While it has clearly been a disappointing start to the year, I believe that there are still grounds for optimism. The’ bears’ will point to elevated inflation, stretched valuations, and central banks that are behind the curve. These are fair observations. I do, however, expect that robust growth and moderating (but still above target) inflation will alleviate some concerns and that, while interest rates will rise, they will remain historically low in both real and nominal terms. Despite this, markets do still appear to be too sanguine on longer-dated rates and this does represent a risk of further volatility, as a minimum.
1. US equities: a more balanced approach
Large cap stocks have provided outperformance for US equity investors in the past 18 months, but Multi-Asset portfolios may do well to consider a more balanced exposure for their US equity allocation. The direction of travel remains away from growth stocks as, despite the correction, valuation spread remains at very high levels and the environment remains less friendly (from a rates, inflation and regulatory perspective).
2. Global equities: US no longer the front-runner?
Second, it remains a big call, but the chances have certainly risen that US exceptionalism in terms of equity market performance is coming to an end. Secular changes, by definition, happen infrequently but the magnitude of outperformance, the valuation gap, and a turn in the economic environment, are all suggestive of opportunities beyond US equities. In 2021, we saw marked factor outperformance of ‘value’, which subsequently (only towards the end of the year and into 2022) led to index level outperformance of value over growth. This has now begun to permeate to country performance, with the notable outperformance of the UK so far this year.
3. Emerging markets: China policy inconsistent
Emerging markets (EM) remain a challenge. China is dominant within the EM equity complex and, following a 20% decline in 2021, valuations appear more attractive although regulatory risks remain a concern. As noted earlier, policy is being eased in China while other areas are tightening but the zero-Covid policy appears inconsistent with the realities of dealing with the virus and presents risks to domestic growth and to global supply chains.
4. Small caps: historically cheap but inflation a headwind
Fourth, small caps have continued to perform relatively poorly and appear historically cheap, but an environment of higher inflation may well present challenges (in terms of the pricing power of corporates). Recent years have seen large caps and private equity both outperform small caps – a barbell.
5. A secular change: outlook will need constant adjusting through 2022
Finally, to repeat an earlier point, there is currently tremendous uncertainty in terms of the true trend of much of the underlying dataflow. This makes a strong conviction and dogmatic conclusion on the future outlook even more challenging than usual. On balance, higher inflation, tighter policy but still robust growth represents a reasonable backdrop for markets, but I do think that the chances are higher than they have been for many years that a secular change is unfolding.
