Growth…with inflation?

6 min read 15 Dec 21

Summary: Risk assets tumbled in November as markets digested the likely impact of the COVID-19 ‘Omicron’ variant. The good news is that corporates are in decent shape heading into 2022, but a number of risks remain. Investment Specialist, Kirsty Clark reviews recent market performance and the challenges contributing to rising uncertainty into year-end.

Equity markets lost ground in November as fears over the impact of a new COVID-19 ‘Omicron’ variant rattled investors. The MSCI AC World Index ended the month down 2.4% in US dollar terms. Growth outperformed Value, and large caps outperformed their small cap counterparts. At a sector level, energy and financials took the biggest hit, along with travel and leisure stocks. Information technology was the only sector to gain ground in the month.

Regionally, the UK and Europe were the laggards, weighed down by banks and energy. US equities were relatively resilient, propped up by outperforming tech stocks. The NASDAQ indices and Chinese A shares were among the few indices to secure positive returns in November.

As risk appetite faded, the flight to safety boosted government bonds. UK, German and Italian 10-year government bonds led the gains in local currency terms (although, German and Italian 10-year bonds were down in US dollar terms as the greenback strengthened). US 10-year treasuries also gained ground. Both investment grade and high yield finished flat or marginally down, as risk aversion extended to the credit markets. In commodities, Brent crude dropped by more than 16%, finishing just above $70/barrel on the back of demand concerns. Gold also finished down as the Dollar index strengthened.

Source: Refinitiv DataStream, 30 November 2021. Total Returns in USD.
 

Off the back of a robust third-quarter earnings season, corporates are in decent shape heading into 2022. Despite broad equity market gains year to date, aggregate valuations remain reasonable relative to other asset classes, while ample liquidity, solid demand and a pick-up in activity continue to provide a supportive backdrop for growth. We anticipate a continuation of above-average equity market return dispersion next year amid ongoing pandemic-related uncertainty, so selectivity will be key. Inflationary pressures and an unwinding of monetary stimulus are potential headwinds in 2022, with a further squeeze on corporate margins on the cards. Companies exposed to structural growth trends, and those with strong balance sheets and pricing power offer greater resilience, and should provide a buffer and in the face of these headwinds.

While there is some evidence that supply-chain disruptions are easing as factories in Asia reopen, energy shortages dissipate and shipping costs (raw materials freight costs and container ship charter rates) come off recent highs[1] – localised bottlenecks remain, due to ongoing port-capacity issues and truck-driver shortages in importing countries. Businesses with complex global supply chains remain most vulnerable to multiple localised disruptions.

Source: Refinitiv DataStream, 10 December 2021. USD. The Baltic Dry Index records the average freight rates for transporting raw materials/dry commodities across four vessel sizes and more than 20 shipping routes – an early indicator of economic developments. The HARPEX Index calculates the charter rates (ship rents) for container ships to transport semi-finished or finished products – an indicator of the current state of global trade. The charter rates are assessed weekly for 6-12 months fixture periods on the basis of actual weekly fixtures reported and Harper Petersen’s own market assessment.

Based on third-quarter corporate earnings commentary, companies are still citing supply-chain challenges in meeting demand. Over 340 S&P 500 companies mentioned ‘supply chains’ during third-quarter earnings calls[2]. The reinstatement of travel bans, and further potential mobility restrictions in the wake of the Omicron variant, could lengthen disruptions into year-end and hinder labour market normalisation.

According to a recent J.P. Morgan analyst survey[3] looking at companies with significant supply-chain issues, most expect to combat rising costs by pushing these through to consumers. Disruptions for these companies are driving leaner inventories, but the majority expect bottlenecks to delay rather than erode demand. Many companies expect supply-chain issues to normalise by the second half of 2022, but risks remain. Macro-economic uncertainty, rising geo-political tensions and virus unpredictability all have the potential to create a more challenging backdrop for companies and weigh on corporate margins.

The uncertainty is also ensuring that inflation concerns – predominantly in the US – continue to loom large as we head into year-end, with expectations that the US Federal Reserve will tighten monetary policy earlier and faster than previously predicted given the uptick in inflation prints and recent change in tone from Fed chair Jerome Powell. Meanwhile, the International Monetary Fund has urged the Bank of England ‘not to delay’ raising rates given strong demand and a potential near-term inflation spike.

There are certainly reasons to be optimistic about the prospects for equity markets and economic growth in 2022 (economic growth expectations have stabilised, corporate earnings forecasts remain robust and cash balances are in good shape). However, any central bank misstep could usher in a more challenging period for corporates.

 

[1] https://www.wsj.com/articles/supply-chain-problems-show-signs-of-easing-11637496002

[2] https://insight.factset.com/highest-number-of-sp-500-cos.-citing-supply-chain-on-q3-earnings-calls-in-over-10-years

[3] J.P. Morgan Global Equity Strategy, 9 November 2021

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

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