some record-breaking statistics:
- The MSCI All-World share index has doubled since the crisis nadir in March 2020, making it one of the most powerful runs for global equities in history.
- S&P 500 recently sealed its longest streak of hitting record highs since 1964.
- The market upswing has been supercharged by a boom in retail trading. For example, the overall trading volume of U.S. calls is now back to the three-decade highs seen at the start of 2021, according to Nomura.
- Globally, $865bn of new money has been invested into equity funds this year, according to EPFR, a unit of Informa Financial Intelligence. That is already almost three times the previous full-year record, and more than two decades’ worth of combined inflows.
- 2021 has seen the strongest opening nine months in mergers and acquisition (M&A) since records began. In the US alone, M&A has surged 139 per cent to $2trn.
- Private equity firms have been involved in $1.1trn of acquisitions this year, already more than 40 per cent above the previous annual record set in 2007. Deals have more than doubled to hit a record $839.6bn, and the number of deals was up by 65 per cent.
- Venture Capital (VC) firms in the US produced a record-setting capital raising of $96bn, topping the $85.8bn raised for all funds in 2020. At this rate, the $100bn VC fundraising mark is well within reach for the first time ever.
With this much liquidity, bidding for assets has been fiercely competitive, fuelled by ample capital to invest and cheap financing. The risk of too much money chasing companies at higher multiples means that returns are more dependent on faster growth, and some of this growth can disappoint.
We know that lofty expectations that don’t deliver can see stocks fall quite a long way, and therein lies the risk. Witness, for instance, the price performance of earlier market darlings Oatly or Beyond Meat. After missing expectations and lowering their guidance on future growth, both stocks are down about 40 per cent this year.
How recent strong earnings growth has supported valuations
In our view, companies that can produce consistent double-digit growth at scale will continue to be rewarded. Analysts often under-estimate the power of category winners in software and other innovation businesses to deliver consistent growth, as many of the well-known mega-technology names have done over the past decade.
See article download for additional charts.
While these companies have been consistent outperformers, as economic growth rebounded this year, 2021 has been an exceptional year for broad-based earnings advance.
- In the US, S&P 500 sales were up 17.5 per cent year-on-year versus 12.5 per cent expected by consensus, while EPS were up 39.2 per cent versus 23.7 per cent. All sectors generated higher earnings than consensus expectations. The fact that earnings are growing more than twice as fast as sales explains the margin expansion for Q3 2021 at 12.3 per cent, which marks one of the highest net profit margins reported by the S&P index since FactSet began tracking this metric in 2008.
- In Europe, earnings per share were up 54 per cent year-on-year versus 39 per cent expectations, against sales up 15 per cent versus 11 per cent.
- In Japan, earnings were up 46 per cent versus 35 per cent expected, on sales up 11 per cent versus 6 per cent. The numbers show that the operating leverage is strong in Japan and Europe, despite weaker recoveries.
- Even in emerging markets, earnings were up 30.6 per cent, 2 per cent above expectations, with many commodity producers being standout outperformers.
The Q3 earnings season showed how analysts underestimated the strength of the earnings recovery after an 11 per cent profit decline in 2020.
As a result, and perhaps counterintuitively, the market as measured by the forward 12-month P/E ratio for the S&P 500 is lower today than it was at the beginning of the year, precisely because companies have delivered. And while this P/E ratio is expensive in historical terms, above the five-year average of 18.3x and 10-year average 16.4x, we are also in a lower interest rate environment than in the past. Indeed, the earnings yield on stocks (the inverse of the P/E) and a measure of relative equity value to bonds is 4.8 per cent; as such, equities still look attractive on a relative basis.
With low interest rates, companies are pursuing share-friendly activity. US corporate buybacks are close to $1trn in 2021, up from $472bn in 2020. Recently, large conglomerates are pursuing “shrink to grow” strategies: General Electric, Toshiba, and Johnson & Johnson, for example, which have over $600bn in combined market value, have recently announced plans to split up their businesses.
Simplifying businesses and unlocking value can contribute to better returns in the years ahead.
Solid fundamentals that still underpin a constructive outlook for 2022
While we expect GDP to decelerate from the 6-7 per cent likely gain in 2021, the forecast for GDP growth from a range of strategists is 4 per cent growth for 2022, far above the average of 2.3 per cent in the years following the global financial crisis. We believe that the US economy remains a key source of fuel for a global reacceleration, especially as the COVID-19 pandemic becomes endemic (and supply chain tensions ease).
As seen below, all elements of US GDP are well-supported.
Consumer is alive and well: Recent retail sales numbers at plus 16 per cent year on year validate strong consumption trends. The US consumer is still sitting on $2.3trn of excess savings and has more recently benefited from increased wealth creation. US household wealth rose $5.9trn, or 4 per cent, to a new record-high $141.7trn in Q2, with wealth boosted by sharp increases in the value of real estate and stocks; in total, US household net worth has increased by a staggering $24.8trn, or 21 per cent, since the onset of the pandemic. Labour markets are also strong as evidenced by job openings at 10 million versus seven million unemployed..
