In our 2022 Investment Outlook, we seek to help investors to navigate the rapids as the global economy stabilises during the next phases of the economic recovery. We also consider the possible broader consequences for macroeconomic policy as the world tackles the social and economic challenges laid bare by the pandemic.
For the full outlook, continue reading below, listen to the audio or download the PDF (with extended macro analysis).
Executive summary
Macroeconomics and markets
In this section, we highlight that:
- While some production constraints will remain well into 2022, they will be resolved eventually, enabling economies to revert to trend growth rates without generating higher inflation.
- Substantial accumulated household savings mean consumers have the resources to go on a spending spree that could have inflationary consequences. If, however, the after-effects of living through a global pandemic inhibit consumption, central bank and state support may be needed to encourage demand.
- We expect the momentum behind rising wages to fade as employers adjust processes and invest capital to reduce their dependence on labour. Today’s relative weakness of organised labour means comparisons with the 1970s are inappropriate.
- Equities will struggle to generate above-average returns in 2022. European equities look set to make up lost ground with their US peers. One of the critical calls will be whether value stocks can begin to reverse their underperformance of the last several years. The wide valuation gap between value and growth stocks and the prospect of higher interest rates suggest upside is ahead.
- While intransigent inflation is likely to lead the US Federal Reserve to raise policy rates several times in 2022, we expect only a short cycle of increases in key rates. The upside of longer-term US Treasury bond yields should be limited by capped inflation expectations and the size of the Fed’s balance sheet keeping real yields low.
A sustainable recovery
We devote a significant section of our outlook to the opportunities we believe the green economic transformation can offer investors.
The current crisis is a reminder that we as investors must align investing with the realisation of sustainable long-term growth. Investing for the long run will be crucial, because the typical 3-5 year investment cycle does not match the lifespan of financing the shift to green hydrogen or the innovation required to achieve e-mobility, restore natural capital and build green infrastructure.
Investment themes for the long run
Our investment themes for 2022 have both a sustainable angle – energy transition and environmental sustainability – and a focus on long-running trends including healthcare innovation and disruption via new technology.
Our regional spotlight focuses on China, the world’s fastest growing major economy, home to many innovative companies and a market that increasingly warrants a standalone allocation within multi-asset portfolios.
Macroeconomics and markets – Shooting the rapids
By Daniel Morris, Chief Market Strategist
Restarting a stalled global economy has proved an awkward exercise. The global economy is struggling to squeeze robust demand through a narrow supply channel. The restoration of supply chains, reallocation of labour, and rebalancing of supply and demand: These will be the critical factors that determine both economic growth in 2022 and the strength and persistence of inflation.
While we anticipate that supply chain and production constraints will fade eventually, labour markets may well not return to where they were before the pandemic. A smaller labour force implies less output and perhaps more wage pressure. While businesses will eventually substitute capital for labour, and productivity should improve, this will not happen immediately.
Equities
This year (2021) is likely to be the fourth consecutive year of US equity outperformance relative to the rest of the world. If history over the last 50 years is any guide, next year could see lagging returns as previous US winning streaks have never exceeded four years (see Exhibit 1).
Patterns aside, there are other reasons to foresee US equity returns falling behind other parts of the world next year. As the US opened up earlier than most of the rest of the world, much of the recovery from lockdowns has taken place and GDP growth has already surpassed pre-pandemic levels. As reopening progresses in Europe and spreads through emerging markets, economic momentum should follow.
Monetary policy, though, will tighten more in the US than in the eurozone, partly because inflationary pressures are higher as a result of the fiscal stimulus. To the degree that higher inflation crimps demand, the US may see household consumption rise at a slower rate than in Europe.
Valuations
In absolute terms, US equity valuations are high, but in our view, they do not pose a threat to market returns. Multiples have been boosted by central bank quantitative easing (QE) purchases and as long as those bonds remain on bank balance sheets and yields low, we believe multiples will be supported. On a relative basis, however, valuations for European equities versus US equities have reached historic lows (see Exhibit 2). This discount is not merely because multiples for mega-cap US technology stocks are high; most European sectors are trading at a discount to their US counterpart.
