Base case and key risks to our base case scenario

We acknowledge the global pandemic is far from over; however, we think the economy has already seen the worst of it. While there is the threat of Omicron and other potential COVID-19 variants, we do not expect another complete, global shutdown in economic activity. What we do anticipate is regional waves and less severe restrictions on the back of new variants, but the acceleration in vaccines and booster jabs being administered should limit this. As such, economic activity should further normalise in 2022. Global growth should remain above the long-term average but decelerate through the year, as the world normalises and fiscal stimulus is gradually removed.

Our view on inflation is that it will remain elevated for the same reasons as it did in 2021, but that it should peak around the middle of 2022. In this context, we note that the Federal Reserve Bank (the Fed) have just turned more hawkish, which is likely to lead to several interest rate hikes over the next couple of years. Around the middle of 2022, the initial base effects will fade and most supply chain disruptions will start to be resolved. Additionally, the increase in global vaccination levels and the return of labour to the workforce should reduce the pressure on inflation. While we expect a decrease in inflation, we don’t anticipate heading back to pre-pandemic levels, largely because of a tight labour market, exacerbated by demographic trends.

Central banks have a big role to play in 2022. The Federal Reserve Bank (Fed) has already moved its tapering timeline forward from the middle of the year to March 2022. However, we expect the Fed to remain stubbornly accommodative on rates for the first half of the year but follow through with at least two rate hikes (and possibly three) by the end of 2022. We expect the European Central Bank (ECB) to lag, focusing only on tapering in 2022, with no rate hikes until 2023 at the earliest. In the UK, however, where inflation is stickier than in the rest of Europe, we expect two further hikes over 2022, following the Bank of England’s (BoE) recent hike from 0.1% to 0.25% on the 16th of December. As the market takes in the transition to slower global growth alongside a patient approach to monetary policy tightening, we expect volatility to modestly increase over 2022.

Risk #1: Persistent inflation

Central banks do not hike interest rates quickly enough, and inflation continues to rise. In this scenario, central banks would probably lose all credibility and be forced to take much firmer action later in 2022 and into 2023.  This would most likely bring an end to the current economic cycle – a so-called hard landing.

Risk #2: Omicron and other variants

Just as the global economy looked like it was on its way to recover from the global pandemic, a spanner was thrown into the works. Omicron, the new coronavirus variant, has concerned both markets and governments alike, with restrictions being reintroduced all over the world. This, just like the Delta variant in 2021, has the potential to prolong the recovery. Worse yet, more dangerous variants that can evade our vaccines could emerge over 2022 and put us all back to square one.

Equities – getting back to normal

Our outlook for equities over 2022 is generally positive. It is unlikely that equity markets will enjoy the above-normal returns that we have been accustomed to over the past two years, but we believe 2022 will be a year of normalisation, and global equity returns should be broadly in line with long-term historical averages. This will be driven by strong earnings expectations, on the back of above-trend growth, as well as strong household balance sheets. We believe that in 2022, the US will not be the key driver of returns but instead lagging other major regional equity markets.

The key risks to these expectations are rising input costs (commodities and wages), supply chain disruptions, a China slowdown, inflation risks and the associated policy errors and the winding down of fiscal stimulus. There is also the risk of new virus variants. Finally, there are a number of potential geopolitical issues to be concerned about, including potential wars with China, Russia and Iran.  Neither should you ignore the risks associated with the US midterm elections and presidential elections in France and Brazil.

From a regional perspective, we expect US equity returns to lag other major regions in 2022. This is perhaps an “easy” forecast given the superior returns that US equities have provided over the past four years relative to the rest of the world. However, there are also other reasons to suggest why this may be the case. While it is easy to say that US stocks look expensive on an absolute basis, this is unlikely to undermine equity market returns. These high multiples should be supported by yields at historical lows and the fact that bonds will remain on banks’ balance sheets.

On a relative basis, European equities look far cheaper than US equities, and this is across most sectors as opposed to just the FAANGs. Additionally, ongoing fiscal support and a relatively dovish ECB should continue to support the European economy and its stock market compared to US stocks. UK equities are at record low discounts relative to global equities, and the market’s composition, which is biased towards financials and energy, could prove to be attractive in a rising yield environment. However, a relatively hawkish BoE is likely to restrict the return potential of UK equities in 2022.

China underperformed global markets in 2021 on the back of slower growth, increased regulation for technology companies and the Evergrande saga. However, in 2022, Chinese growth should stabilise and macroeconomic policies should be more supportive of growth. We also believe that we have now passed the worst of the crackdowns in regulations, while further positive policy changes in for example property should be beneficial. All this should increase earnings and result in strong market returns in 2022. This will help to drive the wider Asian markets and EM markets in general.

