The Big Conversation
Episode 105: 10 Charts for 2022
This week we look at 10 charts that map out some of the key determinants for portfolio performance in 2022. Inflation might be key, but it’s the policy response and the impact on yields that will lead the way for stocks. Will investors get the direction of the dollar right, after it wrong-footed the market at the beginning of 2021? And will this be the year that value finally trumps growth? In the Chatter section, Rob Cox of Reuters Breaking Views picks six big themes that he expects will play out during the next 12 months.
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Roger [00:00:00] Welcome to this, the last episode of The Big Conversation for 2021, and I'm going to be looking at 10 charts that I think are really going to define the outlook for markets next year. And that's going to be the first section, in the second section, we've got Rob Cox of Reuters Breaking Views. He's going to talk about some of his main ideas that are going to pan out throughout 2022.
Roger [00:00:23] So, the charts I'm going to look at, they're ones which are, they're kind of obvious charts, I've sort of beaten these to death over the last year, there's nothing spectacular about them. But just the ones which I think represent the key elements of what might transpire and the key things that we need to look out for in 2022. Now, inflation is going to be a key element to all of this, but that's not one of my charts. But I think this is going to play out, mainly in either yields or in the dollar. So I'm going to kick off with yields, and more specifically, the yield curve, because the yield curve and how that reacts to policy, is going to be perhaps one of the biggest determinants of the mix that people need in their portfolios. I think what's really interesting here is that, you know, we started to see talk of taper, we're starting to see talk of tightening. And that's normally when you're getting growth, getting out of control. We don't really have growth, we've got that inflation. What we've seen so far is that the yield curve has been flattening. The yield has been flattening both from front-end yields going up, so that's the bear flattening, so those are the products selling off, yields going up. And also bull flattening, which is where those long-dated bonds, well they've been being bought, and that means lower yields are going down. So that's the flattening that we've been seeing. Now that normally happens when we're going towards a slowing period. And obviously when the yield curves invert, that's often something that precedes a recession. It's a very unusual dynamic right now. It's an unusual dynamic because if we have seen a peak in the yield curve, it's the lowest peak that we've seen of any cycle and probably one of the shortest cycles over the last 30 years. But what I think is also fascinating here is that rather than 2013 taper, where yields shot up, so far the talk of taper has seen yields coming down at the back end. And I think this is because, loose policy is considered to be something that's stoking the fires of inflation. If they tighten policy, then that fear of inflation might come in a little bit. Those yields at the back end might drop a little bit, and that's where you really see those inflationary elements being prices that sort of 10 year to 30 year space. So any tightening talks seem to be taking some relief out of the back end. The second shot, therefore, is, well, what does that mean, really for asset prices and the mix of, let's say, growth versus cyclical sectors? What I've used here is it's actually the 10-year portion of that curve. So this is the US 10-year yield, and I've mapped against this, the ratio of banks, this is US banks, versus the S&P 500. And I love this chart, I've used it a few times because they're almost the same chart. So when yields, long-dated yields, the 10-year yields are falling, banks tend to underperform the S&P. When yields are rising, banks tend to outperform. So a steeper yield curve and higher long dated yields tends to be good for financials because they can borrow cheap, lend expensive, make a nice margin on their loans. If the yield curve's flattening, that tends to be bad for that part of the market. Now I use the banks because they, their ratio has perhaps the best fit, but those banks represent cyclicals. So these are the value in cyclical stocks. And this is key because a lot of the consensus going into 2022 is that growth stocks, these are the stocks that grow their earnings in any circumstances, such as the big mega-cap tech, people expect those to revert slightly. Not to the mean, but certainly to underperform, and cyclical and value plays to outperform. But if the yield curve's flattening, it's unlikely that those cyclical plays can outperform. They look like they'll be under a bit of pressure. So the yield curve and yields are very key for understanding or thinking about whether we go into cyclical or growth plays for next year. At the moment, you'd probably say stick with some of your growth stocks, even though we know that there's only four or five that have created most of the outperformance for the Nasdaq. The next job, therefore, is when we're talking about yields, we've got to talk about rates, and interest rates and policy response from the Fed, because the policy response from the Fed and divergence between various central banks will help define some of the, the currency moves that we should see through next year. But I think what's really key here is that, where is that terminal rate going to be? When we look at these very, very long-dated charts, of the, of the interest rate policy in the US., you can see it's in this effectively a downward trend channel. And if we do see policy rates start to tighten, where are they going to tighten too? Is it going to be sort of four or five percent that we saw previously, or higher in the previous scenarios? But when you look at the chart, it would suggest that policy rates are going to reach a terminal level, that's probably closer to around about 2%. And will we even get there because there has been this sense that whenever we get higher interest rates or high yields are one or the other, that we tend to have a weakening of the economy. Now, if yields are falling at the long end, as I've mentioned before, that's normally quite protective of the equity market. But certainly we've got to watch this because, policymakers want to tighten rates, but they don't have much room to tighten given the size of debt. So we've got a very clearly watch for those policy rates and where the terminal rate is. Now the next chart is the one where having a little bit of inflation on it and this is one that shows real wages. The reason why I'm showing real wages is because when we look at inflation, we hope there's growth, if we get inflation, but without growth, then we've got a problem. If growth is bigger than faster inflation than people can sort of deal with that rates go up, but we can deal with that. That tightening policy. But when we've got no growth, we've got inflation, then the response from central banks matters because any tightening is tightening into a slow environment, it's a sort of stagflationary environment. What we can see here is that, yes, we know that wages have been going up, but real wages have started to fall. This is real average hourly earnings, because inflation is so high, it's actually impacting effectively spending power. So as we've seen a surge in spending retrospectively, now we can see in our rear-view mirror. When we look forward, spending could be impaired by this inflation or these higher prices impacting real wages and real earnings. That means that when the Fed, if the Fed starts to tighten policy, they'll