A post pandemic world is finally emerging which will have a lot of implications for investing. Since the beginning of the year, we are finally seeing that the market momentum might shift to international markets. U.S. markets have come under pressure, not necessarily a surprise given the very stretched valuations. Markets worldwide are clearly trying to digest the outlook for higher interest rates and rising inflation numbers that are making them nervous. In our latest InSights, we share our outlook for the New Year and what investors need to watch for.
Since our last update in the fall, a lot has happened, even though the dominant story in the news continues to be the pandemic. While the situation was still pretty much under control before winter truly set in, new Covid cases have since been on the rise globally. Especially since the detection of the Omicron variant in November, which is now the dominant strain in most parts of the world, we have seen an explosive spread of the virus.
While we had expected a renewed surge in Covid cases as temperatures dropped, we were surprised, like most people, by how rapidly Omicron has spread. Luckily, current data suggests that this new variant mostly causes mild symptoms with fewer people ending up in hospitals. However, it still poses a major concern, because a lot more people are getting sick at the same time, which is creating serious operational challenges for companies around the world. Within a few weeks, the focus has shifted significantly, as it now becomes increasingly clear that Covid might not be primarily a health issue anymore, but another potential drag on the global economic outlook, a threat that is exacerbated by the various containment measures that governments have taken. However, we think that now a post-pandemic world is emerging and investors need to know what the consequences are for the coming months and possibly the coming years.
Meanwhile, the US and European equity markets had a great year, despite the covid-driven narrative that once again dominated the news cycle in 2021. Monetary and fiscal stimulus more than made up for the pandemic’s impact and the negative real economic performance in many sectors. As can be seen in Figure 1, U.S. markets outperformed, and European stocks didn’t lag too far behind, while Asia in general significantly underperformed.
Figure 1: Global stock market indices, year-to-date performance in local currency
Nevertheless, it is interesting to note that this stellar performance, particularly in the US, was very much driven by a just a handful of stocks. Around 65% of the Nasdaq’s gains (comprising a total of 3,780 stocks) can be attributed to only five stocks - Microsoft, Google, Apple, Nvidia and Tesla. It remains to be seen whether this decoupling is sustainable. It also needs to be seen where the next push upwards can come from, especially taking into account that both the equity allocation of US households and the margin debt levels are at record highs.
While we have some concerns regarding U.S. markets, we remain bullish on European, including Swiss, stocks. Valuations are very attractive and, due to much less financial engineering, the balance sheets of European companies look in general much healthier than those of U.S. companies.
Shifting our focus to currencies, the USD also had a strong year, with the USD index gaining about 8% in 2021. This USD strength has naturally eaten into the relative performance of non-USD assets, but we expect the currency to resume its long-term downtrend in 2023, which would then provide significant tailwinds for non-USD assets. We also expect the pandemic pressures to gradually lift during spring and into the summer and then we don’t expect another major disruption caused by the virus going forward, despite a high probability of rising Covid cases in the fall again. This also means that we might be getting very close to a turning point and we believe we are now seeing the last spike of the pandemic before the virus becomes endemic.
Going forward, we anticipate growth momentum to pick up in areas that have been so far lagging behind, especially Europe and Asia. This also means that investors will probably focus again on stocks that will benefit from a normalization of the Covid crisis. Cyclical stocks, including commodity stocks, likely stand to benefit as well. However, with yet another rotation in the market, we see U.S. markets starting to underperform and we believe they might underperform significantly for a longer period of time. We think investing in European and Asian stocks could be the perfect move for U.S. investors for 2022 and beyond, especially in combination with non-USD currency exposures. Valuations and forward-looking earnings momentum speak a very clear language.
