Jesse Imer
Fixed Income Investment Strategist
Multi-Asset
8 Dec, 2021

Today’s note culminates our aggregate market outlook for 2022, where we summarise our views of the global macro-economy.

In writing this investment thesis, we’re struck by the number of factors multifurcating our views at present, deeply in contrast to both 2018 and 2020.

*** This is why the note is likely our longest for the year, where I’d recommend taking your time to read through this note in its entirety. ***

In that sense, 2018 and 2020 were simpler in that the dominant regimes seemed well known and easier to understand with less uncertainty surrounding them.

In 2018 it was the year of “secular stagnation”, a continuation of the on-going 2010-2020 trend of disinflation, with central banks seeking to unwind the policy measures put in place during the GFC and European Debt Crisis.

2020 was continually a risk-on vs risk-off (RORO) year, cleaving the market into COVID beneficiaries (such as Zoom and Netflix) and COVID losers (such as Sydney Airport and Flight Centre).

This then morphed into a “reopening” trade as RORO unwound, but that again reversed as COVID 2nd and 3rd waves emerged.

2022, however, is set to be a year of opposing forces with key topics to be aware of including:

  • Aggregate supply vs aggregate demand
  • Inflation and inflation expectations
  • Labour market trends & retirement
  • COVID infection and hospitalisation rates
  • Leading economic indicators
  • Climate risk
  • Nominal vs real monetary policy
  • Equity market fragility
  • Fixed income offering less utility
  • The rise of alternatives as an asset class
  • Finding true diversification in factors rather than asset classes
  • Growth/defensive mix

Aggregate Supply (AS) vs Aggregate Demand (AD)

Nearly everything we’re hearing about in terms of inflation; inflation expectations can be boiled down to the interrelation of demand for goods and services and their supply.

Much of the government focus of 2020 and 2021 has been to keep people alive and with sufficient cash assets (liquidity) to survive, allowing for people to quickly resume consumptive household and business behaviours as lockdowns end.

While consumption can resume incredibly quickly due to the internet, supply takes time to come online as it requires people to be available and to return to work.

This can be viewed in the following chart as while AS is higher than pre-pandemic levels, demand is far above these levels, hence the imbalance.

And when AD > AS, ^prices

Source: Bridgewater Associates

Inflation and Inflation Expectations

When AD > AS leads to higher prices, workers on average begin asking for higher wages as compensation for the higher costs of living (fuel, food, transport etc).

Across most nations, “shelter” is a large part of inflation calculations, where construction costs and rents factor strongly on the overall index.

The pandemic has seen increased demand for households in large economies, which usually proceeds a rise in rents by 6-12 months.

Across many nations, particularly the USA, online rents and house prices show that inflation likely has further to go in Q1 2022 because of rising house prices, likely requiring tighter monetary policy or macro-prudential policy measures to reduce the surge in prices.

Source: PriceStats

Labour Market Trends & Retirement

The nature of the current global supply shortage and inflationary pressure goes hand-in-hand with the millions of people less employed today than February 2020.

The reality is that retirees surged in 2020 as highlighted by the blue line likely for numerous reasons.

Some retirees probably saw investment portfolio gains and decided they could retire earlier than planned, others may have retired for health reasons; either way, this divergence represents ~3 million more retirees above the previous trend in the USA alone, a substantial labour market shrinkage.

Source: St Louis Federal Reserve

This above-trend surge in Baby Boomer retirement also exacerbates the tax base who will now need to pay more per person, to support the overall population.

However, we should also be aware that across major developed nations, the Baby Boomer generation is going to be dwarfed by Generation Z, those born between 1999-2020, where the oldest of them are now entering the work force en masse.

While it will take several years for the influx of workers to outweigh the Baby Boomers retiring, and certainly there will be a difference in skill, productivity, education etc, which will also cause supply chains to shift yet again.

Source: US Census Bureau, Knoema

COVID Infection Rates

While the bulk of developed world economies are now majority vaccinated, the on-going concern is the 20-40% of the population that are unvaccinated, who represent a significant number of people that could potentially see hospitalisation rates surge to unacceptable levels.

Coupled with this is a new variant (Omicron) emerging, where it is too soon to know the impact it may have on this dynamic, and if hospitalisation rates will surge as they did with Delta or Epsilon.