Corporate investment is also likely to increase. The structural and cyclical health of the US corporate sector is strong. Companies are running a large surplus cashflow position (of 1.7 per cent of GDP); their levels of cash have grown significantly in the pandemic; and business confidence is at a record high. Companies are likely to start putting their spare cash to work, by rebuilding inventories, creating jobs, and increasing capital expenditures.
Fiscal policy remains expansionary. While fiscal policy is much less accommodative than during the pandemic, and much less reliant on immediate income subsidies, the outlook for multi-year fiscal support aimed at investment in infrastructure remains solid.
Recent data showing the US economy reaccelerating, and leading in the global recovery, supports our view of a healthy GDP advance in Q4. Fourth-quarter economic growth is tracking towards an 8 per cent annualised rate, according to the Atlanta Fed’s purely data-driven real time estimate. That’s a significant acceleration from the 2 per cent for the third quarter. Meanwhile, strong consumer, corporate and government spending trends set the stage for solid economic and earnings growth in 2022.
We also think the worst may be behind China’s recent soft patch in growth due to more stringent controls over COVID, increased regulation, and limits on leverage in the property market. Recent economic numbers have surpassed expectations and we would not be surprised to see further credit stimulus in the months ahead, particularly in advance of the 20th Party Congress in autumn 2022.
Overall, while we think the US will lead the global expansion, there are opportunities for other economies to play catch up in recovery terms as we head into 2022, with more countries learning and electing to live with high infection levels, and given the efficacy of the vaccines (and boosters) and the ongoing improvements in treatments.
That is, as long as this new variant can be contained.
Megatrends that continue to drive exceptional opportunities
A range of innovation changes could support exceptional investment opportunities ahead. The pace at which change is happening is blistering, as new technologies emerge to create wholesale changes in automation, digitalisation and innovation. While recent COP 26 discussions have yet to yield large ‘green’ spending plans, we continue to believe that clean technology and decarbonisation opportunities will grow in scale and importance.
As Bank of America writes in a recent future trends piece:
“There is an explosion of data (we are generating 2.5 quintillion bytes of data every day, which is doubling every two to three years and with faster processing power (>1 trillion-fold increase since Apollo 11), and the rise of Artificial Intelligence and Machine Learning could well bring the fastest rollout of disruptive tech in history.
Carbon capture storage, next-generation batteries and green mining could be the solution to decrease emissions by 70 per cent and enable access to 3x more rare earth metals. Technology is changing the face of life sciences with new technologies bringing faster drug developments and a range of life-extending advances.”
The growth optionality of these opportunities in our view is best accessed in private markets, where we believe that diversification across geography, sector and stage of investment with consistently top-performing private equity managers should allow us to reap the higher returns from this asset class. We also believe that private markets are a hedge against certain public market exposure, as accelerating innovation places incumbents at greater risk of displacement. In 1958 the average company lasted 61 years on the S&P 500; by 2016 it was 24 years and it’s forecast to be just 12 years by 2027.
On the digital asset front, the third quarter saw the launch of the first US bitcoin futures ETF (exchange traded fund), capping an almost decade-long push for a cryptocurrency-linked product to appear on a major Wall Street venue.
We are continuing our research into the potential of digital assets and we have made our first investment in a private markets focused blockchain digital infrastructure fund. This manager believes that we are in the early stages of a multi-decade technology shift that will lead to traditional software being re-architected, leveraging decentralised protocols. He expects the greatest value will accrue to the infrastructure that supports this transition. We agree.
The risk of inflation and earlier tightening of liquidity
Inflation remains a risk. Recent inflation prints have been much higher than expected, with US PPI data, a lead indicator for future inflation, up 8.6 per cent year on year and US CPI at 6.2 per cent in October, the highest inflation print since 1990. Inflation increases are also a global problem. While most economists still expect inflation to fall from current levels next year as supply chain issues diminish and the effect of one-off price increases fade away, above-average inflation is expected to last longer than previously thought, possibly well into the second half of 2022.
Higher inflation can lead central banks to either taper more aggressively or raise rates. Failure to cap runaway inflation can cause increases in interest rates that could also undermine the recovery, cause equity values to decline and compress corporate margins. Unexpected increases in inflation and more aggressive tightening or tapering are a risk to markets that have benefited from high levels of liquidity.
As we think about these risks, we see different types of inflation as outlined below.
Supply side inflation: we think supply side increases in inflation will ease over time. Sectors such as autos, food and lodging, to name a few, have felt the triple whammy of supply side, labour shortages and rising input costs. But companies are responding by raising operating rates, building inventories and integrating supply chain components with increased technology. Base effect comparisons to last year’s inflation rate will look more favourable by the second quarter of next year.
