CIO Outlook—Buckling Up for 2022

It’s always sobering to look back at past predictions and see how you fared. Notwithstanding the bashing that my ego is likely going to receive in 12 months’ time, here I go again: “How might things be different?”

Looking back a year, there was a lot that was on the mark: a shift from growth to value, the performance of “non-Asia” emerging markets, the importance of human rights and regulation, and reflation. And, as has now become customary in these outlooks (it seems to me), I offer the advice that trends tend to continue until they stop, or as my former head of research put it: “Both bull and bear markets always last longer than you think!”

I have to be particularly careful to remember this advice as I have a fairly contrary type of mind. (Just ask my mum.) In terms of market predictions, that usually displays itself as me seldom seeing a mean to which I do not want to revert. With that self-admonishment in mind, let’s take a look at a few of last year’s big market events and try to learn from them.

The Year of India

The gap between the performance of India and China was one of the biggest stories of 2021. It was far larger than I would have imagined. Currently the difference in the 12-month performance of a broad index of India and one of China is about forty percentage points. This gap compares to an average difference post-Global Financial Crisis of close to zero, and a standard deviation in the series of sixteen percentage points. The difference in the performance of the major indices may be greater still. So what caused this?

Well, partly, of course, it is the excellent performance of Indian companies—a remarkable bounce back in earnings from the trough of the pandemic. In addition, the boost that materials prices have had in Latin America has helped some of India’s export markets. Consequently, India’s current account moved from deficit into surplus and the usual weakness of the rupee was replaced with stability. Inflationary pressures, whilst building, have not taken hold and so we had the perfect scenario of profit growth, stable currency and a modest re-rating. Inflation in India is still a modest 4.5%—currently below the U.S.! Of course, perfect scenarios don’t often last for long; it is fair to say that I regard as less than solid the foundations for a further strong rally in Indian equities.

On the other hand, the performance of Chinese equities was hurt by the continued war of words with Washington. The focus of the U.S. displeasure—whilst in reality it is still about the concerns around China’s technological advances—rhetorically switched from trade to human rights, whereby the Biden administration hoped (and wherein it has been somewhat successful) to corral more European support for its China containment policy. Chinese equities were also hit by concerns over regulations—particularly as they affected highly valued internet stocks, often listed in the U.S., and some commonly-held education names. Indeed, the reaction to Chinese regulatory initiatives was far more fearful and intense in the U.S. than in either Europe or China. Breathless headlines that China is reverting to Maoism and culling the private sector are often made even though they are, to me,  ignorant of the history of China and with more attention to polemics than facts. I am tempted, therefore, to think that the extreme negative sentiment around China is unlikely to last for too long. That was one big “reversion to the mean” argument!

So how will India and China fare in 2022? There are plenty of cool heads that will point to some facts that might support continued India outperformance. First, is the likely temporary nature of inflationary pressures and the fact that, even in the midst of an inflation spike, India’s macroeconomic numbers look good. Second, it is undeniable that China’s monetary policy up to this point has been rather tight and has not loosened as quickly as it might have, given the government’s desire to continue to reign in the property market.

The regulatory push by the Chinese government will impose costs on many businesses (though it will provide opportunity for others) and this is not a temporary phenomenon. It is simply an attempt to make capitalism work for the broadest number of citizens. As such, it is no different in intent to the social programs of Western democracies; whereas China is no democracy, its government could not be accused of being dysfunctional—it is just reflecting (with some missteps) the desire of its citizens. But this is a permanent reality in China.

A Catalyst for Emerging Markets

Are there any catalysts for better market performance on the horizon? Well, yes there are. But it comes with a big “Whaaaaat?” attached. China will, I believe, loosen monetary policy. I am sure that the Chinese authorities are sitting on some unpublished economic activity numbers that look very close to zero on a year-on-year basis. No one really knows what the GDP number is, of course; I believe China’s statisticians do the best job they can. However, China’s fourth quarter 2021 macro numbers are going to look weak and the authorities will likely loosen policy. Indeed, there are already signs that they are. I think that this is likely to spur a more positive economic and market cycle for China.

