Stickier inflation and a climate change ‘black swan’ – what could the future hold for equity markets?
- Recalibrating policy for a steady recovery will be a delicate balancing act, especially when factoring in levelling-up policies and – crucially – climate change and the energy transition
- Inflation is likely to be stickier than central bankers and investors had expected
- 2022 will likely see a slowing of global economic growth from above trend and a tightening of monetary policy, but fears of a stagflation are probably overdoing it
- A post-COP26 awakening could see a climate change ‘black swan’ for some asset prices
The third quarter saw a continuation of the low volatility rise in global equity markets in July and August, led by the US but with notable weakness in Pacific and emerging markets, which remained beset by COVID-19. But in September, the trend in the developed markets faltered too: ongoing disruption within supply chains, energy supplies and labour markets have shifted the narrative that inflationary pressures are entirely transitory. Given the extent to which low inflation expectations have caused yields to fall in recent years, driving up the value of all financial assets, a period of slightly higher inflation could suppress some of the recent exuberance.
Central banks began to discuss plans for a very gradual normalisation of monetary policy; furlough schemes began to come to an end, yet labour markets proved unexpectedly tight; natural gas prices doubled in Europe in September (having already doubled since January); supply chain problems worsened; geopolitical tensions rose; and China Evergrande, the world’s most indebted real estate developer, attempted to stave off bankruptcy.
Vast fiscal and monetary stimulus turned the deepest recession on record to the shortest. While the aftershocks from COVID-19’s economic dislocation are still reverberating across global supply chains and labour markets, there is a growing consensus that as societies adjust to living with the virus, emergency policy support will need to be dialled back.
Recalibrating policy for a steady recovery will be a delicate balancing act. During periods of deep uncertainty, monetary support can help underpin consumer, business and market confidence. However, it is not particularly helpful when addressing long-lasting supply-side dislocations. For much of 2021, inflation in the US, UK, Germany and many emerging markets has been running substantially above central bank targets – driven in large part by misalignments between supply and demand. Persistent supply disruptions suggest that inflation will likely remain elevated for much of 2022 as well. If crisis-level monetary support remains in place as supply shocks ripple through the economy, well-anchored inflation expectations risk becoming unsettled. To complicate matters, an ambitious fiscal policy agenda that seeks to ‘level up’ those who have been left behind is likely to sustain supply challenges, and that is before considering climate change and the energy transition.
The short-term energy squeeze driving power prices higher is a global phenomenon and, in many ways, a perfect storm illustrating the disruptions that lie ahead as we decarbonise. Current extreme energy prices will settle back but in the medium to long-term, intermittency of renewables will be an ongoing challenge and new storage technologies and capacity will take time to develop. Higher prices will not lead to greater supply because of the capital discipline being imposed by sustainability policies on energy markets. It looks increasingly likely that energy will remain expensive during the green transition. Added to that, demand for metals like copper and nickel is set to surge as the uptake of renewables and electric vehicles accelerates. China’s control of the rare earth minerals needed for batteries also adds potential price uncertainty.
A clear feature of the post-pandemic landscape looks to be slightly stickier inflation than many central bankers and investors had been expecting. Higher prices may hobble economic growth for consumers and some industries as the energy share of spending increases from the low levels of the last two decades. The regions taking the hardest hit will again be the emerging markets and developing economies that are already struggling to cope with COVID, adapt to climate change and leapfrog to low-carbon development pathways. Central bank policymaking, domestic energy politics and international climate negotiations are all the more challenging and the risks of missteps have risen.
In a year’s time…
Equity markets typically discount 6-12 months forward, so it is worth exploring how some key influences could evolve in that time. By the end of 2022, it seems likely that global economic growth will be slowing from above trend. Fiscal support in the form of long-term infrastructure investment will be less impactful than that designed to sustain consumer demand. COVID will still be present but hopefully will be well contained by vaccination. Although supply shortages, high consumer savings, pent-up demand and rising wages may extend the cycle, these benefits seem likely to wane as 2022 draws to a close. At this point, the US economy should be approaching full employment (under 4%).
