By Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley
The 2022 Outlook: Normalizing but Not Normal, as the Training Wheels Come Off
We’ll publish our year-ahead outlook later today. This is the 18th outlook I’ve had the pleasure to be a part of in Morgan Stanley Research. Each one is the result of a highly collaborative process across strategy and economics, and each has felt uniquely difficult at the time. 2022 is no different.
In the global economy, my colleague Seth Carpenter and our global economics team think it is a story of 'normalizing, but not normal'. Normalizing, because we think global growth continues to improve, led by strong consumer spending and capital investment. We forecast growth of 4.6%Y in both the US and euro area next year, and think China will also top expectations, albeit with improvement that may not be apparent for several more months. A robust capex cycle, driven by strong demand, rising labor costs and cheap capital, is an important way this recovery differs from the last.
Another difference is inflation. We forecast DM inflation to peak in the coming months, then decline throughout 2022 as supply chains normalize and commodity price gains slow. Importantly, we see major regional differences to this story; one reason we like equities in Europe and Japan is that we think inflationary challenges there are much less daunting than elsewhere.
As the recovery continues, monetary policy shifts. The Fed ends asset purchases by mid-2022, and the Bank of England and Bank of Canada start raising rates. EM policy continues to normalize, with ~70% of EM central banks tightening. We think moderating inflation and a sustained rise in labor force participation mean the first Fed hike is in early 2023, but these trends might not be immediately apparent.
For markets, shifting policy means the training wheels are off, so to speak. After 20 months of unprecedented support from governments and central banks, this aid is winding down. Asset classes will need to rise and fall under their own power.
In some places, this should be fine. From a strategy perspective, we continue to believe this is a (surprisingly) ‘normal’ cycle, albeit hotter and faster given the scale of the recession and the subsequent response. Our cycle indicator, a key part of our framework, is back above trend. And we think markets are facing many ‘normal’ mid-cycle problems: better growth colliding with higher inflation, shifting policy and more expensive valuations.
Overall, we think that valuations and this stage of the cycle support equity over credit and duration. The equity case is significantly stronger in Europe and Japan than EM or the US, where the former enjoy more reasonable valuations, limited central bank tightening and less risk from higher taxes. Those same issues drive a below-consensus forecast for the S&P 500 (4,400 by end-2022). That ‘bearish’ forecast is still a historically high multiple (18x) on an optimistic 2023 EPS number (US$245).
The ‘equity over spread’ theme extends to credit, where we attempt to re-run much of the 2004-05 playbook. Better growth and good corporate liquidity should keep default rates low. Along with rising rates, this supports loans over high yield over investment grade credit (the same hierarchy that reigned in 2004-05). Also in line with that period, we prefer securitized to corporate credit, and think the best risk/reward is down the capital structure (CMBX BBBs, CLO equity).
For macro markets, my strategy colleagues see a year of two parts. As we forecast that the Fed will wait until 2023 to make its first hike, it may not be in a rush to signal this action right away. We remain positive on USD and expect US real yields to rise to start the year, factors that mean we suggest patience before buying EM assets. We forecast the US 10-year at 2.10% by end-2022.
As a delay of the first hike becomes more likely, these factors should all shift. To generate alpha, we like owning CAD/CHF, which should benefit from policy divergence and our expectation of higher oil prices in 1H22.
If that’s the story, what are the risks? A better version of our 2022 narrative is more aggressive stimulus by China, a quicker repair of supply chains and a faster jump in labor participation. This would lead markets to price our 'no Fed hikes in 2022' view sooner, and mean a stronger rally, especially in EM, than we forecast.
To the downside, it’s all about inflation and real rates. The biggest surprise of 2021 was global real rates hitting new all-data lows as growth recovered, a boon to asset prices. Markets could reasonably assume these are the wrong financial conditions relative to the level of inflation, and that terminal rates should be higher. Our rate strategists like several trades that hedge such a risk: steepeners in US 2s5s and GBP 2s10s and short EUR 10y10y.
Best wishes for the year ahead, and enjoy your Sunday.