This cycle is different and better

Investing in 2022 will require a different playbook than investors have used to navigate the past decade. So, is this expansion shaping up to be different than the one before? 

The strong starting points for balance sheets of households and businesses alike are novel to this expansion. While the fiscal impulse is fading, governments aren’t decisively pivoting towards the type of austerity that would jeopardize the recovery.

And the quick rebound in consumption means that the outlook for residential and business investment is robust. However, the prospect of higher volatility, inflation and supply chain stresses have a more nuanced effect on the economic outlook while other aspects still, most notably the structural decline in Chinese growth prospects, are clear negatives.

We believe this expansion is poised to deliver stronger nominal growth than investors have become accustomed to. However, in the near term, the new Omicron variant is causing mobility restrictions that may weigh on activity, particularly in Europe. Though there is much uncertainty, we do not anticipate that this variant will cause a deeper or more prolonged drag on growth compared to previous waves of the virus. Prior to this negative development, growth was in the midst of reaccelerating from the third quarter to the fourth quarter. Ultimately, much of this economic momentum will be retained, in our view, with strength in developed markets more than offsetting a more modest growth outlook in China going forward.

Mounting evidence of the robust growth backdrop should likely prove particularly beneficial to procyclical regions and sectors across risk assets, while leading to higher bond yields as well.

Many obstacles faced by households and businesses in the early stages of the last cycle are not present this time around.

At this point following the financial crisis, US labor income was still more than 3% below its August 2008 peak. In the aftermath of the pandemic-induced recession, the nation’s aggregate paycheck is already 6.7% above where it stood in February 2020.

A slow healing of the job market post the global financial crisis and deleveraging in the wake of the collapse of the housing market was a prolonged drag on consumption growth. By contrast, current labor income growth of above 9% year-on-year should be more than sufficient to support solid increases in real consumption, even amid the stiffest price pressures in three decades.

Unprecedented fiscal and monetary accommodation also limited insolvencies and promoted a faster rebound in earnings. The result is that ratios of debt to enterprise value for global equities recovered quickly, and all-in borrowing costs for US investment grade companies are near record lows. That is a much better set of initial conditions for hiring and investment than prevailed in the opening phase of the long-lived, pre-pandemic expansion.

Generating growth last cycle was a difficult task because of the lingering headwinds to activity that remained even after the contraction was complete. The magnitude of the fiscal thrust this cycle is shielding businesses and households from the same outcome and allowing for initial economic momentum to be sustained. In our view, that has laid the foundation for a period of above trend activity led by the private sector.

Exploring new markets and regions

We believe most of the heavy lifting by governments to support this expansion is well in the rear-view mirror. But an important difference in this cycle compared to the last one is that fiscal policymakers are taking more of a prolonged “do no harm” approach, and a quick pivot to severe austerity in the cards. Measures of the fiscal stance that adjust for economic slack imply that the developed-market fiscal policy will likely stay easier through 2023 than at any time since 2010.

The aforementioned supply constraints are, in some instances, consumers’ way of telling corporations to increase capital expenditures.

The response from corporations: we are, and there’s more to come. The recovery in capital goods shipments, a proxy for business investment, has been much stronger in the 15 months since April 2020 than the same period following June 2009.

Banks are easing access to credit for corporations who want to borrow, and the demand for commercial and industrial loans is picking up. Surveys from regional US central banks also point to strong capex intentions. Since capex is currently impeded by supply chain snarls, there is little reason to think momentum does not continue.

The sluggish growth, below trend economic environment of the past decade kept the range of realized macroeconomic outcomes fairly narrow. One consequence of operating in a higher-pressure economy is that the volatility of macroeconomic outcomes is also likely to increase – and this should feed into higher market volatility.

A higher floor for rates and equity market volatility would be a welcome development for active managers. Greater dispersion provides greater potential to generate alpha through security selection. This is particularly true outside of US equities, as other regions have less market concentration risk as well as wide valuation spreads, which we believe will narrow over time. A higher volatility regime also presents more tactical opportunities for multi-asset portfolios to adjust positioning seeking to take advantage when markets overreact to economic surprises.

The surge in short-term rates since mid-September, which has since partially retraced, suggests that rate hikes across many advanced economies are likely to begin in 2022. For the Federal Reserve, this would mean a much quicker pivot to tightening policy compared to the more than six-year lag between the end of the 2009 recession and ensuing lift off.

In addition, we believe market participants are currently underestimating how much central banks will raise rates over the course of this cycle. The removal of central bank stimulus is, on the surface, a seeming negative for risk assets. However, investors must bear in mind that this withdrawal of support is linked to positive economic outcomes. In 2022, we believe it will be clear that the removal of monetary accommodation is a function of not just the stickiness of price pressures, but also the strength of growth and progress towards full employment.

The outlook for Chinese activity is far and away the biggest potential cloud on the economic horizon. We believe that a destabilizing downturn in real estate, which has captured investors’ attention due to the travails of several highly-indebted developers, will be avoided. However, we must acknowledge that the risks of this have risen, and, perhaps more importantly, that trend growth in China has diminished.

Reorienting the country’s growth model towards increasing consumption and enhancing technological capabilities to reduce dependence on foreign markets is unlikely to be a smooth process. It is doubtful that the opportunities for productive investment will be as vast or realized as quickly as credit-intensive growth driven by real estate and infrastructure have been.

Our view is that above-trend growth in major developed markets will be more than enough to offset a moderation in China’s growth. The eurozone, for instance, will likely have only a small degree of fiscal drag in 2022 in light of the EU recovery fund. It is also one of the rare regions in which the growth in consumer spending is projected to accelerate in the year ahead.

Notwithstanding the structural trend, there are a series of catalysts over the short term that point to the stabilization and perhaps modest pickup in Chinese activity. Robust demand from the US and European Union are driving the Chinese trade surplus to a record, underpinning domestic production. A turn in the credit impulse before the year is out should put another floor under activity. And we also believe that a more comprehensive recovery in Chinese mobility will be in the offing following the Winter Olympics, supporting efforts to rebalance growth towards consumption.

Our core conviction is that equity market indicators and sovereign bond yields suggest that investors are underestimating the runway for above-trend economic growth. We are cognizant that such periods have been fleeting in recent history, which helps explain the market skepticism. Market pricing suggests a return to mediocre growth is consensus, and there is a higher burden of proof for view to be realized. If economic activity unfolds as we expect, we are confident this high bar will be surpassed.

Risk assets most levered to cyclical strength such as Japan and Europe and sectors like US small caps, as well as financials and energy should be well positioned to outperform in a world of upside growth surprises that propel bond yields higher. Exposure to commodities, both directly and through energy equities, is also useful from a portfolio construction standpoint in the event that inflation proves to be disruptive to both stocks and bonds.

We have high confidence in our call for above trend growth in 2022, but are not wedded to it. Should downside risks to activity mount – a hard landing in China, fiscal drag proving more material than we anticipate or demand hitting an air pocket after inventories rebuild and supply chain stresses subside – we are prepared to be nimble in adapting to such changes. And we will not hesitate to pivot to more attractive risk-reward opportunities if our optimistic macroeconomic outlook is reflected excessively in asset prices.

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