Our theme going into 2022 has been the “Great Transition” – monetary and fiscal policy shifting from tailwinds to headwinds, causing a deceleration in growth and earnings, with inflation switching to disinflation as the pandemic moves into an endemic phase. We believe the volatility to start the year is a result of markets adjusting to these new realities.
With that in mind, here is a reminder of our top ideas and recommendations by asset class for investors looking to make changes to their portfolios.
In short, we believe the effects of the shifting market environment will be felt more in U.S. stocks compared with those abroad, given the former’s lofty valuations as a result of the significant outperformance these past two years. As such, investors are able to find much more attractive valuations internationally, with lighter positioning and sentiment that is not nearly as stretched.
The most attractive region is Asia, which carries the best risk/reward profile of those we track. Indeed, while the U.S. finished 2021 with double-digit gains, the MSCI Asia-Pacific index was down 3.4 per cent despite exceptional earnings growth of nearly 60 per cent.
For many countries, this resulted in meaningful multiple compression. In fact, it is a similar story in Emerging Markets, where the forward P/E ratio sits at a record discount to their Developed Market peers (data back to 2005) and is a two standard deviation event (same for Asia-Pac).
Revisiting prior analysis when it comes to screening for attractive international options in these regions, we tend to employ a GARP (growth at a reasonable price) investment strategy looking at P/Es relative to expected growth (PEG ratio). When it comes to Emerging Markets, the vast majority outside of Indonesia (1.7x), Hong Kong (1.4x), India (1.3x), and the UAE (1.2x) all trade at, or below, the 1.0x cutoff traditionally considered “fair value.” However, we should note that some may be cheap for a reason – Russia and Turkey are weighed down by geopolitical factors, for example.
Our preference would be to focus on Emerging Asia – such as China (0.6x; a lot of bad news already factored in; PBOC easing policy), South Korea (0.6x) or Taiwan (0.8x). When it comes to the Developed Markets, we would still tend to focus on the Asia-Pacific region – with Japan (0.9x) being the top option, in our opinion.
Keeping with 2022 being the “year of transition,” the slowdown in growth and earnings as monetary and fiscal policy turn into headwinds in many countries implies that, for global investors, there should be a sector bias away from pro-cyclicality to those that are more defensive in nature. It is important to note that this is a general theme, and of course may vary by geography.
Looking at prior occasions when the JPMorgan global manufacturing PMI (a proxy for growth) has peaked and activity decelerated back toward 50.0 – which marks the dividing line between growth and contraction – it pays to focus on defensive/defensive growth parts of the equity market. Health care, consumer staples, technology and communication services tend to outperform (the first two traditionally thought of as defensive sectors while the last two have become “defensive growth” in recent years).
It should be noted that, given the elevated valuations of many technology (and tech related) names this time may indeed be different compared to history. That said, it does not mean indiscriminately avoiding the sector. There are still opportunities within the technology space – profitable companies with stable margins that trade at reasonable valuations – that can be found beneath the surface.
Our view on sovereign bonds is driven by the belief that the current bout of inflationary pressure remains a function of the pandemic. While lingering for longer than we previously expected, they should ultimately fade away, likely beginning in the back half of this year. We are also of the belief that the hawkish rhetoric by the Fed, and other central banks, will be of little help in easing inflation, unless the goal is to induce a recession to bring pandemic supply/demand imbalances under control. Put differently, the likelihood of a policy error is elevated, and the risk of a truncated hiking cycle is non-trivial despite the number of rate hikes priced in for some bond markets in the next two years.
As for specific global bond markets, those countries with the most central bank action and inflation expectations baked in would make the best buying opportunities, as these inevitably get priced out.
Accordingly, New Zealand, the U.S., and Britain would screen the best, with Canada, Australia and Sweden being good alternatives.
Commodities that are involved in greening the economy will be in high demand while the world transitions to a cleaner future and pursues a “net zero” agenda. This will require significant investment in the commodity space with a secular tailwind behind demand.
While there are those that may question if the world has enough resources to meet this expectation, we will remind them that reserves go up as exploration expands, prices go up (making more difficult reserves economical to exploit), technologies improve, and regulations change. For example, when it came to “peak oil” calls, new technologies (such as fracking in the U.S. and horizontal drilling techniques) unlocked reserves that were not economical previously. Those most in demand will be on the metals/mining front, with the World Bank estimating that three billion tons will be needed for cleaner energy infrastructure by 2050; those most essential will be copper, graphite, nickel, lithium and cobalt (aluminum and silver to a lesser degree).
Furthermore, “cleaner” natural gas and uranium (i.e., nuclear power) will be required to help in the energy transition in power generation. Lastly, carbon credits will also become (if not already) a valuable financial commodity needed to meet climate goals.
Bottom line: While 2022 is set to be a transition year, with the potential for plenty of volatility, it is not without opportunity. These ideas should help provide investors with useful starting points when considering changes to their portfolios.
David Rosenberg is founder of Rosenberg Research and author of the daily economic report, Breakfast with Dave.
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