A Winding Road to Normality

In our assessment, 2022 is likely to see policies start to return to more 'normalised' settings, resulting in more modest equity market returns, with somewhat greater volatility than in 2021.

We expect economic growth in 2022 to stay well-supported, above its long-term trend, with H1 likely stronger than H2. The Fed is likely to start hiking interest rates by H2, but the level of central bank policy is likely to remain far from levels that hold back equity markets. The U.S. and Europe are likely to lead global growth, while China is likely to manage a soft landing.

The inflation debate, though, is unlikely to abate quickly. As a base case, we side with a view of moderating inflation. While many supply constraints are likely to extend into the early part of 2022, these are likely to ease as supply catches up and demand growth softens from 2021’s historically high levels. This could still leave U.S. inflation in the region of 3%, though we believe this is unlikely to excessively concern the Fed unless signs of a wage-price spiral emerge, inflation expectations reach a new high or there are other signs of broadening inflation.

A significant upside inflation surprise, a policy over-tightening error, a significant geopolitical event or a vaccine-evading COVID-19 variant are key risks to our base scenario. Against this backdrop, we lay out the following investment strategies:

#1 Equities and Gold Expected to Outperform Investment Grade Bonds and Cash

Q1 2022 marks two years since the start of the pandemic-driven recession, and markets are likely well beyond their initial recovery surge. We expect equities will still outperform bonds and cash in 2022, but at a more modest pace than 2020-2021 and with somewhat higher volatility.

This is not unusual, but characteristic of a more ‘normal’ environment for equities outside of recession-recovery years. Equity earnings growth is likely to be the main driver of returns, with history demonstrating equities perform well in the 6-12 months ahead of the start of a Fed rate hiking cycle.

Our preference for gold, though, is driven by a variety of factors. First, it offers an attractive hedge should inflation prove to be higher, or longer lasting, than we expect. Second, we expect it to offer some mitigation against bouts of equity market volatility. Third, modest USD weakness should eventually offer a pillar of longer-term support for gold.

#2 Strategies Within Equities are Expected to be Increasingly Important for Equity Allocation Performance

We have a regional preference for the U.S. and Euro area, going into 2022. Our preference for Developed Markets (DM) over Emerging Markets (EM) is driven by three factors. First, we believe the U.S. and Euro area are in a relative sweet spot characterised by strong growth (which supports earnings) and supportive policy levels.

Second, while consensus economic and earnings growth expectations are beginning to turn in favour of EM over DM in 2022, we believe three conditions for an equity market rotation towards EM – USD weakness, a significant turn in Chinese policy direction and an economic recovery led by widespread COVID vaccinations – are not imminent. Having said that, we would be on watch should these conditions change and start pointing to a rotation into EM equities.

Third, gradually rising volatility, combined with still-attractive stock and sector dispersion, means equity long/short alternative strategies can offer an attractive risk/reward. Also, we would consider using volatility to generate income, especially when volatility temporarily spikes.

#3 Minimising Interest Rate Sensitivity and FX Risks Key for Bond Investors.

We expect bonds will largely deliver returns in line with the yield on offer in 2022, with the avoidance of downside or defaults being key. Our first preference is for Asia USD bonds. The bonds offer attractive value for an asset class with relatively high credit quality and low interest rate sensitivity, in our view. Within this, we like HY bonds. Default concerns remain elevated, although we balance this with the historical learning that periods of inexpensive valuations led to very attractive returns for most HY markets worldwide on a 6-12-month horizon, even if timing the precise asset class trough was difficult. A softening of China’s policy stance is likely to be the trigger for recovery.

Our second preference are U.S. and Euro area HY bonds. While valuations are relatively elevated, we note HY bonds, being risky assets, have historically outperformed their higher quality peers as the Fed embarks on a rate hiking cycle. HY bonds also have lower sensitivity to rising interest rates, a key characteristic we prefer in 2022. Rising interest rates hurt firms with the weakest credit quality the most, but we do not expect policy to come close to that point next year.

In terms of managing currency risks, though, the USD index’s strong upward momentum is difficult to ignore. This, together with rising short-term U.S. bond yields and expectations of a Fed policy lift-off, means USD strength has room to temporarily extend over the next 1-3 months. In bonds, this is behind our preference to minimise exposure to FX risk.

Beyond this horizon, though, it is equally difficult to ignore fundamentals that point to a weaker USD over a 6–12-month horizon. The USD is expensive from a valuation standpoint and relative yield differentials have room to move further against the greenback once a Fed cycle is fully priced in and attention moves to an eventual policy shift outside the U.S. A move towards greater outperformance of non-U.S. equity and bond markets may very well catalyse a turn in the USD later in 2022.

#4 Position Multi-Asset Income Strategies for Modest Equity Returns and Inflation Risks

Rising policy rates (we expect one Fed rate hike in 2022) and modestly higher bond yields are likely to be positive for income strategies by raising the yields on offer across income asset classes. In 2022, though, we would look to adapt income strategies to account for more modest equity returns and the risk of higher inflation and bond yields.

Within high dividend equities, we have a modest preference for Europe, given the more attractive yield on offer compared to other regions. We also add a tilt towards covered call strategies given their usual outperformance in modest equity return environments.

Within bonds, Asian HY bonds are likely to add both yield and price returns over a 6–12-month horizon, while a tilt towards subordinated and floating rate bonds is likely to offer attractive yields and, in the case of floating rate loans, some mitigation against inflation and interest rate risks.

#5 Tailor Opportunistic Allocations Around Sector Strategies and Our Longer-Term (3-5 Year) Themes

Our four views on core foundation allocations notwithstanding, we believe an additional opportunistic allocation can help take advantage of more tactical or thematic opportunities.

In terms of sectors, in the U.S., we prefer the technology sector. Rising bond yields could still pose a headwind for technology, but we believe the positive earnings growth outlook is likely to more than offset this. In China, we prefer consumer discretionary and industrials. Regulatory risks for the consumer discretionary sector are likely past their peak, allowing a refocus on growth prospects. Industrials, meanwhile, align with policy priorities.

In Europe, we prefer the technology, consumer discretionary, industrials and financial sectors. European financials are likely to benefit from deep value and easy ECB policy delaying a flattening of the European yield curve (ie. narrowing of the 10-year-2-year government bond yield gap).

Longer-term (3-5 years) strategic equity allocations are likely to benefit from a thematic approach. First, ‘The Winds of Climate Change’ theme is likely to be a key focus, within which we favour water scarcity, electric vehicles (EVs) and infrastructure/green capex as investible areas. Second, our ‘Embracing a Digital Future’ theme captures investible opportunities in 5G/Internet of Things (IoT), cybersecurity, fintech and blockchain. Third, China’s ‘Common Prosperity’ favours high-tech manufacturing, green energy, and internet companies.

Steve Brice is Chief Investment Officer and Manpreet Gill is Head of FICC Strategy at Standard Chartered Bank’s Wealth Management CIO office