The fundamental backdrop shows an environment of still robust but decelerating growth globally, and a continued rise in inflation. Growth in the US, UK and Europe should remain above trend, with around 4% GDP increases likely in all three areas. Japan will also likely see strong growth, of around 3% this year.
Moderating growth, from an exceptional recovery in 2021, was not unexpected as the global economy moved past peak growth around the middle of last year. What has been slightly more concerning is some recent disappointment in the US, although growth has been better than forecast so far in most other areas, including China, where authorities have recently begun to ease policy.
Inflation still a priority for central banks
Inflation is clearly front and centre in the minds of investors. In the UK, the December reading of 5.4% is a thirty-year high, and headline CPI in the US is now around 7%. Looking forward, it is highly likely that annual inflation rates will fall relatively sharply in the next few months due to base effects and some moderation in goods price inflation as supply issues continue to diminish. Nonetheless, inflation rates in housing and services will probably remain stubbornly higher. These areas are relatively highly correlated to wage growth, and therefore could remain higher than many are hoping.
My expectation is that inflation rates will fall sharply in the coming months but will remain above central bank targets by year-end. Furthermore, while there is significant noise in current data releases, and underlying trends are difficult to identify with confidence, I would say that risks are probably still tilted to the upside; not from current levels but against expectations. Nonetheless, wage inflation remains key and will be the main focus for central banks.
Markets have adjusted short-term expectations, but the longer-term view is lagging
Markets have recently been relatively relaxed with respect to anticipated future inflation rates, which had pushed sharply higher through 2021 but have moderated somewhat in recent weeks. But where the market has reacted is to push up interest rate expectations and bring forward the expectation of the speed and scale that central banks will reign back on asset purchases.
The market is now pricing in at least four rate hikes this year in the US and is implying that rates there should peak in this cycle at around 1.75%. However, it seems that the market has adjusted short-rate expectations but not longer-term expectations, when investors do make such an adjustment, this will put more pressure on bond yields.
Bonds and growth stocks present challenges
Bond yields have pushed higher recently, notably in terms of real yields, but we believe there is more upside to come. Recent moves in inflation and interest rate expectations, as well as the related moves in bond markets, have been troubling equities. In simple terms, low real interest rates may be viewed as supportive for equities, and particularly supportive for longer-duration growth stocks (stocks that are more sensitive to movements in interest rates). Rising real yields, all else being equal, will have a disproportionately higher impact on growth stocks.
In 2021, we saw a widespread derating in equity markets. Multiples contracted but earnings growth more than offset this negative effect. We should expect more pressure on valuations over the course of 2022. Indeed, this is the pattern observed during prior periods of tightening in monetary policy. What we can hoped for, as was the case during last year, is that modest earnings expectations of 7% globally are beaten, and that growth in earnings offsets a derating in markets.
The tightening cycle is different this time
What is ‘different this time’, amongst other factors, is that central banks are tightening policy from emergency levels, having provided extraordinary and unprecedented support, at a time when economic growth is slowing and inflation is well above target. In addition, equity multiples are historically high, and are particularly extended in the growth segment of the market, with limited scope for interest rate or earnings disappointment. These factors heighten risks for equity investors.