MON, 03 JAN 2022
Welcome to 2022 and hopefully to a prosperous new year. It is an obvious point, but we should generally endeavour to focus on the future; after all, money is made in financial markets by anticipating what will happen, not by explaining the events of the past. Of course, none of us have a crystal ball, so rather than attempting prognostications, we prefer to focus on where risk (both upside and downside) appears under-appreciated or mispriced.
What we do know is that 2022 is likely to be a transition year for the global economy, policy and public health. The recovery from the pandemic lows in 2020 through 2021 coincided with an acceleration in growth, profits and was supported by QE, credit easing, zero rates and expansionary fiscal policy. That was bullish for US equities and credit.
Looking forward, the opposite is true in the United States. QE will end in March and policy rates are likely to rise 3 or 4 times. While equity returns still tend to be positive in the months leading up to and following the first Fed rate hike, valuation multiples tend to de-rate. On the positive side, the real damage from higher rates tends to occur later in the cycle when tighter policy flattens or inverts the yield curve. A potential risk in 2022 would be faster-than-expected withdrawal of liquidity given decelerating growth and rich asset valuations. Macro conditions will not be as bullish for equities in 2022. Broad US financial conditions have already turned, consistent with a deceleration in growth (chart 1).
In that context, the extremely low starting point (level) of financial conditions, suggests credit volatility is materially under-priced. By contrast, implied equity volatility is more neutral in the United States. Put another way, the cost of protection for the implied payoff is more attractive in US investment grade credit than it is in equities (chart 2).
One of the key trends in 2021 was the outperformance of the United States, particularly relative to emerging markets and Asia (chart 3). The large underperformance of Asia was due to MSCI China (down over 22%). From our perch, the underperformance was primarily due to earlier tightening of credit and liquidity that commenced in Q4 2020, combined with the regulatory crack-down and US dollar strength over the past year
On the positive side, there appears to have been a policy pivot in early December that will likely see a reacceleration in liquidity over the coming quarters (chart 4). The credit impulse appeared to trough in October/November 2021 which augers well for China and regional equities. We would also note that re-opening stocks actually outperformed in December and the emergence of a fast-spreading but significantly less harmful COVID variant is the most plausible end to the pandemic and return to normalcy.
While it has been a fruitless endeavour to call the end of US exceptionalism over the last decade, what we do know is that Asia Pacific is now trading at a 65% discount to the United States and the largest since after the Asian crisis in 1998 (chart 5). US outperformance has been warranted by superior profits, particularly in the mega-cap technology/internet/consumer sectors. However, looking forward, the potential growth opportunity likely resides elsewhere. Stated differently, Asia Pacific has positive asymmetry from the current valuation starting point. In contrast, US equities are vulnerable to not meeting lofty expectations. Finally, in an environment where QE ends, rates rise and growth decelerates, investors ought to have a preference for high free cash flow, low balance sheet leverage and inexpensive valuation.