The rising premium awarded to US equities is not obviously warranted given that European equity market earnings growth and performance has kept pace with the US in 2021 and profit expectations for next year are similar, and equally modest (see Exhibit 3).
Fixed income
Inflation
We believe that significant inflationary pressures will persist into 2023, and though they will ultimately be ‘transitory’, they will be strong enough and persistent enough to force the US Federal Reserve (Fed) to tighten sooner than it has projected.
Longer-term inflation expectations remain well-anchored, reflecting one of two things: either the ‘transitory’ inflation narrative, or a belief in the credibility of the major central banks. If inflation looks to be spreading and becoming more entrenched than currently forecast, the belief is that central banks will react to it (albeit belatedly) to bring inflation back down to target. The key concern for investors then would not be medium-term inflation per se but the path for policy rates.
Policy rates
So much of what has happened in the last 15 years has been unprecedented, from the Global Financial Crisis and quantitative easing, to pandemics and lockdowns. Uncertainty about how quickly and smoothly the global economy reaches the next ‘new normal’ is reflected in interest rate volatility and divergent policy prescriptions.
We believe market expectations will be fulfilled and that the Fed will be forced to moderate its transitory inflation narrative. The US labour market looks set to reach full employment sooner than expected thanks to participation rates remaining below pre-pandemic levels, and wage pressures will rise as a result. The increase in government bond yields will be more notable out to five years than later, as near-term policy rate expectations rise more than the terminal rate. The increase in longer-term Treasury yields will be limited by capped inflation expectations and the size of the Fed’s balance sheet keeping real yields low.
Sustainability
By Alexander Bernhardt, Global Head of Sustainability Research
Does meeting the sustainable development goals require new macroeconomics?
In 2015, world leaders developed 17 Sustainable Development Goals as part of the 2030 Agenda for Sustainable Development. The SDGs set forth a blueprint for fostering a healthy planet and equitable society – both critical for a healthy economy.
Yet, while accomplishing the SDGs will benefit the economy, insufficient thinking (and action) has been invested into exploring how macroeconomic policy can support their achievement.
Achieving the SDGs and the Paris Agreement will require trillions of dollars in expenditure over the coming decade. Mobilising this capital will require a concerted joint effort by the public and private sectors and yet, so far, several traditional macroeconomic preconceptions are inhibiting the flow, in particular of public capital.
Arguably, the ‘perfect storm’ of crises – Covid, climate change, biodiversity loss and social inequality – creates an opportunity for revolutionary thinking. Exploring these themes and considering an outlook for how macroeconomic policy may evolve in the future is the focus of our contribution to this year’s Investment Outlook.
In particular, we explore two themes currently being debated in government halls and central bank boardrooms that have the potential to influence sustainable development:
- Government budgets are often managed, like in households, with the aim of ‘balancing the budget’. However, the idea that reserve currency governments with central bank funding cannot default is challenging this view.
- Central banks are often considered to be ‘independent’ players focused on their specific mandates, typically price stability and full employment. This notion is being challenged by the concept of ‘functional finance’, which argues that government fiscal and monetary policy should be managed with a view towards its impact on the real economy[1].
We explore each of these issues in the following sections.
Debt, deficits and inflation
Modern Monetary Theory (MMT) has garnered headlines in recent months for its claim that government debt levels and deficit spending do not matter as measures in and of themselves, since governments with access to a printing press cannot default on their obligations. Instead, MMT posits that the only real governor of public expenditure should be inflation.
This is generally perceived as a controversial position, for two reasons. Firstly, many economists and politicians believe government balance sheets should be managed like a household evidenced by the common refrain from policymakers on both sides of the aisle related to expensive legislative proposals: “How are we going to pay for that?” Secondly, concerns abound that large fiscal expenditures, which might be rationalised by MMT policies, would generate uncontrollable inflation.
Functional finance
For a long time, monetary policy in particular has been focused on nominal budgetary goals with limited emphasis on the distributional or environmental impacts of related actions. Indeed, many central bankers are ardent supporters of the independence and impartiality of their institutional mandates with regard to climate or other sustainability issues.
