Investment outlook 2022

EQ’s Chief Investment Strategist, Kasim Zafar, summarises the causes of recent volatility and details the upcoming drivers of change that could influence markets in 2022.

The last few months have been challenging for financial markets as a confluence of factors have provided headwinds. These include the emergence of the Omicron variant, persistently high inflation (especially in the US & UK), a resulting sharp pivot in US & UK central bank policy direction and geopolitical risk around Russia & Ukraine. So, what’s going to happen in 2022?

 

Growth assets

We believe disruption from the omicron variant could prove sharp but short lived. Meanwhile, we hope the balance of probability lies in economic sanctions on Russia rather than a hot war. The consequence of this will most likely be higher energy costs for European consumers, adding fuel to inflationary pressures. If it does escalate into military action, we will assess whether the negative impact on portfolios could be short lived or warrant further caution in terms of our portfolio’s exposures.

Consequently, the biggest factor shaping our short-term outlook is inflation, especially in the US. Further research has served only to confirm the wide band of uncertainty around the inflation outlook. A key structural change that appears to be taking hold is a lower US workforce participation rate as some over 55’s retire early, creating a shortage of workers. Companies are paying higher wages to get the labour they need.

While some price rises are almost certain to be a pandemic phenomenon (like cars, which usually depreciate), higher wages have the potential to broaden inflation pressure. If these wage increases are a one-time pandemic phenomenon to get people back into work, the pressure on consumer prices should dissipate. For now, bond markets look like they have priced in sufficient interest rate increases to keep long term inflation under control. But as mentioned earlier, the band of possibilities is unusually wide.

This uncertainty has made it a difficult period for performance of several growth asset categories. If inflation pressure moderates, we believe parts of the market that have been hardest hit could bounce back strongly. If inflation pressure continues, it is best to be invested in high quality companies with strong pricing power, that can pass through cost inflation to their customers; or indeed to be invested in sectors that directly benefit from higher rates & inflation (like financials). In the short term, therefore, we are focused on the balance of portfolio exposures, given the wide band of possibilities.

With a medium to long term horizon, our confidence in the fundamental value and growth outlook of our portfolio holdings has increased.

And that’s because there are some inescapable truths:

  1. Humanity still faces a climate crisis.
  2. Global demographic trends and resultant healthcare needs are unchanged.
  3. Technological disruption continues across ever more industries.

Let’s explore these in more detail.

 

Thematic investments 

We define thematic investments as ones that have a clear driver of growth in the long term. Our favourite themes are climate solutions, healthcare innovation and a variety of technology sub-themes.

 

Climate solutions

Tackling the climate crisis needs to remain at the forefront of the world’s focus in 2022 and beyond.  We expect the private and public sector to embed climate change as a priority.

Since COP26 we have seen “climate risks” materialise further. For example, the EU carbon permit price is at all-time highs, trading at EUR85/tonne (up from just 33 in early 2021). This creates a higher cost of doing business for laggards in high-emitting industries, but a competitive advantage for climate solution companies. Investing in energy efficiency solutions that avoid carbon which can decarbonise industry, has a clear long-term tailwind.

Renewable energy companies may have underperformed recently, but the long-term need is ever-increasing. We think the economics of renewables speak for themselves. Particularly in technologies like onshore wind and solar, it is now cheaper to generate electricity from renewables than it is from fossil fuels even when adjusting for subsidies. As the roll out in renewable technologies continues, the cost will continue to fall making the difference ever larger. In addition, none of these companies have credible decarbonisation plans that are in line with global net-zero by 2050 pathways. While they may be enjoying their day in the sun given rising oil prices, the embedded climate transition risks are now an even bigger downside for their investors.

For companies involved in climate solutions, the aggregate consensus forecast for year-on-year earnings growth is currently about 20%. Our climate specialist fund managers believe these consensus estimates continue to underestimate the growth potential and they have been adding capital to their highest conviction ideas.