China navigated the economic ramifications of the pandemic impressively – the economy is now not only back to its pre-COVID size but in Q2 2021 was 8.2% larger. Yet, the government’s financial de-leveraging campaign and efforts to tame property price speculation risk the growth outlook. The failure of Evergrande, with liabilities of over $300 billion, would inevitably affect China’s economy. With 75% of household wealth tied to the fate of the property market, a burst of the property bubble could seriously dampen confidence. Consumption has already lagged the economic recovery after a liquidity squeeze and the uncertainty created by ‘Common Prosperity’ policies and regulatory tightening. But too much of a slowdown will not be tolerated for long and as 2022 unfolds, the Chinese government seems likely to be actively supporting growth.
New governments in Japan and Germany may bring more expansionary policies, whilst improved vaccination rates in Asia and other developing markets should support their recovery. A global capex boom, some easing of supply chain constraints, and inventory rebuild, imply a gradual recoupling. In short, the dispersion in growth rates could be wide in the first half of 2022 but more synchronised at a steady rate as the year closes.
By the end of 2022, the Federal Reserve will have also withdrawn quantitative easing and will be raising interest rates. Other major central banks worldwide will be following suit. Although monetary policy will be tightening, the process by past standards will be exceptionally slow and liquidity is set to remain abundant. While we expect bond yields to rise, real longer-term borrowing costs are likely to remain very low.
Rising Google searches for stagflation highlight the current concern
Rising Google searches for ‘stagflation’ highlight the current concern for slower growth and higher inflation but this is probably overdoing it – central banks have been trying to stimulate modest price inflation since the last crisis. The longer-term disinflationary forces of ageing demographics, technological disruption and excess savings are still in the background and once short-term recovery pressures abate, there is the chance that for a period at least, inflation and growth are more normalised than they have been.
With still reasonable economic growth and generous liquidity, the third important component for equity investors will be the performance of companies. Few predicted the quite remarkable profit outturn in 2021 – it is estimated that in the US, 90% of industry earnings are already above pre-COVID levels, with just travel-related companies yet to recover. Resurgent economic growth, coupled with cost discipline, has produced enormous operating leverage. Over the past two years to June 2021, US nominal GDP expanded 7%, which fuelled S&P 500 revenue growth of 15% and earnings growth of 28%, according to Credit Suisse.
The extent, breadth and duration of earnings beats has been impressive, but after five quarters of huge earnings beats and upgrades, it would be adventurous not to expect some moderation in the trend. Widespread margin contraction is rare outside of a recession and it seems reasonable to expect pricing power to be retained in most industries. Even factoring in some slowdown, positive corporate earnings momentum seems set to continue in 2022.
Code Red / Black swan
The central scenario for the 2022 outlook is that the balance of risk and opportunity has tilted to be slightly less positive, but there is still solid fundamental support for global equities. However, climate change is a potential game-changer. Our thesis on climate change has long been that the pace of transition needs to be faster but countries, companies and consumers are still not making substantial changes to their lifestyles. The latest energy squeeze and rising cost of carbon have set the scene for a post-COP26 awakening to the transition. For some asset prices, this could be a ‘black swan’, an unexpected event of large magnitude and consequence that was considered to be an extreme outlier so is not well discounted.
“Code red for humanity” is how UN Secretary-General António Guterres described the scientific report prepared for leaders ahead of the COP26 conference. To keep temperature rise below 1.5°C and achieve net zero by 2050, emissions need to be cut by 45% by 2030. This is an extraordinary ambition and the evidence report suggests that even this timescale may not be soon enough. Assumptions of a reasonably large ‘budget’ of CO2 that can still be emitted by developed market consumers and industry, in a steady ‘transition pathway’ to net zero by 2050, look likely to be far too high.
The consequence may well be that emissions need to be cut very suddenly and there is a significant mispricing of CVAR (climate value at risk) in a number of carbon-intensive sectors. Our climate change theme has been the weakest relative performer this year as fossil-fuel producers have recovered and energy transition beneficiaries have underperformed, but we expect this to reverse and it remains a key long-term component of future strategy.
Key takeaways for investors
Although the era of easy capital appreciation from falling yields looks to have been curtailed, the downside is mitigated by the prospect of sustained economic growth following the recovery, still strong liquidity and robust corporate performance. The risks of obstinately higher inflation and policy error must not be ignored and so the repositioning of the portfolio for a more uncertain outlook is appropriate. We continue to give the “outlier risk” from climate change careful consideration.
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