Multi Asset: Here I go out to sea again
On the Mark – Multi Asset Strategy - January 2022
Here I go out to sea again - Wonderful Life by Black
We have been at pains to point out on numerous occasions that this cycle (if it is indeed a cycle) has a number of characteristics that are quite distinct from normal cycles. As we recover from the Covid shocks and deal with the after effects of massive monetarey and fiscal stimulus, this is a very noisy environment for data. It remains so and when dealing with the current figures, some caution is merited. However, the inflation outlook remains core to all investors’ considerations for assets in 2022.
Figure 1: US inflation
Source: Bloomberg
Supply chain disruptions combined with preserved income from fiscal stimulus packages and increased goods demand have helped to push US headline inflation up to 7% (Figure 1), a level we have not seen since 1982. Equally, the Fed’s preferred measure of inflation the core PCE price index was at 4.7% in November 21 the most since February 1989. This is well above the Fed’s target of around 2%. Price pressures have broadened, although they are much higher in goods than services. Whilst some of these pressures may ease, persistently high energy costs continue to result in some stickiness to the elevated levels. Additionally, it is evident that rental income will take up the baton in 2022 and act as a driver of inflation.
The good news is that the mix of these factors should mean that inflation has most likely peaked and will fall into Apri/May, as suggesetd by Fed Chair Powell. Unfortunately it is also likely that higher levels of inflation will presist than prior to Covid. Simply put, inflation will come down from the current elevated levels but it is most likely to settle around 3-4% medium term with out any further extraordinary shocks.
Interestingly, Simon Ward of MoneyMovesMarkets suggests “that the surge in US six-month core CPI momentum in 2021 mirrored a surge in broad money growth 14 months earlier. This is a shorter lag than typically found in historical studies, but the inflationary process may have been accelerated by supply-side disruption due to the pandemic. The apparent relationship suggests a slowdown in core CPI momentum in H1 2022, but current broad money growth remains above the pre-pandemic average, arguing against a full reversal of the 2020-21 rise” (Figure 2).
We are in line with these assesments and take some short term comfort in the fact that inflation surprises appear to have peaked and are moving downwards in the US.
Figure 2: US Core consumer prices and broad money (% 6m)
Source: https://moneymovesmarkets.com
As we have pointed out before, the outlook for spending remains reasonably positive, supported by continued employment and wage growth, accumulated savings, as well as strong household balance sheets. However, the marked fall in real disposable incomes due to soaring inflation is likely to act as a headwind to consumption, with recent US retail sales showing worrying weakness. The consensus was for December retail sales to be basically flat, but this was missed by a wide margin as they slumped to -1.9%. Along with high inflation, consumers were hit by the surging Omicron wave, renewed disruptions, and goods shortages. It appears that demand was also pulled forward in October and November, as consumers tried to front-run shortages.
Additionally, the following chart shows that Covid effects and inflation have had a materially negative impact on US consumer sentiment. which is now near ten-year lows (Figure 3). Notably, three-quarters of US consumers in January ranked inflation, compared with unemployment, as the more serious problem facing the nation.
Figure 3: University of Michigan Consumer sentiment
Source: FRED
The consequences of such disaffection will likely mean further reduction in consumption or alternatively higher wage demands to compensate for the fall in real income. Whilst we remain comfortable with the current outlook, we are keeping a very tight eye on wage inflation, given any sustained pressure could in turn lead to unanchored longer term inflationary expectations. The change in participation rates and a switch to more services demand would add a different dynamic with potentially negative consequences.
Figure 4: Global manufacturing PMI inventories
Source: https://moneymovesmarkets.com
Companies have been responding to the increased goods demand and supply chain disruptions by building up higher inventories. As Simon Ward states “the most striking feature of the recent (Global manufacturing PMI) report was a further surge in the stocks of purchases index – a gauge of the pace of input stockpiling – to a record. Finished goods inventory accumulation, by contrast, remains “normal” (Figure 4). Input purchases by downstream manufacturers have boosted order flow for firms higher up the production chain. Such stock building, however, is peaking and even a stabilisation at the current extreme pace would imply a drag effect on new orders.
Alistair Hibbert, Fund Manager at Blackrock, pointed out that this could lead to much slower growth later this year with a global economy awash in inventories which would unlikely lead to benign outcomes.
Figure 4: Atlanta Fed GDPNow
Source: Atlanta Fed
As we can see from the above chart (Figure 4), the Atlanta Fed’s Q4 GDP growth Nowcast has been slashed from 9.7% at the start of December to 5.0% currently, with final sales contributing only 2.0 percentage points (pp) but inventories a massive 3.0 pp, based on data through to November. This is a serious concern for the growth outlook in 2022.
To add further fuel to this argument, the US Empire State Manufacturing Survey collapsed in January into contraction at -0.7 vs expectations of +35. This is the 3rd biggest MoM drop in history and the second biggest miss against Bloomberg consensus in history.
However, the Bank of America Global Fund Manager survey for January 2022 shows that fund managers now expect inflation, but not economic growth, to fade in 2022. They now have record positioning in commodities and stocks and have rotated from Technology to cyclicals and especially Banks. (Figure 5). Net overweight positions on Technology fell to 1%, the lowest level since December 2008 and Net allocations to Banks rose to 41%, near the record highs reached in October 2017.
Figure 5: BofA Global Fund Manager Survey, January 2022.
Source: B of A Securities
At the recent BlackRock Investment Institute 2022 Global Outlook the following chart (Figure 6) was presented. In this chart we can see that in 2021 global equities outperformed global bonds. Additionally, this was one of the rare years when global equities provided a positive return whilst global bonds had a negative return. However, the BlackRock Investment Institute believes that 2022 marks another year when global equities will be positive and global bonds negative. Back-to-back years of such returns have not occurred from the start of the data in 1977. Therefore, one could ask why there is a change in the asset pricing environment! Or, as BlackRock put it, we have entered a new market regime.
Figure 6: Global equities vs global bonds, annual returns 1977-2021
As we have stated before, it is our belief that this is a new regime but whether it will be this ‘long odds’ interpretation is open to some doubt. It could be that inflation and GDP fade just as the Fed start to raise rates and with-it bonds start to produce positive returns once again. The following from UBS Asset Management resonates with us “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.” Whichever way this plays out, this year will tell us much of how investors will price the new outlook i.e., who will be the winners.
The obvious short-term danger is that fundamental news flow confronts fund manager positioning, and a violent rotation ensues, as per UBS’s comments above. All of this said, it does not detract from our longer-term thoughts that the structural themes surrounding technology, the greening of the economy and medical advancements will provide many of the winners.
It is evident that the road will be very bumpy, given the unusual nature of this recovery and the difficulty in interpretating some of the shorter-term data. Whilst there are obvious threats and reasons to be bearish, we believe investors should keep with their equity weightings and look to the long-term winners.
The Multi Asset Team