 

Healthcare innovation 

Developments in some areas of healthcare have accelerated through the pandemic. Our healthcare specialist fund managers liken current innovation to that in e-commerce a decade ago.

Gene therapy and other personalised medicine has real potential. Innovative companies are using cheaper gene sequencing (by companies like Illumina) in conjunction with recent advances in protein modelling to create platforms for drug discovery. For example, the mRNA vaccine technology by companies like Moderna is already being applied to other diseases, such as cancer, HIV and more. If these unique therapies continue to pass through the various testing phases, the potential total addressable market is huge.

But innovation in healthcare goes far beyond drug development. The pandemic has taught us all about remote working, and remote healthcare is no exception. Some insurance companies, such as Ping An Healthcare in China, are at the forefront of providing video call based primary healthcare. The NHS and insurers are backing these solutions in the UK. But the possibilities continue beyond GP facetime. Abbott Labs are at the leading edge of medical wearable devices and implants that can help patients with diabetes through to those needing neuromodulation to control tremors. By connecting through smart phones, physicians can monitor and adjust treatments completely remotely.

 

Technological disruption 

The pace of technology adoption is accelerating. It took 50 years for the telephone to reach 50 million users. It was 22 years for the television. Facebook took just 3 years and for the augmented reality computer game Pokemon Go, it took just 19 days.

Modern technology has a habit of displacing incumbents, and this accelerating disruption is not just happening in consumer products, it’s happening across all industries. Advances in robotics are allowing more jobs to be automated, increasing the quality of work for human labour. Cloud computing offers cost savings, scalability, high performance, and the ability to apply advanced computational techniques like machine learning and artificial intelligence. Even in a sector like construction, technology like smart sensors and climate control software are making buildings more energy efficient, while advances in computer aided design and 3D printing are expanding possibilities further still.

The next stage of disruption is being heralded as the fourth industrial revolution. In a hyper connected world with large scale data analytics and high bandwidth 5G communication networks, we are already seeing efficiency gains for smart buildings, connected logistics networks, smart grid automation and precision agriculture. Meanwhile, we are just opening the door on remote service sector work like healthcare, design collaboration, education, and training.

With the accelerated pace of adoption creating an expanding addressable market, we see a robust growth outlook for several technology sub-sectors. With software businesses having maintained 30-35% margins consistently since the mid 1990’s, current valuations of some sector leaders are incredibly attractive for long term investors.

 

Defensive & alternative assets 

As with growth assets, inflation is the central source of uncertainty in fixed income markets. Simplistically, as prices rise (inflation), a fixed coupon payment (say of 2%, or £2 in real money) will buy you less than it did before. This leads to the prices of bonds falling as their coupon income streams become less valuable. You are probably wondering why anyone would hold fixed income investments in the current environment. The answer is straightforward – these investments play a key role in diversifying portfolios.

This year more than ever, it is important to invest in fixed income carefully. Certain types of fixed income investments are more vulnerable to high inflation and rising rates than others. Where portfolios can do so, we previously increased exposure to inflation-linked bonds (whose coupons and principal values are linked to the rate of inflation), floating rate bonds (whose coupon payments increase as interest rates rise) and bonds with shorter duration to maturity (the proceeds from which can be reinvested at higher yields).

Each of these have proven resilient over the last few months as interest rates have risen, outperforming bonds with longer durations to maturity.

For portfolios that can invest in alternatives, we prefer real assets that have capital appreciation potential while also offering inflation linked income, such as infrastructure.

 

In conclusion

As the market has adjusted to greater inflation uncertainty, it has reappraised the cost of capital overall. This resulted in weakness for some pockets of the market which only served to weaken sentiment further still. While uncertainty remains rife, our focus remains on the balance of risk within portfolios.

At the same time, the valuations of some companies leading the charge across longer term themes are now incredibly attractive for investors and we see our specialist thematic managers selectively adding to their highest conviction ideas.

 

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