As is customary at this time of year, analysts start to publish their economic and market forecasts for the following period. From a top-down perspective, sell-side strategists (and many of the large buy-side firms) will construct index or stock price targets from EPS forecasts driven by GDP, inflation, and interest rate projections from their economists. In simple terms, the forward-looking index return can be a simple function of the P/E valuation multiple multiplied by the index EPS estimate. Or stated another way, the current dividend yield plus growth and the change in valuation. Of course, the challenge is that human beings cannot see the future. Even if we could accurately estimate the earnings per share on a company or index, the valuation multiple could be wildly different depending on the change in risk perceptions and discount rates. The big picture point is that building portfolios based on a set of forecasts is challenging, even with hindsight.
In that context, what we attempt to focus on is large asymmetry (skew) in valuation, risk compensation, positioning and consensus beliefs. Stated differently, rather than attempt to forecast what might go right, we aim to identify what is probably wrong. In addition to a large valuation anomaly, our definition of a behavioural episode is when price has been driven by emotional rather than underlying fundamentals and where there has been a focus on a single story.
Clearly, the pandemic has been the single-story for most investors over the past 2 years and has contributed to some of the large valuation anomalies on a cross-asset and intra-market basis. However, another important episode in this region has been the regulatory crackdown in China and distress in Asian high yield credit. On a global basis, exceptionally accommodative policy and reopening of the economy has exacerbated demand-supply imbalances in product, labour markets and put pressure on global supply chains (especially in the energy markets).
There has been a potential shift in the post-2008 secular stagnation regime from permanently lower growth, inflation and rates to a higher inflation and interest rate regime. That is open for debate, but what we do know is that if the regime has changed, bond risk premiums and cross-asset volatility are under-priced or too low. Other long-duration assets, growth equity (based on the hopes and dreams of profits well into the future) and/or highly levered companies would also be vulnerable to a shift in the regime.
Of course, even if the regime has not changed, highly expensive and speculative assets can still be vulnerable to a renewed growth scare, albeit that would probably benefit mega-cap US tech with strong cash flows, balance sheets and monopoly-like market share. As we noted earlier last week, our sense is that the prevailing bias among most investors, analysts and central banks is that longer-term neutral or terminal rates have not changed at around 2.5%. Indeed, some would even argue that they are lower and therefore will not be disruptive for asset markets. However, the inherent contradiction in the low rate regime as a justification for elevated equity valuation is that it also implies lower trend growth, profits and therefore returns.
In that context, we outline the non-predictions for 2022. This is a combination of the largest valuation asymmetry (skew) and divergence between consensus beliefs and underlying fundamentals. The common thread is where there is vulnerability and upside from a potential shift in the interest rate regime. However, our sense is that most of the observations below would likely perform well even if the existing regime persists and macro conditions remain relatively benign. The greatest risk to many of the non-predictions below would probably be a renewed growth scare or recession. To be fair, some of the markets below (e.g. Asian High Yield) are already priced for recession or distress. We will provide more detail and context for each of the non-predictions below over the coming weeks.