With the consumer price index in the US hitting a four-decade high in December 2021, rising 7% year-on-year, the investment conversation in 2022 will be dominated by persistent inflation and its impact on financial markets. With a collision between pandemic-related supply chain bottlenecks, labour shortages and growing demand, the US Fed is no longer talking about inflation as transitory.
The world economy is forecast to surpass $100 trillion for the first time in 2022, driven by continued recovery from the pandemic. As we peer into the year ahead, inflation and how the world’s central banks will respond to this, is perhaps the single biggest known risk facing clients’ portfolios. Some central banks in Brazil, South Africa and Russia, for example, have already begun an interest rate tightening cycle.
Meanwhile, markets are anticipating three to four interest rate hikes in the US over the course of 2022, with the first being in March following the end of the tapering of asset purchases that same month. The Fed started the year by issuing hawkish minutes indicating it may need to hike interest rates sooner than anticipated to curb inflation. This raises a higher possibility that we may see liquidity withdrawn from equity markets as interest rates rise and bond yields become more attractive again.
Only time will tell whether policymakers can strike the right balance between keeping inflation at manageable levels and maintaining GDP growth in 2022 and beyond, which in the last week, the Fed has moved to assure markets that this is an objective it can achieve. Our baseline scenario is that corporate earnings growth will continue, although at a more moderate pace than 2021, underpinning high single digit returns for global equities during 2022. This is informed by our view that Covid-19 disruptions should be significantly less severe this year than they were in 2020 and 2021.
Dangers of forecasting
However, both current and continued Covid-19-related distortions in the market make it difficult to make forecasts with any great certainty. There are many variables at play – including ongoing shortages of many key commodities and components, the amount of cash US consumers have saved up during the pandemic, and how new variants, prevention and treatment protocols, and government policies will shape a full emergence from the Covid-19 crisis.
We also cannot discount the possibility of other economic responses and geo-political factors causing volatility in the months to come, including Putin’s potential seizure of Ukraine, China’s brittle relations with the US, and their ongoing regulatory crackdown on bigtech companies and foreign IPOs.
In his annual letter to shareholders at the beginning of 2021, Terry Smith, CEO of one of our cornerstone funds, Fundsmith, illustrates the dangers of forecasting and market timing even if you were to know with certainty what major events will occur:
“Imagine if you had been told this time last year that there would be a pandemic and that the measures taken to contain it would so affect the world economy that US GDP would fall by 9% in the second quarter of the year and the hospitality and travel sectors would be devastated by the measures as would large segments of traditional retail activity. Considering this would you have predicted that the MSCI World Index would deliver a return of 12.3%*, slightly above its ten-year average?”
*12.3% in Pounds, 16.5% in USD for 2021
From our side, at the outset of 2021, we were concerned that many stocks could be overvalued and outlined a defendable strategy to achieve non-speculative growth. With the S&P 500 ending 2021 with a nearly 29% gain and the Nasdaq up more than 21% for the year, the markets surprised on the upside. However, equities may run out of steam this year as central banks embark on the abovementioned tightening cycle.
With that in mind, we are doubling down on backing quality-focused, offshore funds to deliver growth while mitigating risk. These funds build their portfolios on robust businesses that have strong balance sheets and low capital intensity. Such companies usually operate in less cyclical industries and have price-setting power that enables them to protect their margins even in a high-inflation environment.
Pricing power without capital intensity
Examples of such companies include, but are not limited to, food producers and fast-moving consumer goods that manufacture essentials, giving them the ability to pass price increases on to their customers when their input costs rise. Quality portfolios hold up well in nearly all market conditions, even if they do not deliver the outsized returns of more cyclical companies during periods when the stock market is booming.
Our approach may run contrary to the traditional wisdom of backing the stocks that benefit from an inflationary environment, such as mining and energy companies. These businesses are asset-intensive, with capital investment soaking up much of the profits they generate during times of booming demand. By contrast, cash flow and dividend payments of less cyclical quality companies are more resilient.
However, we balance this approach with investments that track major indices to pick up general market beta and cyclical recovery stocks. Such passively managed funds and instruments provide long-term growth and returns in line with high-level market indices, together with the benefit of reducing the cost ratios of our house-view portfolios.
As we embark on the New Year, we cannot be sure whether we are on the cusp of a post-pandemic boom akin to the Roaring Twenties, or a 1970s-like period of anaemic growth paired with high inflation.
Backing quality allows us to manage the risks of a volatile environment. It creates a moat that protects clients’ portfolios against inflation, while delivering consistent returns over the medium and longer term, irrespective of shorter-term share price volatility.
