By Tim Sharp
The key questions that are likely to affect investment decisions in the medium-term focus on the effects of the Omicron variant on global growth, earnings growth justifying current equity valuations, and the strength of inflation accelerating changes in monetary policy.
There are many categories of risk within markets and investment management, and we would like to focus on idiosyncratic risks for a moment. Idiosyncratic risks are the opposite to systemic risk as they are uncorrelated to overall market risk and effect individual assets or investments. The risk may come from the macro-environment, including economic, political and society risks, or from determinants within a specific industry. Moreover, the term may be used to refer to non-financial, unsystematic risks within the global economy whose effects on financial markets may be difficult to quantify, such as, natural disasters, pandemics, and geo-political tensions.
We believe the rise in geo-political risks, such as Russian / Ukraine tensions, and social tensions caused by new Covid-19 variants, can be added to supply chain disruptions, continued uneven economic reopening’s, and the short-term spike in energy prices, amongst others, that make up an important list of idiosyncratic risks that could have a material effect on financial markets in 2022.
The present disruptions to supply chains are arguably caused by the rise in the consumption of goods instead of services during the pandemic that continues while complete re-opening is delayed. Furthermore, should companies decide that shortening or onshoring of their supply chain would reduce risks in the long term then this disruption will also influence global growth both at a consumption and a country level. More recently there have been reports of companies over-ordering in fear of continuing component shortages leading inadvertently to the very shortages they hoped to overcome. While China continues with a zero-tolerant COVID response policy and other Emerging countries continue to ramp up their vaccination responses, this headwind could last into 2023 in some instances with the inevitable cost to earnings, growth, and financial returns. Absolute Strategy Research (ASR) has recently cut its equity forecasts for 2022 from 10%-20% to 5%-10% in line with the belief that idiosyncratic risks will constrain risk assets meaning EPS growth will fall to 0-15% as nominal growth slows[i].
The likelihood of a China slowdown in 2022 as the economy transitions to a consumer-led framework could see GDP growth of approximately 5% in 2022 falling further to 4.5% in 2023[ii]. This has significant implications for commodity markets unless another systemic consumer comes to the fore – such as perhaps sustainable energy sources. The EU plans to put EUR1trn to work in sustainable investment over the next 10 years as part of the Green Deal making Europe one of the global leaders in sustainable energy[iii]. We believe the level of proposed investment will allow European to embrace the environmental challenge with innovation that could see European companies at the forefront of green energy technologies.
The rapid rise of ESG investing coinciding with an increase in the fiscal response to climate change as highlighted by COP 26, will continue to shape the investment landscape. Many investors are looking for pure play green energy investments when it seems that many of the existing energy companies are transitioning towards alternative energy sources. Total has changed its name to TotalEnergies in an attempt to highlight its multi-source energy strategy and activist investors are trying to persuade energy companies to split green and fossil fuel businesses[iv]. This has led to many traditional energy companies such as Shell, BP, TotalEnergies, ExxonMobil, and Chevron facing ESG discounts, further highlighting investors unwillingness to invest in carbon intensive industries. We believe that the world’s reliance on fossil fuels during the transition to sustainable energy sources should not be under-estimated and the role of the incumbent energy suppliers in investing in that transition is currently not being fully valued by investorsi.
Although the strength and persistence of the inflation spike means that it is difficult to continue to consider the implications as temporary, some of the pricing pressures do seem to us to be linked to the imbalances from the delayed re-opening of the global economy which is likely to be exacerbated by the Omicron variant. High vaccination rates in the western world could also discourage governments from imposing greater restrictions. Ironically as Central Banks meet this week to implement the beginnings of a change to a tighter policy, the characteristics of the new variant could have a restrictive effect on consumer behaviour and government guidance. In the UK there is a reasonably close link between hospitalisations and people choosing to stay at home[v], however, equity investors have bought the dips over the last week as anecdotal evidence from South Africa suggests that although more easily transmissible, the symptoms are weaker than previous variants.
Scarring of the global economy due to the effects of Covid-19 has been debated throughout the pandemic and much of the evidence will become clear once the economy has re-opened. However, the emergence of the Omicron variant creating another wave of infections may bring the virus closer to its conclusion, but not before many temporary changes in consumer behaviour potentially become the new normal. ASR point to a Gallup poll that suggests approximately 70% of US white collar workers are still working-from-home[vi] suggesting a new hybrid working week could become more likely in the future. This will have an effect on the number of housing bubbles that have inflated during the pandemic as consumers switch between suburban and out-of-town living with consequences for housebuilders, office rental companies, and consumer service providers. The Omicron wave may also be the event that alters business travel behaviour for good with inevitable effects on airlines, hotels, and remote communications providers. We believe the longer it takes for the global economy to emerge from the pandemic the more the likelihood that consumer behaviour will move to a new normal.
If we are approaching the final phase, Absolute Strategy Research are predicting that many of the current inflation causes will prove temporary and the rate will return to 2% over the course of 2022i. Consumption growth would eventually normalise between goods and services alleviating some of the employment shortages and supply chain disruptions. Energy prices would be expected to normalise, and the continued strength of the US dollar would remain a headwind for global growth. Under this scenario of weaker growth and less pricing power leading to lower corporate earnings, we may see the cyclical recovery replaced by a move into more defensive sectors, such as, healthcare, consumer staples and utilities.
In conclusion, we believe there are many transitional events taking place in the global economy, increasing the level of idiosyncratic risk in financial markets that will affect the outlook for sectors, industries, and companies at different levels. As active investment managers we will look to navigate the path to consistent, long-term returns, and anticipate the effects of a changing world on portfolios.
[i] Absolute Strategy Research – Asset Allocation – De-Risking in a “Trend Everything” World – December 9, 2021
[ii] Absolute Strategy Research – 2022 Outlook: a test of regime change – November 30, 2021
[iii] Portfolio Adviser – Why European Equities could rise as the US Stock Market lustre fades by Cherry Reynard, October 14, 2020.
[iv] FT.Com – Shell warns hedge funds risk derailing energy transition – October 28, 2021
[v] Absolute Strategy Research – New variant, same activity concerns? – December 3, 2021
[vi] Absolute Strategy Research – Omicron & On – December 14, 2021
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