1 December 2021

As investors establish their 2022 market strategy, I summarise my answers to many key questions:

• Will the current rise in inflation be temporary or are rapidly rising prices here to stay? In the USA, for example, I expect price growth to peak in the first quarter of 2022, and “core” inflation to revert to 2-2.5% by the end of next year.
• Following the unsustainable 6% GDP growth in 2021, global growth will cool next year. However, recent proposals in the USA, UK, and elsewhere suggest fiscal policy will remain stimulative in 2022. And, while the US Federal Reserve will soon begin to taper its asset purchases and several emerging markets have begun to raise interest rates, global monetary conditions will remain accommodative in 2022. As a result, the global economy will post another above-trend 4.5% advance in GDP in 2022, but will continue to decelerate towards 3% in 2023. Similarly, US EPS growth will decelerate sharply, but EPS should gain another 7% next year.
• The recent emergence of a new Covid variant in South Africa is a reminder that the pandemic is not over. In coming weeks, we will learn more about the variant’s transmissibility, its virulence, and its ability to evade existing vaccines. While this winter will be challenging, early comments from vaccine manufacturers express optimism that existing drugs can be modified to deal with the new challenge. However, financial markets (and much of the general population) have been complacent about the ongoing risks posed by the pandemic. The success of vaccination programs will be an important differentiating factor in market performance again in 2022.
• Slower economic/earnings momentum and high inflation may give the impression that a period of stagflation could be emerging. However, stronger labour productivity would avert this outcome, justify sustainably higher wage growth, and pave the way for the next leg of the bull market. There are early signals that these effienciency gains are emerging.
• Climate change will be the most important macro-issue in the next decade. While COP-26 was insufficient to ensure the 1.5%C temperature goal will be achieved, Green initiatives are accelerating world-wide. As a result, I expect capex to outpace consumer spending in 2022 and beyond.
• The US Federal Reserve will begin tapering in coming weeks, and interest rate hikes will begin cautiously in Q4 2022. The ECB and BOJ will remain on hold again next year.
• Higher US bond yields will lead to a derating of equity market PE ratios. A 19X PE produces a 4,300 S&P 500 target in 2022. (During the next few years, I expect the US PE ratio to decline towards 17X). Europe will outperform.
• Emerging markets are relatively cheap. However, higher US interest rates, a strong dollar, and low vaccination rates will lead to further underperformance, at least in H1 2022.
• The overvalued US dollar will strengthen further in H1 2022. Many undervalued EM currencies will decline further. FX valuation will not be an important currency market determinant in coming months.

USA: Higher Bond Yields Leads to Market Derating

Supply chain problems and rising energy and commodity prices have led to sharply higher inflation worldwide. In the USA, for example, the 6.2% rise in consumer prices in October was the highest in over 25 years (up from 1.4% in January). As usual, whether accelerating inflation persists depends largely on whether rising prices lead to higher labour costs. The Chart above does indicate that worker shortages have led to a modest acceleration in wages: the employment cost index rose 3.6% in Q3 2022 compared to 2.5% a year ago.

While I expect US labour compensation will rise another 4% in 2022, rising labour force participation should boost worker availability next year, especially as generous unemployment benefits have now ended. The Chart above illustrates the recovery in labour participation lags Europe, whose furlough schemes more successfully maintained the link between workers and their pre-pandemic employers.

Likewise, improving worker productivity could justify the rising wages, and offset the impact on profit margins and inflation. While it’s too early to conclude definitively, the trend in US labour efficiency does appear to be accelerating following the lull in the wake of the Global Financial Crisis. (Chart above). President Biden’s infrastructure program and incentives for Green investments may reenforce this favourable outcome (higher corporate taxes won’t help). Rising productivity has the potential to boost real wages, incomes, consumption, profits, investment, and GDP: paving the way for the next leg of the bull market. In 2022, wage and productivity growth of 4% and 2% respectively will bring “core” inflation (and unit labour costs) back towards 2% by the end of next year.