Leading Indicators

In economics there are Leading Economic Indicators (LEI) and Coincident Economic Indicators (CEI) which project both future economic conditions (LEI) or current conditions (CEI).

A quirky way to display these is to measure the ratio between LEI and CEI, where LEI/CEI usually starts to fall before recessions begin.

i.e. future projections deteriorate in respect to current conditions.

While there are false alarms from this approach, it does tend to be a reliable indicator of near-term recession risk.

As of Q4 2021, the ratio is still rising, and recession doesn’t look like a near-term risk.

Source: Advisor Perspectives

Climate Risk

While COVID may have derailed the climate change agenda that become a vogue subject in 2019, 2021 saw this topic as an increasing focus for discussion and investment portfolio implementation.

Chances are that 2022 will pose a bigger year yet again for the topic as the world continues to congregate in large international conferences to discuss initiatives and sign pledges.

On the domestic front, APRA and the RBA recently signed the “Network for Greening the Financial System Pledge”, which will ultimately seek to establish a risk framework for climate impacts, and how that should be reflected in lending rates.

This “climate vulnerability assessment” (CVA) will see higher risk weightings associated to businesses and business models that have more climate risk, driving up their funding costs, and likely sees a growing weight of money allocated to less vulnerable businesses.

Moreover, natural disasters are undeniably occurring with increasingly regularity, which is also seeing insurance premiums rise, making these business models less profitable.

Source: IMF 2020 Global Financial Stability Report

Nominal vs Real Monetary Policy

I honestly think people are not as aware of real interest rates as they should be, where they should be on EVERYONE’s radar.

The objective of investment management is to at least maintain our purchasing power, which means we need to assess the REAL (ex-ante) worth of an investment portfolio, subject to its purchasing power of real-world goods and services.

When inflation spikes higher (like it is now), we would want an offsetting higher return in nominal terms that maintains or improves our differential between nominal and inflation-adjusted (real) returns.

What I’m already looking at continually as part of my duties as an investment manager is the market’s gauge for REAL monetary policy forecasts, as a real tightening of policy or a perceived real tightening of policy will be important for EVERY OTHER ASSET CLASS AS WELL.

Sorry to shout that but it really is important.

The logic is simple, if the market prices in 200bp of rate hikes in the coming 5 years but we project inflation to rise >200bp during that time, then this may be a nominal tightening of monetary policy, but it’s a real loosening of policy.

Below are the market projections (implied policy) for various regional economies, where rate projections are higher almost across the globe.

Source: Bloomberg, as at 7-Dec-2021

Therefore, there’s less chance of equities, property and infrastructure to sell-off, where financial conditions are still expansionary in real terms.

In the below chart we chart US 5y cash rate expectations (1.08%) vs US 5y inflation expectations (2.78%), where there’s a real rate differential of -1.70%, very negative.

This is usually supportive of growth just like it was in 2010-2013.

Source: Bloomberg, as at 7-Dec-2021

Equity Market Fragility

I have too many data points to list here, as nearly every traditional metric for measuring stock market valuations show that most index valuations are lofty. Not all, but most.

Statistically, having such high returns over the past 5 years is suppressive of expectations for the coming years, but investors don’t seem to be too worried by this, where fixed income yields don’t offer significant returns to meet return objectives and they look to stock markets to meet those hurdles.  

As at November 18, Rydex Mutual Fund allocations to stocks, bonds and money market were as follows:

  • US domestic and global (ex-US) equity mutual fund assets = 94% (all time high)
  • US domestic and global (ex-US) bond mutual fund assets = 1.33%
  • US money market assets = 4.68%

Stock market exposure is at an all-time high, bond exposure near all-time lows and cash/MM allocations at all-time lows as well, where it shows investors are all-in on equity allocations.

Looking at “Stocks as a Percentage of Household Financial Assets” (excludes superannuation assets), US investors are 47.5% allocated to stocks, almost half their total assets and the highest level since 1951, a time when equity investments weren’t as well accessible.

Furthermore, large-cap stocks are a larger and larger part of overall equity indexes, diminishing the breadth of the market.

This is well known as well, causing concentration risks for investors piling into scant few stocks, but worried about missing out on their compelling returns > index returns.

Source: Ned Davis Research

Lastly on equities, we always need to be wary of the pricing that we’re buying.