Figure 2: Equity allocation among US households at record highs
Source: JP Morgan, WSJ
Why do we think that way? First of all, valuations for U.S. equities have gone up to such extremes that we don’t believe this large premium is sustainable. Additionally, as mentioned above, U.S. markets have become increasingly driven by a few large growth stocks, while the broader market has actually underperformed European equities in recent months. Just to make our point clear, we don’t expect a large correction in U.S. markets, but we do think that the small number of tech stocks are very likely not going to sustain their extraordinary performance going forward. In the short-term, they might even move lower and consolidate to absorb the large price moves seen in 2021. The tech sector has by far the largest weighting within the S&P 500 index (29%) and together, the largest nine US stocks by market cap (Apple, Microsoft, the so-called ‘FANG’ stocks and Tesla, Nvidia and Netflix) account for 27% of the S&P 500 and 54% of the Nasdaq 100 index. Once they stop rising and start to roll over, the main pillar supporting the rally will be gone and these indices could drop fast within a short period of time, which would then create headwinds for the whole U.S. market.
Figure 3: Stock market forward earnings growth expectations
Source: Refinitiv Datastream, ECR Research
Inflation is another important consideration that could cloud the outlook for 2022. Although it was dismissed as a “transitory” phenomenon just a few months ago, significantly higher consumer prices in the US, but also in Europe, now appear to be here to stay. Of course, this price rise can be in part attributed to supply chain disruptions that could be resolved in the coming months, but there are other inflationary forces at play too that are most likely going to be with us for longer.
Figure 4: Inflation rates in the US and the Eurozone, yoy %
Source: OECD, Roland Berger
Central banks will have to adjust monetary policy and currently the market expects the Federal Reserve to hike rates by 0.25% three times this year. Of course, this does not look like a serious fight against inflation, but it is clear that policymakers have to perform a tightrope act: a more aggressive stance would probably cause a lot of market volatility and perhaps even jeopardize the economic recovery at large. Thus, solid economic growth with higher inflation and central banks that will stay behind the curve will very likely continue to create a constructive environment for stocks and for precious metals too. This inability of central banks to raise rates aggressively is bound to persist and this could be one of the most important big picture trends in the coming years.
Overall, our advice has not changed much from last year. Investors need to hold a globally diversified portfolio of high-quality stocks, commodities, precious metals, global real estate and even digital assets. The investment environment going forward will be more challenging and it will certainly not be enough to simply buy and hold the market. This is especially true for U.S. investors who still tend to have a very strong focus on U.S. markets. For the past few years, it was simple and effective to merely hold the U.S. market and enjoy the ride, however, this ride might soon be over. There are already indications that this shift is underway, with increasing divergencies and a growing number of stocks lagging or even correcting. We also expect that inflation is going to impact the U.S. more negatively simply because rising prices will put a lot of pressure on U.S. households, 70% of which still live paycheck to paycheck. Climbing prices will dent consumer spending, which continues to be the main driver of GDP. This might also indicate that the relative momentum for the U.S. economy could turn more negative compared to other countries and regions around the world.
And what about other factors influencing financial markets in 2022? While inflation and interest rates seem to be the dominant drivers, other developments might have an impact as well, for example, fiscal spending, which seems to be high on the agenda of many governments. In the U.S., President Biden has had a hard time pushing through his BBB (Build Back Better) plan, but we still expect that at least some of it will eventually be implemented. Then there are also geopolitical concerns such as the growing tensions with China or the frictions between the U.S./Europe and Russia. In addition to the existing Ukraine conflict, another crisis could emerge in Kazakhstan, while there could also be further flare ups in the chronic tensions between Israel and Iran. However, unless there is a more serious escalation in any of these fronts, it is unlikely that financial markets are going to be impacted too much.
It may come as a surprise to many of our readers that we didn’t count the pandemic among the key trends and factors to look out for in 2022. Indeed, at this point, we don’t expect Covid to be a major issue anymore, especially from spring onwards. The world seems to be learning to live with the virus and a lot of people in the West are now immunized in one form or another. This might be a little different for places like Russia and China, where vaccination rates are either low or vaccines don’t show as much of an effect. But in general, the world seems to be getting over this health crisis and this year, we look forward to our lives increasingly going back to normal. Well, to a “new normal” to be more accurate, as certain things have changed more permanently in our view, for example the way we work. This will again lead to some very interesting so-called “Super Trends” that we already see evolving, but we’ll look into that more closely in our next update in the spring.