In the near term, however, US GDP growth will decelerate to 4.4% in 2022 and 2.8% in 2023 (compared to 5.7% in 2021), largely reflecting weaker consumer spending. Tax cuts and pent-up demand temporarily boosted household incomes and spending. In recent months, however, rising inflation has eroded consumer purchasing power. The Chart above shows real incomes are declining. Initially, consumers maintained high spending by dipping into temporarily elevated savings. However, that cushion has now evaporated. Therefore, household spending will advance in line with modest gains in real incomes. Consequently, I expect climate-oriented business investment will outpace consumer outlays in coming years.

Reflecting the combination of above-trend GDP growth and above-target inflation, the Fed soon will begin tapering its asset sales, paving the way for its first rate hike in Q4 2022. However, with economic growth slowing and inflation decelerating next year, the Fed will proceed cautiously: perhaps delaying its initial rate hike until H1 2023. From a market perspective, I expect the prospect of higher interest rates will lead to a compression of the S&P 500 PE ratio — a trend which has already begun (Chart aboveprovided by Ed Yardeni). During 2022, a PE ratio of 19X EPS produces an S&P 500 target of 4,300.

Europe: Economy and Market to Outperform

Europe’s economy and equity markets are poised to outperform the USA next year. First of all, while European inflation is accelerating, relatively modest wage increases suggest the recent price spike may be temporary (Chart above). Likewise, as noted earlier, European labour market participation remains high; so, worker shortages should be less problematic than elsewhere.

In addition, as Europe’s savings rate remains elevated, the region’s consumers can dip into savings should higher inflation temporarily erode household purchasing power (Chart above). As a result, Europe’s 4.5% GDP advance will outpace the USA in 2022.

Unlike the USA, the ECB should remain on hold throughout 2022, provided inflation proves temporary. As a result, European PE ratios should not derate in line with the US equity market. In addition, European markets are extremely cheap compared to the USA (Chart above). Lower inflation, stronger growth, and attractive relative valuations point to outperformance. Vaccine hestitancy in Russia, Eastern Europe, and parts of Germany, however, pose potential risks.

Emerging Markets: Cheap Valuation Doesn’t Offset Risks

Following recent underperformance, Emerging Market equities appear inexpensive relative to Developed markets (Chart above). Nevertheless, it’s probably still too early to buy.

First of all, EM economies still confront considerable global headwinds, e.g. rising US bond yields, a strong dollar, and supply chain disruptions. In addition, Covid risk remain greater in EM countries. While the EM vaccination uptake varies widely, the programs are generally less advanced in poorer nations (Chart below). Not only do low vaccination rates pose a direct health threat to local populations, but also present global risks via the emergence of new variants. The current situation in South Africa is a reminder that the the pandemic will not end until the whole planet is vaccinated.

Furthermore, increasingly EM countries must be considered on their individual merits rather than as an asset class. Differing experiences with Covid, vaccine programs, macro-policy responses to the pandemic, and vulnerability to the inflationary consequences of supply chain bottlenecks have all contributed to a wide disparity in economic outcomes (Chart below). North Asia and certain Eastern European countries appear the best bets for now.

Finally, given China’s heavy weighting in EM indices, developments in the Asia giant will remain critical. And, I am still cautious during the upciming Year of the Tiger. Recent debt problems in the property sector shed light on the need for extensive deleveraging in China’s corporate sector. Further, while China is making progress in addressing climate change, its slower approach will have economic costs. Likewise, China’s heavy-handed crackdown on prominent business leaders reflects an interventionist regulatory approach, which will prove damaging to the climate for business investment.

FX: Cheap is Not Enough

I encourage you to look at my forecast table for explicit exchange rate projections. The Chart above reveals that FX valuation will not be a key driver of currencies in coming months. For example, the overvalued US dollar and Swiss franc are likely to appreciate further. Meanwhile, deeply undervalued EM currencies and the Japanese yen are likely to weaken, at least for now. There are exceptions: undervalued UK sterling should outperform, while overvalued PHP and INR are expected to decline.