There is often a disconnect between market moves and domestic headlines but last week it was particularly acute. The wave of new restrictions in the UK, along with Boris Johnson’s warnings of an Omicron tidal wave, were juxtaposed with a 3.0% rebound in global equities.
All the more odd, at least superficially, was that Omicron was behind the bounce. Markets took heart from news that a third jab should provide substantial protection against infection (up to 75% according to a UK study). It is still early days but this was enough to bolster hopes that Omicron will provide no more than a temporary dent to the global recovery.
Global equities are now back up to their mid-November high in sterling terms and only 1.5% below it in local currency terms. They have returned, including dividends, a sizeable 20-21% year-to-date. More impressive still, global equity prices are now some 26% above their pre-pandemic high in February 2020.
Despite the size of these gains, we believe equities still have further upside over the coming year. The key driver here will be corporate earnings, just as it has been over the past year. Despite Omicron’s best efforts, we continue to expect economic growth to be quite strong next year.
A further reopening of the service sector, spending of some of the excess savings built up during the pandemic and a rebuilding of inventories should all keep growth above trend. These positive forces should more than outweigh reduced fiscal support and the squeeze on spending power from the surge in inflation.
Earnings, however, will only drive further market gains as long as there is no major de-rating. We expect valuations to decline a little, as they have done over the last year, but not dramatically so. Price-earnings ratios are not as stretched as they were and equities still look fairly valued relative to bonds.
The outlook for inflation is critical. It will determine the extent of the forthcoming central bank tightening which represents a potential drag on both economic growth and equity valuations.
Friday saw US inflation hit 6.8% in November, the highest level since 1982. The core measure also rose to 4.9%, a 30-year high. These numbers follow Fed Chair Powell’s recent admission that the surge in inflation could no longer be described as transitory. They mean the Fed is all the more likely to announce on Wednesday an acceleration of its QE tapering plans.
We discussed the inflation outlook in detail two weeks ago. Suffice it to say, we expect inflation to remain elevated into next spring before falling back as some of this year’s upward pressures reverse. With economies continuing to run relatively hot, inflation should settle around 2.5-3% in the US and UK, some 1% higher than pre-pandemic and above the 2% target of the Fed and BOE.
In the US, with quantitative easing now looking likely to end in March, this sets the stage for two or three rate increases by end-2022. As for the UK, Omicron means an increase this week now looks unlikely. Lift-off should be delayed until February, with rates then heading up to 0.75-1.0% by the end of next year.
Policy tightening of this order of magnitude should not prove a major headwind for equities. However, it does leave the outlook for bonds looking poor. Yields should continue to trend higher even if, as over the past year, the path is far from a straight line. Government bonds may deliver outright negative returns over the coming year while corporate bonds are unlikely to return much more than 1%.
All this leaves us comfortable retaining our constructive pro-equity stance, with our allocation a little higher than we would expect over the long term. Prospective returns are considerably lower than over the past year and the risks have risen now policy is starting to be tightened. But even so, equities continue to look more attractive than bonds. With considerable cash still on the side-lines and looking for a home, TINA (there is no alternative) looks set to remain a support for equities, even as central banks reduce their support.
Rupert Thompson
Chief Investment Officer