Less of the same: Investors should brace for positive but below average returns in 2022, says Pictet’s Paolini

The outlook is still good for investors, says Luca Paolini, chief strategist at Pictet Asset Management.

“Equity prices have reached a record high, up nearly 100 per cent from the pandemic low, much faster than anticipated. Whilst the outlook should seem good for investors, some factors will cap the expected returns for both equity and bonds in 2022.
 
“Record valuation, tighter monetary/fiscal policy and the surge in inflation will keep the pressure on, resulting in single digit return for equities. Bonds, we think have entered a secular bear market, although a significant breakout in yields looks unlikely.”
 
“Next year will be ‘less of the same’, rather than a turning point. We are in the last third of the expansion in what has been the most accelerated market and business cycle in history.
 
“Economic activity will return to pre-pandemic trend levels. We forecast a synchronised growth with less sectoral and geographical divergences. The global economy is a super tanker that takes time to change direction. Consumption of services should close the gap with goods consumption. The easing of mobility restrictions should boost production and ease supply constraints.” 
 
“For the first time in living memory, the US economy will outperform China’s, growing at 5.6 per cent in 2022, and will register a positive output gap, potentially the largest in three decades. Inflation, driven by demand, will persist and unemployment will fall.
 
“Europe, the UK and Japan will also continue to recover, although lagging the US and with Brexit and potentially a premature monetary tightening creating uncertainty for the UK.
 
“China will be a story of two halves – a weak start to the year followed by a brisk recovery driven by consumption, but with real risks to growth such as demand destruction from rising inflation. Furthermore, regulatory restrictions and weaknesses in China’s vital property sector cannot be ruled out.
 
“Even though, on balance, we believe economic overheating is more likely than stagflation, there are three specific risks to global growth.
 
“Rising inflation – and a possible USD100 a barrel oil price – could seriously dent demand. Further regulatory clampdowns in China can’t be discounted. And Covid hasn’t gone away – there’s the tail risk a deadlier new variant that evades current vaccines could arise.
 
“Monetary policy is set to shift in 2022 – even if there’s no outright U-turn. Emerging economies have already started to tighten. We expect the major central banks to expand their aggregate balance sheet by some USD1 trillion next year, less than the expansion of overall economic activity, meaning that excess liquidity is shrinking for the first time since the global financial crisis.
 
“Real interest rates will stay low despite the Fed’s tapering of quantitative easing and expected rate hikes later next year.
 
“Historically, at the start of a US monetary tightening cycle, equity returns drop to below average, though performance still tends to be positive. Any sudden drops in prices or increases in market volatility tend to be short-lived, even if they can be severe at times.  
 
“But the warning stands: asset prices generally are richly priced after a decade of quantitative easing and cheap money and rising demand for financial assets from ageing populations.
 
“The real pockets of value are in areas that are unattractive for a significant number of investors – energy, mining, China’s property sector, Brazilian and Turkish equities – but there is plenty of relative value in equities.  
 
“We expect cyclical value markets and sectors to outperform in 2022 as economies continue to re-open and yields rise. That includes Japan, financials, property, and US small caps. If the regulatory crackdown eases, Chinese tech stocks have significant underperformance to make up for.” 
 
“In Europe, we like the UK for its value-tilt, very cheap valuations and a weakening currency. Italy and Spain also look attractive.”
 
“The US is a bit more nuanced. US equities can look very expensive. But earnings will likely rescue returns in 2022, surprising again on the upside due to higher profit margins. Analysts are too optimistic on the evolution of profits in the medium term, however, with taxes, interest costs and wage bills all set to rise.”  
 
“Whilst we remain very cautious on emerging market (EM) equities (and EM assets in general), a rotation back to those markets is likely in the second half of 2022. Overall, we maintain a cautiously optimistic outlook on equities.”
 
“Fixed income investors should brace themselves for another challenging year. US Treasuries will likely post losses on the year even though yields on the 10-year note will struggle to rise above 2 per cent. And with real yields on inflation protected bonds at an all-time low, this part of the market will also fail to deliver for investors.”
 
“Markets are pricing in the possibility that central banks in the US, euro zone and the UK will have raised interest rates by at least once by the end of 2022. This may appear overly hawkish, but conditions for bond investors are at their most bearish in a decade – not least because valuations across fixed income asset classes are high.”
 
“Hence, investors will have to look harder to achieve gains. We like Japanese inflation-protected bonds. Japan’s real rates are higher than those in the US and UK. The country’s inflation is rising as a weak yen pushes up import costs. We also like US leveraged loans, which have attracted significant inflows this year thanks to low duration and a floating rate.”
 
“Corporate credit will struggle in the coming year as developed market corporate spreads stand near record lows in both investment grade and high-yield markets.”
 
“But we see relative value in short-duration corporate bonds, especially in EM.”
 
“Based on current yields and duration, short-term bonds will allow investors to better insulate themselves against volatility from interest rate fluctuations without giving up much yield.”
 
“We see little value in euro zone and other developed market government bonds. Furthermore, overbought inflation-protected bonds are unlikely to offer attractive gains and look unlikely to be able to repeat their year-to-date return of 6-7 per cent.”
 
“In emerging markets, we see value in Russian bonds, which offer a high real yields and where the central bank is at an advanced staged of the tightening process. We think EM corporate bonds are particularly attractive. These dollar-denominated bonds offer low duration and default rates are likely to stay low thanks to rising commodity prices.”  
 
“In currencies, we expect the US dollar to remain strong whilst we think sterling will weaken as the UK economy may struggle to absorb interest rate hikes and fiscal tightening. Other currencies, such as the euro and Swiss franc, should remain rangebound against the dollar.”