A shift in this view is being driven in part by a recognition that impartiality is a difficult line for central banks to walk. Moreover, central bankers are increasingly aware that real world issues like climate change can have dramatic impacts on financial markets, and vice versa. Enter the Network for Greening the Financial System (NGFS) – a global group of over 90 central banks and supervisors[2] which convene “to enhance the role of the financial system to manage risks and mobilise capital for green and low-carbon investments in the broader context of environmentally sustainable development”[3].
SDGs, Paris and MMT
These actions and statements by monetary policymakers are arguably similar to some of the MMT precepts. While adopting these MMT-like approaches may not be intentional, they nevertheless signal a strong direction of travel in macroeconomic practice towards a more functional and fiscally coordinated remit for central banks.
It is a lack of urgency that puts us all at risk. We must use the tools at our disposal – including macroeconomic thinking and policy – to usher in a more sustainable future.
To read our full analysis of how macroeconomics could evolve to achieve the Sustainable Development Goals, click here.
Investment themes
Our investment themes for 2022 have both a sustainable angle – energy transition and environmental sustainability – and a focus on long-running trends including healthcare innovation and disruption via new technology.
Our regional spotlight focuses on China, the world’s fastest growing major economy, home to many innovative companies and a market that increasingly warrants a standalone allocation within multi-asset portfolios.
Environmental thematic investing set for strong growth
By Ulrik Fugmann and Edward Lees, Co-Heads and Senior Portfolio Managers, Environmental Strategies Group
While 2020 was one of the best years on record for pure environmental thematic investing, with the theme up by more than 100%, it saw a significant – and healthy – consolidation in 2021. The segment underperformed broader markets by 31% (as of end of October) relative to the MSCI ACWI index despite company fundamentals improving significantly and regulatory and policy support bolstering its long-term outlook.
Excessive positioning at the start of 2021 in passive exchange-traded funds (ETFs) and a marked rise in interest rate and inflation expectations penalising long-duration growth assets primarily drove the theme’s underperformance.
Furthermore, inflation resulting from what we see as transitory supply bottlenecks combined with a significant rise in freight rates led to market concerns over margin and profit compression.
Finally, we are finding that investors are struggling to arrive at appropriate approaches to valuing the type of innovative companies generally associated with thematic growth. The Environmental Strategies Group applies top-down total addressable market models, technology life cycle theory and long-term discounted cash flow modelling to assess the value of innovative companies in this space.
Attractive valuations
In late 2021, positioning in the environmental thematic universe had fallen to at its lowest in three years. Meanwhile, companies in the segment generally had one of the best earnings seasons in 20 years in the context of demand vastly outstripping supply.
Valuations for our energy transition innovation universe are now at less than half those of equities in the US Nasdaq index, while having more than 1.7x the earnings growth (3-year compound annual growth).
It should come as no surprise that as we look ahead into 2022, we are upbeat on the environmental theme relative to broader equity markets that are likely see volatility amid the push and pull of monetary policy actions, the pace of interest rate moves and earnings growth developments. This dynamic should be positive for our environmentally themed long/short absolute return strategy that typically thrives in uncertain and volatile markets.
Stock selection will be crucial in 2022
2021 has seen a historically wide dispersion of performance at the sector level, with the MSCI World Integrated Oil & Gas and MSCI World Financials indices up by 41% and 31%, respectively, while the MSCI Global Alternative Energy index fell by 7%. This in turn has created significant volatility and dispersion between the growth and value styles.
We believe that 2022 could see a substantial reversal of this pattern: While we have subscribed to peak oil and prices overshooting, we believe that oil market rebalancing in combination with demand destruction is likely to see oil prices retrace over the medium to longer term. In view of the volatility in gas and power prices, the world has woken up to the need to accelerate the build-out of renewable energy infrastructure, including wind, solar, energy storage and hydrogen. This is needed to both decarbonise economies and achieve energy and geopolitical security.
With population growth still accelerating and, along with climate volatility, increasing the pressure on global food systems, food price inflation is rising. This in part is why investing in the restoration of the world’s lands and oceans has become a top priority for policymakers. It is also a core theme within our ecosystem restoration strategy at BNP Paribas Asset Management.
Thematically, we see the most attractive investment opportunities in companies that operate with significant competitive advantages, particularly in segments that have high barriers to entry. We also prefer platform businesses that can gain a meaningful operating advantage from upselling and service revenues compared to manufacturing and intermediary goods companies in more commoditised parts of the supply chain, where competition and margins are tighter.
