Edison Insight: Strategic Perspective and Outlook 2022

Welcome to the January edition of the Edison Insight. This special edition strays from our usual format as it does not include any company profiles. Instead, we look at the outlook for 2022. Healthcare companies are covered separately in Edison Healthcare Insight, which can be found on our website homepage.

 
Alastair George believes that the economic risks of Omicron appear to have fallen short of earlier worst-case predictions. Even though other COVID-19 variants are likely to emerge during 2022, developed market economies and the pandemic appear to be steadily decoupling and the world economic recovery should continue.

Equities in the first half of the year are likely to be supported by relatively strong economic momentum although the lagged impact of tighter monetary policy and the prospect of slower growth in 2023 may hinder returns during H222. Our key concern is that the good news on COVID-19 is already firmly embedded in equity market prices.

Furthermore, inflation remains at an uncomfortably high level in the United States and Europe while in China the property sector remains in distress. Nevertheless, extended equity valuations are by no means universal and are concentrated both geographically and by sector.

This valuation dispersion may offer opportunities to active investors. US markets may be trading well above long-term averages, but many other developed markets are at least within sight of traditional valuation metrics and European and ‘old economy’ sectors appear better hunting grounds for returns at present. We expect energy sector profits to be supported by strong commodity prices while financials should continue to benefit from rising interest rates.

We remain cautious on government bond markets as still-low yields do not appear to factor in a return to the pre COVID-19 trajectory of global GDP. We acknowledge valuations for global equities in aggregate are high but also balance this with the likelihood of another year of corporate profits growth and few alternative options for portfolio asset allocation. Furthermore, outside the United States, equities are not as highly valued and there remain opportunities for active investors.

We therefore initiate a neutral outlook on global equities for 2022 while expecting a significant sector and regional rotation in relative performance during the year. Readers wishing more detail should visit our website, where reports are freely available for download (www.edisongroup.com).

All profit and earnings figures shown are normalised, excluding amortisation of acquired intangibles, exceptional items and share-based payments. Edison is an investment research and advisory company, with offices in North America, Europe, the Middle East and AsiaPac. The heart of Edison is our world-renowned equity research platform and deep multi-sector expertise.

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We welcome any comments/suggestions our readers may have. Neil Shah Director of research
 

Global perspectives: Finding value in the tail

• The economic risks of Omicron appear to have fallen short of earlier worstcase predictions. Even though other variants are likely to emerge during 2022, developed market economies and the pandemic appear to be steadily decoupling. The world economic recovery should continue in 2022. Equities in the first half of the year are likely to be supported by relatively strong economic momentum in our view, although the lagged impact of tighter monetary policy and the prospect of slower growth in 2023 may hinder returns during H222.
• Our key concern is that the good news on COVID-19 is already firmly embedded in equity market prices. The equity risk premium for global markets remains close to 15-year record lows and corporate credit spreads are also tight. This demonstrates a strong investor appetite for risk, even as economic growth is set to moderate over the course of 2022. Furthermore, inflation remains at an uncomfortably high level in the United States and Europe while in China the property sector remains in distress.
• Nevertheless, extended equity valuations are by no means universal and are concentrated both geographically and by sector. This valuation dispersion may offer opportunities to active investors. US markets may be trading well above longterm averages, but many other developed markets are at least within sight of traditional valuation metrics.
• European and ‘old economy’ sectors appear better hunting grounds for returns in 2022. Regional sector aggregates suggest a ‘long tail’ of sectors outside the United States that fall into this category. We expect energy sector profits to be supported by strong commodity prices while financials should continue to benefit from rising interest rates. While non-US equities are not ‘cheap’ in absolute terms, many sectors are trading only a little above historical valuation norms and priced to offer returns well above domestic bond yields.
• We remain cautious on government bond markets as still-low yields do not appear to factor in a return to the pre COVID-19 trajectory of global GDP. We acknowledge valuations for global equities are high but also balance this with the likelihood of another year of corporate profits growth. Furthermore, outside the United States, equities are not as highly valued and there remain opportunities for active investors. We therefore initiate a neutral outlook on global equities for 2022 while expecting a significant sector and regional rotation in relative performance during the year.

Outlook for 2022: Finding value in the tail

 
We believe the primary challenge to global markets in 2022 will not be a new variant of COVID-19 nor further increases in geopolitical tension, even if these factors are likely to continue to buffet markets as they have done during 2021. In a generally positive environment for global growth the primary challenge for risk assets such as equities is instead more prosaic and reflects the unfavourable combination of extended equity market valuations, compressed credit spreads and inflationary pressure, which has now triggered a policy response by central banks.

Nevertheless, extended equity valuations are by no means universal and are concentrated both geographically and by sector. This valuation dispersion may offer opportunities to active investors. While US markets are trading well above long-term averages other developed markets are at least within sight of traditional valuation metrics and offer similar if not higher levels of earnings growth during 2022.

The currently high profile global technology equipment sector is trading at a multiple of twice its long-term average on a forward price/book basis. However, a variety of ‘old economy’ sectors trade at levels which, if current earnings guidance can be achieved, would appear to offer scope for shareholder returns well above cash and inflation. We believe a key theme for 2022 will be a rotation towards slower growing but more cashgenerative sectors as investors seek safety in asset values on balance sheets and retreat from richly priced growth themes as monetary conditions tighten and the rate of GDP growth slows in the second half of 2022.

There are likely to be new developments in the COVID-19 pandemic which increase the risk of short-term bouts of volatility. However, we believe exposure to the longer-term trends of 2022 should be maintained. Portfolios should be prepared for higher interest rates as monetary policy settings are normalised and central banks contend with a sustained period of higher inflation.

Tightening liquidity conditions should favour the value sectors of the market where free cash flow yields and expected returns remain closer to long-term averages and compare especially favourably with the very low yields on risk-free assets at present. Provided the overall economic recovery continues, this should also favour non-US equities where valuation ratings are less demanding.

A focus on ‘value’ investing for 2022 should not however be mistaken for relaxing individual company investment criteria, as over the long term a value-destroying company can underperform a value-creating peer almost regardless of the valuation starting point. Yet there are many more sectors than technology that can deliver sustainable value creation – and a broadening of stock market returns is in our view likely to be a further theme of 2022.

Finally, we highlight that earnings estimates for many sectors in 2022 are ahead of those prevailing prior to the advent of COVID-19. This highlights the decoupling that has been achieved between the evolving nature of the viral threat and the still-strong outlook for corporate profits.
 
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