At the moment, the median P/E of the S&P500 is what would be called “very overvalued” at 28.3, compared to the 58 years average of 17.3.

If we were to see a mean-reversion of P/E multiples from 28.3 to 17.3, this would require a 38.8% decline in the market to get back to “fair value”, or the S&P 500 at 2,818.49.

The decline required to get back to “bargain” opportunities not experienced since the 1980s would be 58.7%.

Source: Ned Davis Research

Fixed Income

We wrote about our fixed income views in detail last week, where it’s worth repeating that net supply of forthcoming bonds in 2022 should see yields grind higher, also supported by higher and more sustained inflationary pressure.

This is backdropped by the influence of COVID infection and hospitalisation rates, which tends to elicit risk-off investing and see bond yields lower.

Because of this incredibly hard to assess directionality of interest rates, we prefer avoiding significant interest rate duration, targeting less than 3 years towards 0 years of duration.

Instead, we prefer absolute return focused FI allocations, where returns are derived from income (carry and rolldown) as opposed to capital price improvements.

The Rise of Alternatives as an Asset Class

 Okay, alternatives aren’t really an asset class as they don’t fit the definition, they’re more of a catch-all for all the asset aggregations outside the conventional cash, domestic and international fixed income and equities.

My point is that if equities are vulnerable but still expected to have some form of nominal return next year (though diminished) unless we see a material real tightening of monetary conditions, and given fixed income bond yields are expected to rise, then we should be looking for diversified risk premia to avoid correlation risk.

2022 should see a further appreciation for alternative assets, such as global property, domestic and global infrastructure, hedge funds, private equity, private credit, commodities and FX.

You could also include crypto in that list, but it doesn’t quite fit into an asset class yet, it’s more a commodity given the variability of price.

Factors & Styles Instead of Asset Classes

When asset classes offer less diversification, we can simply try and find more asset classes to diversify across, or we can pivot and analyse portfolios differently.

Our approach is to use both quantitative factors and manager styles to build diversified portfolios amongst asset classes we want exposure to, but in a nuanced manner.

To repeat our fixed income outlook, we’re seeking fixed income exposure, but under the active style which we expect will remain resilient in 2022, rather than benchmark-like passive beta that will quite possibly lose us money in nominal terms, and probably lose money in real (inflation-adjusted) returns.

In equities, property and infrastructure, we are seeking companies that benefit from inflation and increasing inflation expectations (i.e. resource companies and food producers), or infrastructure and property assets that are less regulated and have pricing power.

Growth vs Defensive Mix

This is one of the hardest parts to get right for 2022 as the confluence of factors described above will likely evolve over the year, vying for overriding importance.  

As I write this outlook, we are still in an expansionary economic environment, where fiscal deficit spending and central bank policy is incredibly accommodative for risk assets.

This will persist in 2022, as deficit spending will likely be maintained as a form of policy support while COVID continues to impact many nations, and central bank policy will take months/years to tighten.

As such, we’ll continue to monitor our real vs nominal tightening charts to assess whether financial conditions have tightened and will be likely restrictive of future growth and growth expectations, where we would expect to shift to a more defensive position, seeking capital preservation in both nominal and real terms.

Closing Remarks

While this note has covered so much, there’s still so much to say.

Suffice that sentiment likely remains positive while monetary conditions remain expansionary as well, and while consumer behaviour is buoyant as mobility and global travel resumes, where AD > AS.  

However, the market’s rise in H2 2020 and throughout 2021 has been predicated by government support and concentrated on specific industries and mainly a few companies, highlighting the fragile nature of the economic rebound.

Markets are lacking breadth where central banks are the marginal buyer of fixed income, and corporate buybacks and retail punters are the marginal buyers of equities.

This ownership structure is known as “soft hands” rather than “safe hands”, where these investors may be quick to sell when they expect or realise that growth is not going to be as strong as it has been.

The views expressed in this article are the views of the stated author as at the date published and are subject to change based on markets and other conditions. Past performance is not a reliable indicator of future performance. Mason Stevens is only providing general advice in providing this information. You should consider this information, along with all your other investments and strategies when assessing the appropriateness of the information to your individual circumstances. Mason Stevens and its associates and their respective directors and other staff each declare that they may hold interests in securities and/or earn fees or other benefits from transactions arising as a result of information contained in this article.