Principal Monthly Viewpoints (December 2021)

Q: Principal Asset Management (Asia) Investment Management Team

A: Crystal Chan, Principal Asset Management (Asia) Senior Investment Specialist

 

Q:The U.S. Federal Reserve intends to end its tapering earlier than expected, what will be the future direction of U.S. monetary policy?

A:Less than a month after commencing the tapering, the Fed has decided at its most recent meeting to double the scale of its tapering to $30 billion a month from January 2022 onwards. The entire program may end in mid-March as a result. US may enter the interest rate hike cycle shortly after the end of the bond-buying program. The latest dot plot shows that the committee members believe interest rates may be raised three times next year. High inflation in the US and an improving labor market support the Fed's decision, but the pace of interest rate hikes may be more aggressive than we have originally expected.

With consumer demand remaining strong, supply chain issues persisting, and energy costs surging, US inflation is at its highest in nearly four decades. Recent inflation data reflect that the increase in prices of most of the goods is higher than normal, which means prices are rising more extensively and may not be only due to the economic reopening. In the short term, in face of the threat of Omicron, inflationary pressures in the US may continue to rise until after the first quarter of 2022. The data may return to levels close to but higher than 2% before the end of 2023. The entire normalization process may take up to about two years, which is longer than our initial expectations.

Apart from maintaining price stability, full employment is another objective that the Fed is required to achieve. The US unemployment rate unexpectedly dipped to 4.2% in November and the labor force participation rate rose to 61.8%, the highest since the outbreak of the pandemic. With the US economy on the path to sustain positive growth in 2022, more Americans are expected to return to the labor market. The unemployment rate may drop to below 4% in the first half of 2022, and full employment may be achieved by the end of next year.

According to the current path, the Fed may raise interest rates for the first time around June 2022, followed by another two hikes in September and December. However, inflationary pressures may gradually ease during the middle of next year. To avoid excessive impact on the economy and large fluctuations in financial markets triggered by the rapid tightening of liquidity, the pace of interest rate hikes should not be overly aggressive. During 2023 and 2024, interest rates may be raised twice a year.

Investment markets may be volatile in the run-up to and during the early stages of a rate hike, but the uptrend in the stock market usually stays unchanged until the end of the rate hike cycle.. Even during the period from 2004 to 2006, the Fed raised interest rates 17 times in a row, the annualized total return of S&P 500 reached more than 10%. In fact, the Fed eliminated a key market uncertainty by making this decision. In 2022, stock market returns are more likely to continue to outperform bond markets. Among them, we continue to prefer the mature markets, including the US.

 

Q:Will the pandemic have a further impact on the economy?

A: Despite the continued increase in vaccination rates, the world has yet to contain the effects of COVID-19 on the economy and investment markets. According to WHO officials, the Omicron variant discovered in South Africa at the end of November will gradually replace the Delta variant as the main variant of the disease. In spite of its symptoms being milder than Delta, Omicron spreads quickly and existing vaccines are less effective in the protection against the Omicron variant.

The global seven-day average of number of confirmed cases has rebounded from a low of about 400,000 in mid-October to the current level of over 600,000. The numbers are still rising in more than50 countries, with the highest counts of confirmed cases in the US, major Eurozone countries and the UK. Development of the pandemic, duration of the new wave and the stance of various countries remain the risk factors which investors should focus on in the coming year. Should a new wave of cases induce widespread lockdowns once more, the global economy would be adversely affected.

The situation in Europe has worsened despite over two thirds of its population having been vaccinated. Austria has imposed nationwide lockdowns to prevent the virus from spreading, while some state governments in Germany have also decreed lockdowns. Nonetheless, given the high vaccination rate, we tend to believe Eurozone governments will adopt limited restrictive measures that have limited impact on the economy and consumption, such as early closure of stores and restaurants and tightening vaccination requirements. However, if more countries follow Austria's lead and implement restrictive measures for extended periods, the Eurozone’s economic growth in the fourth quarter would undoubtedly be harmed, with actual impact depending on the strictness and extensiveness of restrictions.

The US has made it clear that it has no intention of imposing lockdowns and therefore the new coronavirus variant should have relatively minimal impact on its economy. In spite of this, investors should remain wary of Omicron further disrupting supply chains and extending the duration of high inflation, which could force the Fed to tighten monetary policy more aggressively and trigger asset price corrections.

 

Q: How should assets be allocated in 2022?

A: We can analyze this question from different angles, beginning with the economy. Looking towards 2022, although the global economic growth continues to slow down, while 4-5% global economic growth rate is still ideal and higher than the long-term average. While the economic expansion cycle has passed its peak, forward-looking economic data revealed that it may be very close to or even at a declining regime, asset prices may not be poised to fall. Historical data showed that various equity, bond and alternatives had recorded gains during this cycle.

Market volatility rose as central banks around the world began to tighten monetary policy; global financial conditions tightened quicker during the past quarter. However, stock markets were still able to attract capital inflows. As of November, the amount of capital flowing into stock markets was nearly five times greater than the total amount of last year. Since the Fed has started to restrict monetary policy, yield of US sovereign bonds may rise in tandem with expectation of rate hikes in 2022. Propelled by rising actual rates, yield of 10-year US Treasuries may reach 2% by the end of 2022. But with real rates remaining negative, actual bond yield will also be negative, supporting the performance of stocks and other risk assets.

In terms of fundamentals, valuations of major asset classes are relatively expensive. On the other hand, overall earnings growth of global corporations is expected to normalize next year, falling considerably from 46% this year to 6% next year. The impacts of higher operating costs will gradually emerge, and upward adjustments in earnings are expected to be limited compared to this year. Based on the aforementioned factors, we predict returns from stocks to stay ahead of the curve. We are slightly constructive on stocks in the first quarter of 2022, but with the slowing economic and earnings growth, inflation on the rise and tightening financial conditions, overall performance may lag behind in the next year compared with 2021. Among them, we are still optimistic about the developed markets, in particular the US and Europe; neutral in Japan, Asia and China; and slightly bearish on Hong Kong. The performance of cyclical value stocks, such as those from financial and industrial sectors are more likely to outperform.

As for bonds, slowly rising yields are unfavorable to sovereign bonds and other traditional bonds that are negatively correlated to inflation. Stronger inflation may benefit high yield bonds, which possess a spread advantage and are more correlated to economic development. This is especially true for high yield bonds with low duration, as this may help mitigate potential interest rate risk. Investors may also consider switching from traditional bonds to preferred securities and other assets with potential stable incomes.

In an environment of rising inflation, besides stocks and bonds, alternative assets such as commodities and REITs may benefit and help diversify portfolio risk. As income from REITs is mostly generated from rent and management fees, and rent usually rises in times of inflation, holding REITs can help hedge against inflation risk. Additionally, REITs had performed exceptionally well during economic slowdowns.

(Written on 10th December 2021)

Crystal Chan
Senior Investment Specialist
Principal Asset Management (Asia)

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