be tightening policy into an environment where growth is not particularly strong. And obviously, then that policy, the other impact of that policy is going to be how divergent will that policy be and how will that impact currencies? The chart that I've got here is one which shows a J.P. Morgan Emerging Market FX index versus the DXY that's been inverted. And the reason why I show this is that what's crucial to understand from 2021, is that we never had reflation, not the inflation or reflation that people thought we were going to get. Reflation is normally where you get coordinated global growth, emerging markets do well, China's, you know, sucking up loads of commodities and emerging markets and emerging market currencies do well. The beginning of 2021, copper prices were rising. Commodity prices were going up. Everyone said this is reflation. These were reflationary assets that were going up because of bottlenecks. There was some demand coming through there, but it was a tightness of supply. But it wasn't true reflection, you can see that here because although initially we saw weakness in the dollar, the strength in emerging markets just really didn't catch fire. Most of that strength against the dollar of other currencies was the euro and the Chinese currency. But broad based emerging markets did not catch fire. They've now rolled over and actually, at the end of 2021, the J.P. Morgan Emerging Market FX Index is at a new all time low. We've just not seen global growth. We've not seen globally coordinated strength. And this is key again, because if we are seeking to see tightening from the US and that tightening is forcing other central banks in emerging markets to tighten. Well, that's actually bad for those currencies in general when you're tightening in emerging markets, because of inflationary fears, often that's a negative on the currency. Now, some of those central banks have been pre-emptive and may not have to tighten much more. But the US is tightening. There is a big risk out there, and we've already seen that the backdrop is that China is not the powerhouse on the global stage that we've seen before, because the refocus from the global stage effectively through commodities towards the internal stage and consumption. And because of that relationship that we know exists between the dollar in emerging markets, we've therefore got to think what's going to happen with the relative performance of emerging market equities, to the to the S&P. The long term relationship we've seen before is that when the dollar is weak, generally emerging market equities outperform, when the dollar is strong, generally, the S&P has outperformed. What's been noticable over the last couple of years is that, even when we've had dollar weakness, we've not had the same sort of emerging market equity strength. Again, emerging market equities, like currencies, have been largely on the back foot, and there's a lot of people looking again into 2022 and thinking, will emerging markets catch fire? It was the big consensus trade going into 2021. Coming into 2022 is a little more uncertainty around that. There's a little less expectation because of the regulatory changes that have happened in China. But certainly that's an area we've got to watch for because if the dollar does strengthen from here, then those emerging markets will generally be expected to underperform and should underperform. And we've seen this quite dramatic outperformance of the S&P versus those emerging markets, pretty much unless we're seeing incredible weakness in the dollar. We've just not seen much weakness in the dollar over the last year. And what's the reason for this? Now, the dollar is one of the main reasons, but as I mentioned, China, China is that key pivot and China's regulatory changes through 2021. So the tech sector, the Chinese tech sector, dramatically underperformed the US tech sector. When we look at the KW EB ETF, you can see its divergence from the Nasdaq. And because China is such a big part of emerging markets, emerging markets have struggled because China's stock market has also struggled. Not only have we had the regulatory changes that have been impacting the tech sector, but we've also had those well, well known issues going through the property sector as well. So China is key. Will China rebound? If China's equities rebound, then actually maybe emerging markets, well, the broad based emerging market index can start to pick up, regardless of what the dollar does. But China is absolutely key. And then we come into one other region, which is the region that probably keeps most people despairing, which is Europe. What will happen in Europe? Again policy matters here, Europe wants to stay loose, if U.S. yeilds do move, and at the moment, it looks like they're going to stay relatively capped. But if they did move higher than other global bond yields will move as well. We watch Europe not for the equity market, but really for the bond market. We're looking at the bund versus BTP spread, so that's 10 year Germany vs. 10-Year Italy. That spreads started ticking up at the end of 2021. We don't want that spread to widen that too much because that would be a sign of stress. It would be a sign that Italy is starting to feel a bit of stress because, global financial conditions might be tightening. So for Europe, it's perhaps the least sexy one. But a lot of people are looking at Europe to start to outperform in the equity market. And I think it could well do, but if those spreads start to widen out, we do have to be careful and within that, obviously, then it's the euro that is one of the key determinants. At the beginning of 2021, everyone was bearish, the dollar and bullish the euro. But positioning in the euro was very, very strong, very, very long. We were saying throughout 2021 that we expect that the US dollar will do better than most people expected, which it did. Now, coming into 2022, the consensus is generally for a stronger dollar and a lot of the tailwinds for the dollar is still in place. That divergent policy, but positioning now is far, far lower. If you look at the length on the CME futures market, which is a small market relative to OTC, but it's a good indicator of positioning, it's not quite neutral, but it's fallen a long way from those extreme levels. So positioning of long in the euro is not quite so impressive. Why does this all matter? Well, ultimately the dollar and the dollar index, the last chart, we can't do it without the dollar index. The dollar index has had a good year, but all it's done is go back into the middle of the five year range. The dollar matters because the dollar is the apex of the financial system, it greases the wheels of finance. If the dollar moves up quickly, that tightens financial conditions. If it grinds up, it's not so bad, but if it moves rapidly to the upside, that would be a significant problem. So I started with the yield curve and I finished with the DXY. The reason why that is, is I think yields are the most important thing for 2022. But the dollar and the speed that it moves is also significant. If yields move up and the dollar moves up and they both move quickly, that will be very, very destabilising for financial assets. So if you're looking for a hedge outside of the equity market, long against the dollar and it would be looking for those yields to go much higher, not a base case. But those are the big risks. So dollar and yields those things to really focus on for 2022, which will be the determinants of how things perform through the year. And as I said in the next part, we've got Rob Cox and he's just going to run through a few ideas of some of the geopolitics, and some of the sort of big topics and themes that he thinks will play out over 2022.
