Solving For A Year Of Inflections

By Erik L. Knutzen

The Solving for 2022 delegates voted on what they think will be this year’s best-performing investment category – and here’s why we think they are right.

Last week, we hosted our annual European investment conference, Solving for 2022, gathering online for the second year running.

It’s a shame that Omicron disrupted our plans to meet our friends and clients in person. On the other hand, it gave us a much larger online audience for our traditional conference poll question: Which will be the best-performing investment category in 2022? Here are the results.

Equities came out on top again, but only marginally, and their vote share of 51% was markedly lower than last year. Most of that share moved over to commodities, which accounted for 43% of the votes, up from 19% last year. Cash also improved its vote share, from 3.5% to 5%. In last place, compounding a steady decline from 17.2% of the vote in 2019, was fixed income, with a share of just 1%.

As usual, to get the conference started, Joe Amato presented our economic and market outlook for the year, and I followed with an asset allocation framework designed to put that outlook into practice. It was interesting to note how the delegates’ votes aligned with that framework.

Five Major Inflection Points

Joe developed the theme sketched out in last week’s Perspective: the five major inflection points of 2022.

Monetary and fiscal policy are set to stop loosening and start tightening this year, after more than a decade of the authorities fighting the forces of disinflation and sluggish growth.

As a result, a greater volume of liquidity is planned to be withdrawn from financial markets, at a faster pace, than ever before.

The reason for this tightening is inflation: We believe inflation is likely to ease from its current rate, but persist at a structurally higher level than that experienced over the past 20 years.

There are a number of reasons why we anticipate persistent inflation, but one other major inflection point stands out: the transition from fossil fuels to renewables.

And finally, following 20 years as the biggest contributor to global growth, China, with its aging and shrinking workforce, is now prioritizing “common prosperity” with a managed long-term slowdown.

Interest Rate Risk

With that background, it’s no surprise that fixed income fell out of favor at Solving for 2022.

We think strong corporate fundamentals make positive total returns possible for investors who assume credit risk rather than interest rate risk, and who balance coupon income with the flexibility to invest across credit sectors and trade tactically. But few would back fixed income to lead the pack this year: Rising rates pose the most risk to bonds; government bonds have been the chief beneficiary of the central bank liquidity that is about to be withdrawn from markets; and inflation erodes the real return of fixed income assets.

Our delegates still back equities, but some of the shine has come off since last year. Its vote share fell from 75% to 51%.

That’s understandable. While fundamentals remain positive, three years of exceptionally strong performance has left us with stretched index valuations. Moreover, many benchmarks have become dominated by growth stocks, which are expensive and sensitive to rising rates. We think value stocks, cyclical companies, smaller companies and non-U.S. developed markets offer more direct exposure to the ongoing reflationary environment, at more attractive valuations, and with lower exposure to rising rates.

Not a 60/40 Environment

What to make of the big jump for commodities?

That fits with our view of how important diversification is likely to be in 2022, as the major inflection points that Joe described could cause uncertainty and volatility. The challenge is that the traditional, bonds-versus-equities approach may no longer work, given the high valuations and interest-rate sensitivity in both asset classes. As Joe explained in his outlook, and as we’ve been saying for a while, this is not a 60/40 environment.

Among alternative diversifiers, we think there is a special place for inflation-sensitive assets such as commodities and real estate, given the underlying economic dynamics. Commodities could offer potential inflation exposure and diversification at a time when bonds are too expensive, too sensitive to rising rates and too highly correlated with equities to perform that role. Our conference audience appeared to agree.

Uncorrelated liquid alternative strategies may help, too, as well as equity index put-writing, which has tended to benefit from historical periods of volatility and offer a slightly smoother exposure to equity risk. Private equity and debt offer ways to generate potential return away from the volatility of the public markets.

On the Same Page

We and our Solving for 2022 audience appear to be on the same page.

We both think that risky assets like equities are the place to be, given the fundamentally strong economy – but high valuations and the prospect of rising rates, less liquidity and more volatility make us more cautious than a year ago. Risk management is high on the agenda. We value genuine diversification, as well as flexibility and the capacity to stay nimble amid the potential volatility, and we recognize that inflation is likely to be the key risk to manage in 2022.

You got it right last year, with your strongest vote for equities on record. Let’s see how well we do over the next 12 months.

In Case You Missed It

• Bank of Japan Policy Meeting: The BoJ made no changes to its policy stance
• NAHB Housing Market Index: -1 to 83 in January
• U.S. Housing Starts: +1.4% to SAAR of 1.70 million units in December
• U.S. Building Permits: +9.1% to SAAR of 1.87 million units in December
• Eurozone Consumer Price Index: +0.4% in December month-over-month and 5.0% year-over-year (core CPI increased 2.6% year-over-year)
• Japan Consumer Price Index: increased 0.1% month-over-month and 0.8% year-over-year (core CPI (All Items, less fresh food and energy) decreased 0.7% year-over-year)

What to Watch For

• Monday, January 24:
  • Eurozone Purchasing Managers’ Index
• Tuesday, January 25:
  • U.S. Consumer Confidence
  • S&P Case-Shiller Home Price Index
• Wednesday, January 26:
  • Federal Open Market Committee Meeting
  • U.S. New Home Sales
• Thursday, January 27:
  • U.S. Durable Goods Orders
  • U.S. 4Q 2021 GDP (First Preliminary)
  • Initial Jobless Claims
• Friday, January 28:
  • U.S. Personal Income & Outlays

– Andrew White, Investment Strategy Group

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