More Jabs needed
Inflation and Omicron pose major concerns for investors and policy makers as 2021 draws to a close. If there was a massive push towards raising vaccination rates in emerging economies in early 2022, the risk outlook would improve. An end to the pandemic would help restore supply chains and remove distortions to businesses. This would help pull the rug from under some of the drivers of inflation. In the meantime, investors will need to hedge against inflation and rate hikes. Diversification and climate mitigation need to be key principles for investors in what appears to be a more uncertain outlook again. But bulls need jabs.
The current Bloomberg economists’ consensus forecast for the monthly change in the US consumer prices index for November is 0.7%. That would translate into a 6.8% year-on-year inflation rate and more or less ensure that US headline inflation will remain above 6% at the beginning of 2022. Falling oil prices will help bring headline inflation down but the numbers are likely to confirm the need to “retire” the word transitory – as suggested by Federal Reserve (Fed) Chair, Jerome Powell, last week. All being well, year-on-year inflation will head lower next year but it is likely to remain above at least 4% for most of the next twelve months. Inflation and its consequences for rates, bond yields and equity multiples will remain a major theme for investors, as I discussed last week. Prospective standalone bond returns, for the most part, don’t look as though they will match prospective inflation over the next year. Inflation linked or something very high yielding remain the best bets.
Rates and inflation are some of the headwinds investors face. Another is the potential for activity to be broadly disrupted again by the Omicron variant. Equity volatility has responded to announcements from around the world of new travel and social distancing restrictions and it might get worse before it gets better. The combination of weaker growth and higher inflation demands higher risk premiums across asset classes.
Market performance through 2021 has reflected the reflationary phase the world economy has gone through. Best performers have been high beta equity assets while the worst performers, generally, have been long-duration fixed income assets whose return profile is the most sensitive to change in interest rate expectations. The difference in total return between the S&P Growth index and the US Treasury 10-yr plus index has been 30%. History suggests that the gap will not be as big next year – there could be some mean-reversion in relative returns. I have always stressed that long-duration bond returns and returns from risk assets are negatively correlated when it matters. Having a balanced bond-equity approach over the next year might not be a bad idea. Over the last 25 years, taking these two representative indices, every year of negative equity returns has been met with positive bond returns. Bonds hedge equities but the bond exposure has to be more or less as volatile as the equities, but in the opposite direction when things turn risk-bearish.
There are plenty of defensive options if you are worried about 2022 being a less positive year. Floating rate-linked and short-duration fixed investment instruments have little downside risk even when they are heavily credit loaded such as asset-backed securities and CLOs. Credit risk remains low in my opinion but in the longer-duration fixed income world of credit, the excess return offered by the credit spread might not be enough should the duration component of return continue to be volatile. Essentially investment grade corporate bond returns have been flat this year and I can’t see that changing unless there is a huge decline risk-free yields.
COP26 and climate risks
On a more secular theme, responding to climate change is going to become increasingly important for investors. While there were a lot of good things to come out of the COP26, the key takeaway is that there is no guarantee that the world is on a path to stop the rise in atmospheric temperatures exceeding 1.5oC by 2050. Thus, both physical and transitions risks will become more material for companies and investors. If we are a long way from global temperatures peaking, extreme weather events and environmental disasters are likely to be more frequent. Investors are exposed to losses resulting from these events impacting on businesses through damage to physical assets, disruptions to production and distribution, and increased costs through insurance and mitigation requirements. In addition, because we are not on the right path yet, the transition risks will build as there will be more urgency from policy makers, increased pressure on business models from investors and consumers, and from the technology needs required to shift to low carbon.
It’s becoming more commonplace and more credible to identify these climate risks and put a price on them. More widespread application of carbon pricing would help in that respect, but valuation models can incorporate different carbon pricing scenarios to assess potential value-at-risk. What is less clear is whether these risks are rewarded via higher risk premiums on brown company assets. A cursory review of the academic literature on this is not conclusive. It makes sense that investors would seek a higher potential return on assets that have exposure to more physical or transition risk. This may become clearer as more investors allocate to green assets and away from brown ones. The more active and focused climate strategies will also incorporate a transition path so that there is clarity on future emissions, and therefore, risks associated with the companies in a portfolio.
Diversification and managing carbon risk should be two principles for investing in the next few years. There is a need for protection as well, from inflation being higher and thus eroding real returns, and from the potential for a policy driven re-rating of assets. While supply issues may subside, the energy transition could continue to provoke bouts of higher inflation. Short-duration inflation strategies remain an attractive option in that respect. On the growth side, renewables and climate related technology and a broad exposure to digital trends will provide the longer-term growth. Regionally, Europe is less at risk from endemic inflation and monetary tightening than the US, and certainly on the equity side there is a valuation advantage in European stocks. Lastly, as I mentioned before, the value trade next year could be one driven by a recovery in Asian asset values.
More jabs everywhere
The most bullish development in 2022 would be something that created an end in sight to the pandemic. Vaccination rates in emerging economies need to be significantly increased to prevent the opportunity for additional mutations to take hold. There are very few countries with more than 80% of their populations being fully vaccinated. More worryingly there are many emerging economies where vaccination rates are well below 50% - including populous nations like Indonesia (35.3%), Russia (39.6%) and South Africa (24.65) – data compiled by Our World in Data from national and international agencies. It really makes me think about international co-operation to deal with climate change being feasible when there is a collective failure to deal with something that we already have the tools for and experience of doing. If this doesn’t change, then there will be more waves of the disease, more impact on global trade and activity, and a growing risk of stagflation which would be extremely negative for investment returns. The breakthrough of vaccine developments in 2020 was a major fillip to markets – in 2022 we need to see real progress on the rollout of jabs to achieve global immunity and a real and more equal expansion of global wealth.
A new era begins for Manchester United with the departure of Michael Carrick in the wake of Ole Solskjaer’s dismissal a couple of weeks ago. Welcome Ralf. Another German manager in the Premier League. If he can have the impact that has been seen at Liverpool and Chelsea then bring it on.
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