Thematic investing can help deliver on the COP26 priorities
The UN Climate Change Conference COP26 has taken encouraging steps towards additional major climate pledges and policy agreements to further the development and deployment of technologies that can help deliver a significant reduction in CO2 and methane emissions, as well as restore and protect the world’s natural capital.
The principal areas of focus at COP26 included:
- Green hydrogen
- Residential solar energy
- Offshore wind energy development
- Energy storage to reduce carbon emissions
- Practical packaging solutions to reduce plastic pollution
- Land-based fish farming to address fish depletion
- Sustainable farming methods to protect the world’s soils.
All these areas are investable themes covered by the Environmental Strategies Group at BNP Paribas Asset Management
Distancing sparks even brighter future for disruptive tech
By Pamela Hegarty, Portfolio Manager and Senior Equity Analyst, US Equities & Vincent Nichols, Investment Specialist, US and Global Thematic Equities
Disruptive trends in technology were already widespread when the pandemic-led social and economic lockdowns triggered a seismic shift in the way we work, buy and communicate. The abrupt transition to socially distant lifestyles has accelerated these trends and sparked booming demand for technology and innovations to support virtual solutions for many everyday interactions.
Many of the digital solutions that have made social distancing both possible and more bearable have presented us with an easier way of life, even when compared to pre-pandemic times. The pandemic has simply sped up a transformation that had otherwise been more likely to evolve over many years.
Remote working unlikely to go away
Flexible working practices have been around for some time now, and the widespread adoption of remote working is unlikely to be reversed significantly once the pandemic abates fully. The pandemic has also given rise to an uptick in automation, particularly in service industries where social distancing kept many workers away from the workplace for months.
E-commerce has mushroomed, boosting web advertising and electronic payment services. Significantly, it has created a boom in physical and automated warehousing and home delivery. More companies can be expected to integrate their physical and online channels; augmented reality help provides for an easier and more enjoyable shopping experience; and dynamic pricing adjusted for consumer demand looks set to boost earnings and revenues.
Tech tools to overcome complex problems in many sectors
Big data, artificial intelligence, data analytics and cybersecurity are all now seen as essential tools to help overcome the complex economic, demographic and societal problems that many sectors face. The digital transformation has become inevitable across society, and nations need to act to prevent the digital divide in their populations from widening.
As with each iteration of the digital evolution, 5G tech is set to transform how we use technology. Its superior speed and scale is expected to open up the market for smart connectivity in homes and businesses further, as well as involve the greater use of big data, AI and the automation of vehicles.
The USD 1.2 trillion bipartisan infrastructure bill recently passed by Congress in the US will be another catalyst. The provision of satellite broadband is also well under way, and promises to extend global internet coverage to rural and remote areas that are not currently well served. This would be transformative for communities particularly in the developing world.
With regulators scrutinising each company, so should investors
Globally, the tech sector faces increased regulatory scrutiny concerning data privacy and the monopoly power of some of the largest platform providers. China has recently seen increased tensions between the government and several tech giants.
In the US, these issues have bipartisan attention and regulatory efforts are gaining momentum. The proposed legislation would usher in sweeping changes both in the way anti-trust regulations are enforced and in how companies run and supervise their platforms. The commercial impact on profitability may vary considerably among the affected targets, so we believe fundamental analysis of individual companies is crucial to assessing the impact on investment cases.
Another concern could be the persistent supply chain shortages and disruptions. These may continue to affect operations for technology companies, particularly those that provide physical goods. To date, Covid shutdowns remain an area of uncertainty. Adding semiconductor supply will be slow due to the time it takes to build and equip new factories. It will also take time for companies and countries to resolve the constraints on shipping and logistics.
However, we expect semiconductor demand to moderate with less consumer-oriented stimulus. Some of the constraints should lift as the year progresses, resulting in supply progress.
