As we approach the final days of 2021, we look back on a year of strong returns for equity investors, as the recovery from the COVID-19 shock continued. The year-to-date total return for global equities (MSCI World Index) of +31.2% (in euro terms) represents a significant improvement from the +7.0% (in euro terms) total return delivered in 2020, as was expected at the start of the year.
Not everything went as planned, with Europe (STOXX 600 ‒ +24.5%) still underperforming the US (S&P 500 ‒ +37.6%) and the outperformance of value strategies fading in 2H21. These variances can be mainly explained by the deterioration on the COVID-19 front seen since summer, whereby at the beginning of the year we expected a more linear recovery which did not materialise.
As we approach the new year, investor attention has turned to the outlook for inflation and growth and their potential impact on equities. On inflation, Fed Chair Powell’s testimony to the Senate Banking Committee on November 30 was hawkish, where he signalled that the “transitory” language used to describe the expected short-term impact from inflation would be dropped.
This was followed by a similarly hawkish FOMC December meeting, with Powell sounding more hawkish on inflation and the labour market. FOMC officials now expect three rate hikes in 2022 and 2023, based on median projections. We believe that a gradual rate hike cycle against a backdrop of healthy economic growth should have little impact on the equity market prospects.
However, long duration equities (mostly growth names) might underperform in such an environment. The biggest risk is a rapid rate hike cycle in a scenario where the FED has fallen behind the inflation curve.
The inflation situation in Europe has been less discussed and largely ignored. Notwithstanding, core HICP inflation rose to +2.6% in November, which was well above consensus expectations.
Although inflation in the EU seems to be less of a problem when compared to the US (core CPI stood at +4.9% in November, a 30-year high), there are several factors that will add to inflation in the future. This includes the promise by the new coalition in Germany to raise the minimum wage by 25% to €12 per hour, with a pledge not to implement pension cuts over the next legislative period.
Additionally, it is likely that some of the temporary price increases related to supply chain issues and higher wage costs will not reverse.
There is scope for the equity market to generate a decent return in 2022- Robert Ducker
On the growth front, the discovery of the Omicron virus in November has added to the uncertainty around the global economy’s growth prospects. The news flow on the new strain has been conflicting, however, it seems like the virus is highly transmissible but less severe when compared to the Delta variant. Despite this, several countries within the EU have announced new curtailment measures to limit the spread of the virus.
The reaction from the public has been quite negative, which implies that more draconian measures are unlikely to be taken well if introduced in the future. Some have also questioned whether the vaccine is effective, especially when record cases are being announced daily within the bloc. However, we believe that the relatively low ICU admissions confirms that the vaccine is working, at least against serious illness.
The biggest risk coming from a new strain is a situation where the health authorities are overwhelmed, similar to what happened in the early months of COVID-19. The data being released lately has showed that despite the record of new daily cases being announced, ICU admissions remained well below peak, especially in countries with a high vaccination rate. We note that there is generally a lag between a spike in cases and an increase in ICU admissions, but so far, the relationship seems to have decoupled.
We will continue to closely follow the data to be released in the coming days to see the impact from the holiday season, a period that is generally known for social gatherings and travelling.
In the meantime, authorities continue to urge people to get vaccinated and take the booster shot, which should help provide immunity from the Omicron variant. The WHO, on the other hand, has warned that an increase in the vaccination rate in emerging economies is needed to reduce the risk of new variants emerging over the near term.
We continue to think that there is scope for the equity market to generate a decent return in 2022, against a backdrop of above-trend economic growth. We do not expect a repeat of the large real returns seen in 2021 as valuations are quite high compared to history and risks remain elevated.
As for sector exposure, we believe that a mix of value and growth is appropriate in the current environment. Higher inflation expectations may benefit value and cyclical companies. On the other hand, investor preference for high growth companies is unlikely to abate, with preference to those companies that generate high free cash flows and have strong balance sheets as opposed to the unprofitable growth stories which tend to underperform during periods of rising rates.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.
Robert Ducker is a senior equity analyst at Curmi and Partners Ltd.