‘Greenflation’: Of greater concern is increases in various commodity costs due to the transition to a green economy. Rising demand for sustainable energy is beginning to drive price increases from raw materials and commodities through to end products.
Electric cars use far more minerals than conventional cars (kg per car), as indicated in the chart below.
See article download for additional charts.
Sticky inflation: Shelter costs are considered to be a more structural component of the CPI and make up about a third of the overall index. Hence recent trends in rising rents will be a concern for central banks. For example, rents for single-family homes rose 10.2 per cent in October, and with vacancy rates near 25 year low, most forecasters expect continued rent increases, particularly in the now more desirable southern eastern and western part of the US.
Wages are also seen as a more structural component of the CPI. Data released recently showed a record 4.4 million Americans quit their jobs in September while job openings remained near a record high at 10.4 million. This has been referred to as ‘The Great Resignation’. But it is not all about money; jobs that align with personal values, offer appropriate work/life balance, and support virtual engagement are in greatest demand. All of this indicates that workers have the upper hand in the current labour market, though it is not clear whether this will result in ever-higher wage gains.
We are keeping a close eye on these risks. For the moment we still side with Oxford Economics who believe the “triple P” of pricing power, productivity and (labour force) participation will limit the risk of a price-wage inflation spiral. Productivity gains in the US this year are already above 4 per cent. We also see a range of longer-term disinflationary forces such as aging demographics and innovation helping to keep runway inflation at bay.
Bond markets around the world seem to agree. While they have been volatile of late, they continue to trade in a narrow range of yields. However, mounting evidence of increases in more structural inflation may force some central banks to taper more aggressively or raise interest rates sooner than expected.
Risk and opportunities in our market outlook ahead
As we end 2021, investors are feeling good as it has been a rather spectacular year for risk assets. We caution that markets feel ebullient and expect an increase in volatility ahead. Record increases in risk assets everywhere leave markets vulnerable to corrective action.
However, seeing through to 2022, we remain constructive. We expect moderating financial market returns in 2022 compared to 2021, though we don’t believe the world economy or equity markets are near a peak or turning point.
We think the US will continue to lead global growth, with 4 per cent increase in GDP in 2022. EPS growth should slow substantially after a likely 45+ per cent leap in 2021. In the coming two years, most strategists expect global EPS gains of 8-9 per cent a year. With dividend payments and slightly higher bond yields, global equity index returns should average close to EPS gains.
A Cornerstone Macro analysis focusing on the S&P 500 is in line with this view:
See article download for additional charts.
We see recent inflation trends as lasting for longer, perhaps into the first half of 2022, but we do not see stagflation or runaway inflation as our base case scenario. Having said that, ongoing supply side issues and inflation challenges could remain a risk to fourth quarter earnings. And we continue to watch the more structural risks to inflation, such as increases in wages and rents, and the unintended consequences of the shift towards a sustainable economy on energy and materials prices.
A combination of the risk of higher future inflation and persistently lower interest rates creates an unfavourable environment for fixed income. We choose to stay short duration and invest with fixed income managers who focus on quality and can dynamically benefit from assets exposed to rising interest rates. We also use absolute return strategies to produce fixed income-like returns from less correlated strategies, which can also benefit from market volatility.
Within risk assets, our quality growth bias has done well in 2021 as the ‘strong get stronger’ theme remains. We favour global companies with above-average profitability and cash-flow metrics as we think they will continue to deliver solid earnings and thus grow into valuations. We also think China will do better in 2022. Global funds are still overwhelmingly underweight on China; managers running active global equity funds reduced their allocations to China to their lowest level in four years last month. We think that while regulatory challenges remain a near-term concern, China and more broadly Asia still represent a further way to gain exposure to long-term growth.
Finally, private markets remain our preferred way to access the powerful digital and emerging green trends and technologies. We use diversification across types of top-performing managers to access the higher returns from this illiquid asset class, commensurate with its longer time horizon to realisation.
In summary, we are feeling good about returns for 2021, but caution that too much market ebullience (and liquidity) create conditions for rising volatility and corrective action at some point.
Peering ahead to 2022, we recommend remaining well diversified and invested. We see ample opportunities for quality companies and risk assets to deliver solid returns to patient investors.
Alvarium is an impartial, global multi-family office offering tailored investment solutions for leading global families and foundation clients. We provide bespoke investment management and a powerful network for co-investment, collaboration and connection.
As well as acting as trusted advisors in the financial markets, we are able to offer proprietary direct co-investment opportunities, outside traditional asset classes, with specialisms in real assets and the innovation economy.
Alvarium has over 220 employees and 28 partners, working across North America, Europe and Asia Pacific. We advise assets in excess of $20bn in value.
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