2022 Mid-Year Outlook
Is it as bad as it seems?
In January, the consensus 2022 market outlook anticipated less accommodative monetary and fiscal policies leading to slower growth, a withdrawal of liquidity, and a moderation in earnings growth (meaning the potential for lower equity valuations). We agreed with a cautiously positive approach as economies appeared to be recovering following the pandemic.
Six months on, much of this has happened, with notable variations. Inflation has been far stronger, more persistent and widespread than expected, made worse by the Russia-Ukraine conflict, forcing central banks to take action as they seek to re-establish their inflation fighting credibility. As a result, markets have weakened materially across almost all asset classes, giving investors few places for refuge.
The increased correlation between growth and defensive assets is rare, and a real challenge for investors. History suggests it’s likely to be relatively short-term, so for long-term investors this may represent an opportunity from which to build sequential returns.
Here are 5 key takeaways from the first half of the year.
1. Tighter financial conditions drive lower valuations
Central bank action to rein in inflation by aggressively raising interest rates and tightening financial conditions has caused heightened market volatility.
The resulting bond market re-pricing has taken yields from close to zero (or even negative), to positive territory very quickly. This ‘discount rate’ adjustment is used by investors to work out the fair value of future earnings for companies, which inevitably led to lower equity valuations and a de-rating of market multiples around the world.
2. Economic resilience persists
Despite a tougher liquidity backdrop, tight labour markets are helping to support the consumer. That, plus healthy corporate and household balance sheets mean economic activity measures such as the Purchasing Managers Index (PMI) are showing resilience. A PMI reading of 50 or above indicates expansion, and less than 50 indicates contraction. Current levels show we’re managing to remain in expansion, though notably down from recent highs.
3. We’re nearing peak in inflation
The key challenge for central banks is preventing entrenched inflation. Tight labour markets bring fears of wage inflation, and this is compounded by post-pandemic supply side bottlenecks and the tragedy in Ukraine - all putting upward pressure on food, fuel, energy, and housing prices. But there are signs that prices are becoming more stable, and in the case of commodities and transportation, even rolling over.
Global supply bottlenecks are also easing as China relaxes their draconian zero covid policy. Combined with moderation in demand due to increased living costs, this is leading markets to expect inflation will be brought under control, so market implied long-term inflation expectations remain near the Fed’s 2% target
4. Expect downward earnings revisions
Anticipated GDP growth slowdown and rising input costs make the earnings outlook more challenging, with analyst forecast downgrades widely expected. Much of this already seems to be priced in. In a recent Deutsche Bank fund manager survey, 90% of respondents assumed a recession before the end of 2023. However, corporate earnings are still expected to remain reasonably robust.
In the forthcoming earnings season, companies will need to evidence their ability to handle cost increases, preserve margins and demonstrate resilience in sales growth and market share. Investors will expect updates on changes in inventory and the cash conversion cycle.
5. Time to hold your nerve
With continued uncertainty over inflation, interest rates and recession, it’s no surprise that risk off strategies and caution have dominated so far this year. Cash positions are now the highest in 20 years, indicating widespread negativity. There’s room for upside surprise should things turn out to be better than feared though. Long-term investors will do well to remember that the benefits from compounding are usually at their greatest following periods of market weakness.
Looking ahead
Liquidity, valuation and sentiment are currently under downward pressure. Valuations have come back meaningfully, but not enough to single-handedly support a market recovery until there’s clear evidence of inflation falling back towards central bank targets.
At that point, investors will be more confident in predicting a peak in interest rates, and that will help to stabilise sentiment and underpin forecast valuations of future corporate cashflows.
Inflation is not expected to revert to the low levels seen following the global financial crisis of 2008/09. The shift towards a more responsible and sustainable energy mix and away from ‘just in time’ delivery means central banks can be expected to retain their tightening bias.
The path ahead will likely be bumpy, with heightened volatility. As liquidity is withdrawn, risk aversion will increase. But with higher yields available in fixed interest, the conventional uncorrelated/low correlations between fixed interest and equities can be re-established, allowing diversified multi asset portfolios to weather periods of uncertainty.
Final thoughts
It’s been a testing and turbulent first half of the year so it’s understandable that investors may feel despondent and overwhelmed. It’s important to remember that market cycles have always been a feature of investing. Periods of weakness can present an opportunity for long-term investments in quality companies at lower prices, helping to support the compounding of returns over years to come.
Investors have reason to be cautiously optimistic when they remain disciplined and committed to their agreed investment plan.