From a sector perspective, we are more optimistic on those that will be driven by the re-opening of international trade and on those that are less sensitive to rising rates. We believe the value trade has some steam left in 2022. Consumer services, which includes restaurants, hotels and leisure, have lagged the recovery since the start of the pandemic, but we believe increased consumer spending on services in 2022 should support those industries. Industrials and materials should also be supported by the normalisation of global growth (and an increase in global inventories) and supply disruptions abating. Lastly, financials and energy are likely to do well, boosted by expectations of rising interest rates.

Sectors that are likely to underperform include technology/communication services, utilities and healthcare. Our concerns here are founded upon rich valuations as well as potential regulatory issues.

Fixed income – too much risk, too little reward

We have a broadly negative view on fixed income markets, as we believe risks are to the downside. Given where bond yields currently are, the upside potential is limited, certainly not enough to compensate investors for the downside risk. Having said that, we do believe there are pockets of potential opportunities, particularly in loans and emerging markets.

Given the prospects for the unwinding of quantitative easing and policy normalisation, as well as economic growth momentum, we expect government bond yields to rise in 2022. Additionally, we expect shorter-duration bonds to outperform longer-duration bonds on the back of expected rate rises. This is particularly the case for US Treasuries, where inflation seems to be a more pressing concern. Also, in the US, the path to policy normalisation will likely be quicker than in other developed markets. In Europe, there are fewer inflationary pressures, except for rising gas prices. Fiscal stimulus in Europe was also relatively small, resulting in a weaker recovery. This leads us to expect European bond yields to rise but to a lesser extent than in the US.

Inflation-linked bonds almost always do poorly in rate-hiking cycles but, as we don’t expect any rate hikes in Europe in 2022, we favour European inflation-linked bonds to UK or US inflation-linked bonds. As far as corporate bonds are concerned, the dynamics are precisely the opposite, i.e. those bonds tend to outperform straight bonds and equities in hiking cycles.  Therefore, an investment in corporate bonds should be restricted to the US market.

If the landing is indeed soft, we expect investment grade as well as high yield bonds to perform well; however, should the landing be harder, those bonds are likely to perform relatively poorly. Policy normalisation will play a big role in this context. In fact, we expect credit spreads to rise and normalise back to long-term historical averages. This means that shorter duration positioning will likely be more beneficial to returns. That being said, the carry available on high yield bonds is still modestly attractive, just less so relative to equity markets.

Loans, on the other hand is an asset class that looks relatively attractive given their floating rate nature (which will be beneficial in a rising-rate environment), lower expected default rates and associated recovery rates. Additionally, this is an asset class where we expect favourable rating actions. In fact, the ratio of upgrades to downgrades is at multiyear highs. This is because of accommodative lending conditions, the reopening of economies and a favourable sector composition, i.e. less energy companies than in the high yield market. Moreover, there is additional technical support from the Collateral Loan Obligation (CLO) market, where issuance is at record levels.  

EM debt is another asset class we are broadly positive on for 2022, though this is for local currency debt only. Over 2022, we expect most EM nations to have completed their hiking cycles, with real rates higher than in DM countries. At this point, they will be looking closer to the next rate cutting cycle while developed markets are only beginning to raise rates. On the back of this, we do not view hard currency debt favourably because higher US rates and high debt levels will result in hard currency spreads to widen. We have a positive outlook for local currency EM debt, in particular, Chinese government bonds. This is on the back of stable/lower rates and an undervalued currency. Meanwhile, despite all the problems with Evergrande, government intervention should prevent the risks of a full-blown credit event in China.

Real estate – live, work, maybe not shop

Broadly speaking, real estate should have a positive year. The steep economic recovery should boost the leasing market, although there will be a much greater focus on the quality of real estate. This should result in a flight to quality, which will be supportive of core property assets, with strong quality tenants. There will also be a real effort from lessors to supply properties in line with tenants’ post-pandemic needs, largely in the form of technology and ESG requirements.

The trend of online shopping, which accelerated through the pandemic, should continue and result in brick & mortar retailers to continue to underperform. However, we believe the damage will largely be constrained to high street retailing. We believe retail warehouses (large, single-level stores for home improvement, gardening, furniture, electrical goods or general DIY) should not suffer the same fate. We have not yet seen, nor do we expect to see, a significant shift to online purchases for those goods. Moreover, we believe that retail parks still have a role in society for leisure purposes, i.e. restaurants, bowling alleys etc., as consumer spending on services is expected to surge in 2022.

For the same reasons that high street retailers are struggling, the industrials and logistic sectors are outperforming. The sector is experiencing high demand on the back of the boom in e-commerce and fragmented supply chains. Additionally, limited supply in prime locations is adding to price pressures on property values and rents.