Underlying growth trends should outplay short-term inflation
What of inflation and higher interest rates? Potential weakness in bond markets poses a risk to higher growth technology names with longer-term future discounted cash flows. In the event of protracted above-trend inflation, tech stocks could underperform, but we expect this to be short-lived given the strong growth trends centred on areas such as cloud computing, automation and the Internet of Things. We seek to mitigate the risk of inflation and higher interest rates through managing position sizes and by balancing high-growth, high-valuation names with investments in more stable growth companies with compelling valuations.
Tech sector relative valuations are currently higher than historical norms in some areas, including high growth software. However, we believe the sector deserves a premium multiple versus the broader market due to its improving returns on invested capital (ROIC) and its superior growth prospects.
We expect persistent strength in IT spending and in industrial and car sector demand for chips and components. Experts predict robust global IT spending will moderate, but remain at a high level of growth in 2022. Gartner forecast 9.5% higher corporate IT spending globally in 2021, followed by 5.5% in 2022 (October 2021, Gartner Inc.). Based on surveys of IT professionals, top spending areas include cybersecurity, cloud migration, collaboration tools, and data analytics. These areas line up well with our view on the top secular growth themes and foundational technologies.
China outlook – Some unconventional thoughts
By Chi Lo, Senior Market Strategist APAC
While there appears to be a large degree of market consensus on China’s GDP growth in 2022, there is less clarity on the three to five-year outlook. A raft of issues could slow growth momentum in 2022. They range from a high base effect from 2021, slowing export growth, further regulatory reform and the country’s ‘zero-Covid’ policy to carbon emissions control and a cooling property market. There is also a lack of ‘animal spirits’ to spur private investment due to policy uncertainty.
Avoiding unhelpful policy signals
Cautious tweaks to macroeconomic policy would only partly offset these headwinds. Beijing’s tolerance for slower growth appears to have grown as it accepts that this is a price that must be paid when prioritising debt reduction, cutting carbon emissions and implementing further reforms. For 2022, the government’s economic management looks set to focus more on resolving structural problems and supply-side disruption, notably power shortages, surging energy prices and producer price inflation.
Given these objectives, the People’s Bank of China is highly unlikely to open the monetary floodgates as it will be keen to avoid sending out policy easing signals that could fuel inflation and derail the government’s debt reduction and ‘Go Green’ efforts.
Structural considerations in the growth debate
Conventional wisdom argues that China’s annual GDP growth would fall to 4%-5% in the next three to five years. However, the market may have overlooked the impact on the outlook of the return of industrialisation alongside structural changes.
The manufacturing sector has regained policy favour under Beijing’s new reform tactics. These favour high-value manufacturing and hard tech production over traditional manufacturing and soft tech investments. Hard tech refers to the production of hardware and components that cater for the country’s strategic and high-tech development; soft tech refers to the development of e-commerce catering for non-strategic consumption demand.
China’s domestic sector started a slow rebalancing in 2005. This involved reducing costs and improving infrastructure to drive industrialisation towards poor inland provinces (Exhibit 1). The strategy resulted in a regional division of labour, with the expensive eastern region moving from manufacturing to high value-added services industries and cheaper inland regions picking up low value-added manufacturing. This industrial migration could generate a momentum that could maintain China’s average GDP growth rate at above 4%-5% beyond 2022.
However, the migration process has reversed since 2013 (see Exhibit 1) when Beijing refocused on shifting the drivers of economic growth from investment and manufacturing to services and consumption. This move led to a rise in the tertiary sector’s share of GDP at the expense of the secondary sector. Overall GDP growth slowed, reflecting Beijing’s policy at the time to trade off a slower GDP growth rate against higher growth quality.
Under this reform approach, industrial migration to the interior provinces is likely to resume, with high-value-added industries dominating. The government’s efforts to achieve carbon neutrality by 2060 are set to open up new growth sectors and investment opportunities to replace the ‘sunset’ sectors.
Investment opportunities in new industries
China needs to upgrade its electrical grid infrastructure and develop energy storage systems to improve energy supply and distribution. It also needs to wind down its fossil fuel consumption by using more green electricity and achieve a structural shift from energy-intensive heavy industry to high value-added segments to boost energy efficiency. New-sector investments are estimated to amount to RMB 5 trillion (USD 781 billion) a year – about 10% of China’s annual total fixed asset investment – over the next decade.[4]
Mobilising private capital is crucial to support investment in the ‘Go Green’ areas. Together with hard tech development, this should revive China’s GDP growth momentum and raise the country’s medium-term productivity. Time will tell how well these trends evolve, but they already provide useful food for thought when assessing China’s growth outlook and thus how investors can best position their 2022 investment strategies.
