Three major asset allocation themes are likely to dominate in 2022: the slowdown in China and its effect on the global economy, the outlook for inflation, and the investment case for bonds versus equities.
Slowing Chinese economic growth
Much of China’s economic growth remains investment-led, and a large proportion of investment has gone into home construction. This year, housing is set to become a headwind to GDP growth instead of the tailwind it has been for nearly two decades.
The construction sector has contributed nearly half of GDP growth. As it contracts, this means the 6% GDP growth rate we have become accustomed to – and last year’s 8.1% bounce back from Covid-19, could halve if other sectors of the economy (consumption, government spending or net exports) don’t plug the gap.
A material slowdown in the world’s second largest economy could have severe knock-on effects for the rest of the world. China’s economic growth has been the enabler of growth across the western world, where many listed businesses generate their revenues. As the Chinese economy slows, investors will need to calibrate their expectations across the commodity, trade, and manufacturing industries.
This argues for investments in to high-quality businesses exposed to secular growth themes in consumption, technology and healthcare over cyclical businesses that may stumble as China slows.
Inflation
While we do believe inflation will slowly reassert itself from the ultra-low levels of the past decade, we remain unconvinced that inflationary forces are greater than the deflationary forces of demographics, technology and financialisation over our investment time horizon. According to Viktor Shvets (Macquarie), so far, “Evidence for the regime change is weak”.
Three data points support the view that change will be gradual (and manageable):
1. The markets are not signalling higher inflation. US 30-year bond yields are below 2% and the US five-year/five-year (the five-year expectations of inflation in five years’ time) also remain low. Inflation in Europe remains very low, and monetary policy remains accommodative.
2. While wages, especially in the US, are rising, increases are heavily concentrated in disrupted segments (i.e., transport and warehousing, travel-related). In other areas we see no such increases. In Europe and Asia, we see no evidence of wage growth.
3. When dissected properly, US inflation is coming almost solely from used car prices, housing prices and energy prices. All of these factors were driven by pandemic-related shortages, and almost all are decelerating rather than accelerating.
4. Social inequalities are high on government agendas, as expressed by the rising percentage of the population that are asset owners (who benefit from higher inflation) versus those that own relatively fewer assets. Interest rates must keep abreast of this dynamic, making a sharp reset incredibly unpopular, and thus unlikely.
The investment case for government bonds
Since the global financial crisis, and the financial repression that has taken place in world’s fixed income markets, the pressure for investors to move up the risk curve towards equities has remained stubbornly high. This has changed as bond yields began expecting the end of monetary accommodation. Thus, for the past three years at least, the decision to steer clear of bonds in favour of equities has been the correct one. But as inflation rises, is this still the correct stance?
The correlation between equities and bonds tends to turn positive in times of higher inflation. Therefore, the risk of investing in bonds relative to equities increases with greater inflation as returns (both up and down) will be more correlated, but with bonds carrying arguably more price risk.
In the absence of an attractively priced fixed income allocation, the current environment suggests a higher allocation to cash. A large cash allocation doesn’t help in terms of real returns but allows the managers greater discretion to adjust to market conditions aggressively when the time is right. It also greatly reduces fund volatility.
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