The greatest uncertainty comes in the office sector. Our base case is that there is an ongoing and permanent shift to hybrid working. Offices still have a major role to play for the social culture, training and team building and, as such, offices will remain an important part of the property market. However, it is difficult to quantify precisely what the net impact of the new, hybrid model will be. Having said that, we anticipate that demand will be the greatest for modern buildings in prime locations, i.e. in major cities with good transport links.

Within property in general, we have the highest conviction on the residential sector. This is largely because of a significant global supply and demand imbalance in housing. There are simply not enough homes being built to meet demand. Moreover, the affordability of housing has been falling to the point where many people will take longer to buy outright, lengthening the time they are having to rent. For that reason, there are attractive pockets in social and affordable housing, in shared ownership and in private rented sectors.

Commodities – a year of two halves

2021 has been a positive year for the commodities market. The recovery at the beginning of 2021 and the associated overwhelming demand drove down inventories, pushing prices upwards. The potential power crunch as the year went on further supported commodity prices. Overall, we expect this to continue into the first half of 2022 as the recovery continues. However, in the second half of the year, as growth subsides, demand for oil and wider commodities will drop while supply disruptions will be resolved. This will push prices down. At this stage, we anticipate green metals, i.e. copper, nickel, aluminium and lithium, to perform strongly on the back of the energy transition.  That said, we should add that industrial commodities rarely do very well in hiking cycles.

Oil: Prices will remain elevated for the first half of 2022 with demand being generally supportive as the recovery continues. Later in the year, as growth subsides and supply constraints are less of a concern, prices are likely to come back down to more sustainable levels.

Copper: We expect prices to be relatively flat in the early parts of 2022, largely due to the China slowdown. However as Chinese demand picks up and we see a ramp-up in green initiatives, copper prices should rise and remain elevated throughout the rest of 2022.

Gold: Gold has underperformed in 2021, and we expect this to continue in 2022 on the back of rising economic momentum and tighter monetary policies, which should also result in the US dollar appreciating.

Agricultural commodities: Generally speaking, agricultural commodities such as coffee, cocoa, sugar, wheat, etc. should remain supported by rising living standards in the EM world and growing demand, caused by the economic reopening. Furthermore, there have been supply shortages across a number of these commodity markets, which has resulted in a drawdown of global inventories. This should provide further support for prices over 2022.

Private markets – the party’s stalling, but there are still pockets to exploit

Private equity: The market was driven by greater consolidation on the back of weakness from the pandemic and a buoyant exit market on the back of the steep recovery in public equity markets. We expect these themes to continue into 2022. M&A activity will be ripe, as companies look to grow post-pandemic. Also, exit avenues in the form of strategic buyers, IPOs and late-stage private equity mega-funds should provide support for high multiples. While we expect returns to be high, they are likely to be lower than long-term averages. This is because of the challenges of high entry multiples and record levels of dry powder, which are likely to persist. The key for private equity investing is to exploit long-term structural trends. This includes technology, healthcare and the transition to a greener economy. Additionally, given we expect volatility to modestly increase in 2022, we believe there will be an opportunity to exploit market dislocations in the form of stressed and distressed investments as well as secondaries.

Private debt: Private debt offers a meaningful illiquidity premium when compared to publicly traded high yield debt. At the same time, private debt provides better protection in the form of higher recovery rates and tighter covenants, particularly in the senior tranches. With public debt yields at historical lows, record levels of dry powder in private debt had been adding pressure on yields and the illiquidity premium. However, this has been offset by rising demand for financing, which kept the illiquidity premium intact. The premium is expected to remain as the post-pandemic recovery continues. Companies will search for capital for their M&A activity, particularly in the European middle-market space, we believe. Moreover, there will be further needs for short-term, alternative (gap, bridge or rescue) financing. There will also be a massive financing need for infrastructure debt to service the energy and digital transitions. Simultaneously, banks are continuing to reduce risk as per regulations, meaning that demand for non-bank financing will remain elevated, keeping the illiquidity premium favourable.

Infrastructure: This will be the key to the energy transition. Governments are clearly relying on investments into infrastructure to stimulate growth while delivering on their climate change policies. From an investment perspective, there has been, and is expected to continue to be, substantial crowding in this market. The returns that could be expected from the likes of solar and wind energy or other forms of renewable energy five years ago, are not what we can expect today. To generate those returns in today’s environment, construction and development risk must be taken; otherwise returns will be far below past levels. That said, you can expect higher returns in new infrastructure sectors, mainly to do with the digital transition. This includes data centres, 5G towers, fibre, energy transport and storage as well as new and upcoming areas like vertical farming or bladeless turbines.