We’ll get the usual concerns about “Japanification” of China, which is essentially saying that China’s aging population may make it hard to mobilize enough investment and consumption demand to offset the high level of desired savings, resulting in unemployment. This is not an unfounded concern. However, China has a roadmap to deal with it: invest overseas to build the labor-intensive manufacturing in Southeast Asia and Central Asia; build up state spending and welfare systems; and tax the rich (who are more likely to save) and give to the poor (who are more likely to spend). The one crucial lesson that China must learn from Japan is to maintain an easy monetary environment. It may be that in 2022, Chinese bond yields are trending lower, price to earnings ratios trending higher and corporate earnings start to rebound. That’s not a bad environment.

China’s roadmap for mobilizing investment and consumption may also help other emerging markets. The pace of Chinese investment abroad will pick up and that obviously favors countries in Southeast Asia, such as Malaysia and Indonesia, and particularly Vietnam, which is proving to be one of the great economic stories. China’s increasing overseas investment will also boost emerging markets in Latin America in terms of demand for raw materials. This in turn will help these economies invest in their domestic infrastructures.

The nation’s goal of “common prosperity” will also bring more purchasing power for its poor. China will continue to become a bigger market for emerging markets to sell into, and industries like tourism and healthcare in other parts of Asia will benefit from increased Chinese consumer spending. 

Anything Goes for 2022

In 2021, emerging markets benefited generally from the rally in raw materials and energy. Russia stands out thanks to the price pressures in the oil sector. Latin America markets also benefited though some countries were a little disappointing. Brazil, for example, has its own fiscal and political challenges while Mexico still seems to lack that boost to growth that some of the Asian economies have. That said, Latin American economies may perform well in 2022. Mexico, for example, has put a lot of work in to stabilize the macroeconomic numbers.

But 2022 is probably not a year to be thinking about continuing trends in the markets. There's just so much going on in terms of the recovery from lockdowns and potential policy responses. The biggest question is what will happen to inflation. That will hinge on the reaction of the Federal Reserve, from which global central banks often take their cue. There is scope here for errors of judgment from the Fed in either being too tight or too loose—it is a precarious situation. I would caution against tightening. I have always thought that the inflation spike would be temporary—once the reality of lockdowns was clear, the question of what happens when we emerge became paramount.

It seemed to me then and now that the key is that stimulus would be large and, crucially, demand would come back more swiftly than supply. This seems to be the case. Although the latest inflation numbers in the U.S. look scary on a year-on-year basis, when you look quarter-on-quarter, they have already started to moderate. It is true that breakeven inflation expectations from the bond markets are above the 2% level, even on a 10-year horizon, however, even these markets suggest that the inflation spike is a temporary one. Politically, can the Fed withstand the pressure to raise rates? I hope so, because that will probably be best for the economy.

If the Fed can absorb the pressure to raise rates that will likely continue to be supportive for Latin American performance and for some of the more cyclical sectors. However, these trends in favor of the cyclical parts of our markets—if I am right about the temporary nature of inflation—are on shaky ground. My contrary mind cannot help but believe that there is a switchback coming! This has been an unusual recession—as we all sat at home, not eating out, but still buying gym equipment to rust away in our garages.

Consumer services and staples never recovered while discretionary spending soared. That’s the “wrong way round.” I believe there are some cheap-looking discretionary stocks that are actually expensive because earnings are abnormally high; there are also their “anti-matter” counterparts in consumer services and retail. In 2022, cyclical sectors may weaken while the conditions for more secular sectors may become more favorable. And I do think the fear factor has hit some of the mega-cap China companies too hard and there is some value there, although I will admit that across all emerging markets, the likely robust pace of nominal GDP growth will favor small caps.

Finally, let’s not forget Japan. It has produced pretty strong earnings and market performance ever since the introduction of policies by Bank of Japan’s Governor Haruhiko Kuroda. It has tilted back to deflation in 2021 but Japan also benefited from the manufacturing cycle and global inventory rebuild. This seems likely to continue for a while and as always seems to be the case in Japan, there is still plenty of room for monetary stimulus. That reflation should start to impact domestic demand. Next year, I believe, should see an environment that favors smaller companies.

Looking back, it’s been a volatile few years. As the pendulum swings too far one way, thus it will ultimately swing sharply back the other way. I wish it were as neat as this! But I do think 2022 will be a year where having a bit of contrariness may help. Of course, we don’t try to time these cycles—we’d just get financial whiplash. However, if we can forecast reasonably accurately the long-term operational success of a business, then excitable markets like these sometimes offer up surprising opportunities—let’s hope for that in 2022.