Financing economic growth with private debt
By David Bouchoucha, CIO Of Private Debt & Real Assets
Listed assets no longer suffice to build an investment portfolio. Private debt is becoming a central element among allocations.
Despite recent concerns over a possible weakening of economic growth and intransigent price pressures, the broad picture at the end of 2021 remains clear: Conditions in the G7 economies are picking up thanks to fiscal and monetary stimulus, with a corollary of equity markets retesting their all-time highs, while interest rates remain low.
A hybrid financing of the economy
At this time of unattractive valuations for equities and expensive bonds, private debt can be a suitable alternative. For the same level of risk, it offers investors a liquidity premium relative to listed bonds. This explains why inflows into private debt have been so strong – amounting to USD 120 billion in the first half of 2021 in Europe (source: Preqin).
A broader group of investors is now allocating to private debt. Insurers, attracted by favourable treatment under Solvency 2, led the way. They are increasingly being joined by pension funds, sovereign wealth funds and even individual investors. Many institutions have permanent allocation programmes at 10% or 20% of their portfolios, sometimes above 40%, with a balance between private equity, real assets and debt.
Of course, private debt does not escape the debate over the impact of excess liquidity on risk premiums. The amounts of dry powder are contributing to the pressure on credit margins. However, liquidity premiums have remained intact because demand for financing has also been rising.
Growth driven by the explosion in merger and acquisition activity is fuelling the financing needs of European mid-capitalisation companies. The infrastructure needs related to the energy and digital transitions are huge, particularly at the intersection of information technology and traditional infrastructure: Battery electricity storage, smart infrastructure (networks, cities, roads), and data processing and transmission.
Separately, Basel Committee rules are putting additional constraints on banks’ balance sheets. As a result, private debt has become part of a complementary financing model for banks and investors in Europe.
A triple imperative
The contribution of private debt to financing growth is in itself an attractive element motivating investors. Increasingly, private debt involves respecting strict environmental, social and governance (ESG) criteria. Rightly so: financing the economy is good, financing tomorrow’s economy is even better!
Meeting ESG requirements requires significant resources and an approach tailored to each underlying asset. For our infrastructure and real estate loan portfolios, we measure the carbon and environmental impacts and, for example, the number of households gaining access to digital networks. For a small to medium-sized enterprise (SME), it involves assessing the awareness of a company’s executives of ESG themes and analysing the choices the company is making.
A further reason to invest – the search for diversification – also applies to private debt. The pandemic has shown investors that seemingly robust sectors are not necessarily immune to shocks. The risk of excessive valuations for the most sought-after assets drives us as asset managers to consider a wider range of assets. This is why we believe it is important to have a multi-sector approach in infrastructure and real estate investing. We look at a broad range of companies, applying diverse strategies among SMEs and even more granular financing with mortgages.
Finally, the search for a fair compensation for the risk taken must be at the heart of any credit decision. A classic ratio adhered to by asset managers is the case selectivity rate. We have found that many apparently good credit opportunities can be put to the side if they do not offer a fair level of remuneration. That is why we integrate into our investment process a systematic calculation of the liquidity premium based on our analysis of listed peers.
We are convinced that by meeting these three prerequisites – sustainability, diversification and relative value – we can succeed in adding value and impact to portfolios through our management of allocations to private debt.
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[1] Functional Finance Definition (investopedia.com). Note in his original conception of functional finance, Abba Lerner was primarily concerned with using fiscal and monetary policy to manage down unemployment and maintain price stability. The Modern Monetary Theory (MMT) movement has broadened this aim to ‘advancing public purpose: EconStor: Modern Monetary Theory and the public purpose.
[2] Membership | Banque de France (ngfs.net) – accessed 9 June 2021
[3] https://www.ngfs.net/en/about-us/governance/origin-and-purpose – accessed 9 June 2021
[4] “China’s new growth driver”, HSBC Global Research). Decarbonisation can drive mainland China’s growth | Insights | HSBC