Rob [00:12:57] Hi i'm Rob Cox, the global editor of Breaking Views, the commentary arm of Reuters news. And I'm excited to tell you about the book of predictions and prescriptions that my team across the world has assembled for 2022. This year's theme is a world in Transition. The dictionary defines transition as change from one state of being or condition to another. That pretty much sums up where we are as the New Year arrives. Whether it's the move away from an economic system reliant upon hydrocarbons vanquishing the COVID 19 pandemic or central banks ending the free money era, extraordinary shifts are taking place across the planet that will shape markets, corporate finance, politics, economies well into 2022 and beyond. We've broken these down into six categories in the book. The first is the ecological transition. The efforts by governments and companies to reduce carbon emissions and reach net zero by 2050 or sooner, will basically continue to dominate the financial and business landscape in 2022. Switching away from coal, gas and oil is a priority, but every sector, including heavy industries like steel and cement, transport, agriculture, banking, will need, soon, to make huge commitments to meet the lofty ambitions of the next generation. A subcategory of this is the phasing out of the internal combustion engine by 2030, in many parts of the developed world. The decisions and investments needed to make this switch are happening right now. The digital transition is another big theme. A third year of the pandemic, with the persistent threat of new, more virulent strains, continues to dramatically accelerate the shift to digital everything. The winners and losers of this transition will become more evident in 2022, and by the way, we think Microsoft itself will be the big, big winner. Money is undergoing a massive transition in 2022 as well. Inflation is less quiescent than in the past couple of decades. Central banks will have to start pulling away the punchbowl or, or ending the party or whatever it is, and it has huge implications for the cost of capital. Mainly, it goes up, and money itself, by the way, will go through a huge transformation this year as monetary authorities try to keep up with the emerging dynamics of crypto and digital currencies. The world of work is another one, and even as people trickle back to offices, post-pandemic dynamics and communications, training, travel, social interaction are permanently reshaping the way we work productivity. And this has huge implications for labour, property, urban planning and beyond. It also poses new challenges for leaders, none of whom were trained at Harvard or INSEAD to run sprawling organisations of employees working individually from their kitchens, right? That's why we're predicting higher than ever turnover of CEOs themselves. The increasingly chilly war between the United States and China will continue to dominate international trade and geopolitics, with Zhejiang being set for another term. As China's president and US President Joe Biden has a chance to reach detente of some sort, to cooperate on climate change, the pandemic and other priorities. But with Biden's own party facing a trouncing in November congressional elections, his hands may be tied. On the plus side, European leadership will have a chance to shine, as French President Emmanuel Macron probably wins a second term in May. Germany welcomes a new chancellor after sixteen years, with Angela Merkel at the helm and Italy chooses its new president. Success will require extraordinary social inclusion. Governments, companies, taxpayers, especially the richest, will have to proactively prepare for the sacrifices that are needed to prevent the Earth from scorching, while delivering greater equity and financial inclusion and social justice. Failure to do so will lead to widespread civil unrest or worse. In addition to being terrible for business that would torpedo many more existential goals, like limiting global warming, whose deleterious effects will disproportionately affect the world's poorest. And with that, we hope for a better 2022.
Roger [00:17:07] As you heard from Rob, next year is going to see many of the themes from 2021 continue through 2022. But the big ones for me are things like the geopolitics, China and the US. I've talked a lot about China and the US, their importance on the economy. Geopolitics is going to impact that. And clearly, COVID is unfortunately going to be with us into next year and beyond. And that's going to have a major determinant or be a major determinant for a great many things. But I hope that 2022 will be a great investing year for everybody. I'm looking forward to the festive season, I hope you enjoy the season too and I look forward to seeing you in 2022.