A year ago Shares said it was feeling more optimistic about the year ahead. Despite inflationary pressures, stock markets overall have delivered good rewards for investors in 2021 and Covid vaccines have helped to restore some sense of normality.

As we move into 2022, the outlook is still upbeat although there are plenty of factors which could trip up markets.

This article pieces together all the key issues and offers various opinions from the Shares team and experts in the investment world as to where you might want to put your money, and the risks to consider.

It is intended to provide food for thought rather than a precise investment plan. It should help with your own investment research and make you better informed for the 12 months ahead.

What will happen to inflation in 2022?

Federal Reserve chairman Jerome Powell spooked markets this month when he suggested inflation may no longer be as ‘transitory’ as previously thought.

With US inflation hitting levels not seen in three decades and Chinese producer prices rising at the fastest pace in 26 years, policymakers and business leaders are right to be concerned.

Yet the arrival of the Omicron variant may have handed governments a ‘Get Out Of Jail Free’ card.

As UBS Wealth Management chief economist Paul Donovan points out, the response to Omicron doesn’t need to be the same as in March last year. Vaccination programmes are well advanced around the world, and there is no need to implement widespread lockdowns.

Just as manufacturers slammed on the brakes last year, consumers found themselves time-rich and cash-rich thanks to government handouts, creating a massive supply-demand imbalance which led to strains on the global supply chain, which fed through into higher prices.

Without the same level of disruption or welfare, Omicron could be a deflationary force. The reaction of the Brent crude oil price, which dropped 15% within days, was extremely telling.

Moreover, companies have adapted to the supply chain squeeze and evidence suggests consumers have pulled forward their spending, so the inflationary impulse could be much weaker. [IC]

What is the outlook for interest rates?

The US Fed was already facing a tricky 2022 even before the Omicron variant appeared as it tries to walk a fine line to keep the economy bubbling along while also removing emergency liquidity and normalising monetary policy.

Earlier in December, Fed chairman Jay Powell said the US central bank would discuss speeding up the removal of asset purchases. This means interest rate rises could start earlier next year than previously thought.

The key question for investors now is how high Fed policy rates will go and according to fund manager David Roberts at Liontrust Asset Management, the bond market is pricing in a peak far below the Fed’s assumption of 2%, implying only a couple of rate rises.

Economist Mohamed A. El-Erian is in the camp which believes the US economy is far too indebted to withstand more than a couple of interest rate rises.

At the other end of the spectrum economists at Bank of America believe the economy is strong enough to allow the Fed to hike more aggressively.

In the UK, the Bank of England was scheduled to decide on rates today (16 Dec). We wouldn’t be surprised to see it hold off from putting up rates amid near-term uncertainty from the Omicron variant, and instead put up them up in the first quarter of 2022 assuming Covid pressures ease. [MGam]

What’s on the agenda for tax?

There is a risk that increasing tax burden acts as a brake on UK corporate profitability, economic growth, and job creation.

According to independent fiscal watchdog the Office for Budget Responsibility, taxes are now at a level not seen since the early 1950s. This follows the decision by chancellor Rishi Sunak to increase taxes by £40 billion.

On 7 September 2021, prime minister Boris Johnson announced the National Insurance contributions rate will rise by 1.25 percentage points at the start of the new tax year in April 2022.

This additional cost for employers may act as a disincentive for additional hiring and job creation. Furthermore, the intended increase in corporation tax from 19% to 25% in 2023 is the first attack on company profits since Labour chancellor Denis Healey raised corporation tax in 1974 in the wake of the three- day week.

The decision to freeze personal income tax allowances from April 2022 until 2026 is not a positive move for individuals. It means more people will be paying taxes as wages rise. [MGar]

What are the key geopolitical risks to consider?

There are sufficient issues bubbling away for geopolitical tensions to be a major risk to global markets in 2022.

First there is an increasing risk that technology decoupling between the US and China becomes more pronounced.

Competition between the US and China is heating up as both countries are focused on mitigating vulnerabilities.

The US Senate has passed industrial legislation aimed at enhancing US competitiveness in critical technologies, and the Securities and Exchange Commission is increasing disclosure requirements for Chinese companies listed in the US.

This pressure between the two global superpowers has culminated in the ride hailing company Didi saying it will delist from the New York Stock Exchange. This marks a disconcerting acceleration in China’s decoupling from American capital markets.

The second key geopolitical risk is that China takes military action to accelerate reunification with Taiwan, or more forcefully asserts claims in the South China Sea.

In early October, 38 Chinese military jets crossed into Taiwanese airspace as Beijing marked the anniversary of the founding of the People’s Republic of China. In response Taiwan scrambled fighters to warn away the Chinese aircraft.

Then there are heightened tensions between Russia and Ukraine. Speculation is growing that Russian troops are ready to invade the country, possibly as soon as January. [MGar]

Will green/ESG factors remain in vogue?

A key coda of the COP26 climate change summit in Glasgow in November was the part of the agreement which required countries to come back to the table to revisit and strengthen their 2030 emissions targets by the end of 2022.

This should help give focus to the market’s sustainability and environmental considerations as we move through the course of next year.

Janus Henderson’s global head of ESG investments Paul LaCoursiere says: ‘ESG investing is evolving at an unprecedented pace and we see no reason to expect this to slow in the year ahead.’

Bank of America commodity strategist Michael Widmer points out that revised emissions targets may have implications for metals prices as it will remind people that ‘the more aggressive you are with targets, the more mined commodities you need to maintain a modern lifestyle’.

In other words, there will be greater demand for the raw materials required for electric vehicle and renewables infrastructure. [TS]

What is the outlook for earnings growth in 2022?

There is a great deal of noise in the stock market, largely stemming from the uncertainty surrounding new Covid variants, potential lockdowns and inflation. But when push comes to shove, it is the earnings and cash flow companies generate that drive stock markets and share prices in the long-run, and the outlook for earnings is good according to many analysts and fund managers.

Goldman Sachs estimates that FTSE 100 earnings will grow 9% in 2022, nearly twice that of most recent 5.1% inflation figures, and almost three times that of next year’s projected 3.3% average.

Berenberg sees 10% to 15% growth in earnings per share for stocks in Europe in 2022. ‘Equity markets tracked earnings in the 2003-2007 period; since then, equity markets have more closely tracked liquidity, especially over the past 18 months. Further share price gains from here require either another excess liquidity injection (unlikely, in our view) or earnings to take the baton and support equities.’

The investment bank says earnings revisions remain positive, with medium-term earnings growth expectations also looking supportive. It says delivery of these growth expectations should be positive for equity markets, but flags key risks as including more supply chain disruption and inflation/margin pressure.

James Rutland, who manages funds for Invesco, believes that GDP could surprise on the upside in 2022, especially in Europe, and that would be very positive for share prices.

‘Corporate earnings expectations remain modest, so I anticipate upgrades to company forecasts as better GDP flows through to sectors,’ he says. [SF]

Dividends will become more important

There is a growing view among market experts that returns from equities could be a lot less in 2022 than we saw this year, with dividends making up a more significant proportion of those returns.

‘High valuations today imply low returns, that’s across all asset classes,’ says James Harries, manager of Troy’s Trojan Global Income Fund (BD82KP3). ‘A lot of the areas which traditionally paid an income are being disrupted and they need to be avoided. You need to focus on businesses that have sustainable competitive advantages, are not subject to technological disruption, but are still able to pay and grow dividends.’

Savita Subramanian, equity strategist at Bank of America, says dividend growth has lagged earnings growth because companies were hesitant to be too generous with dividends during the pandemic because of the less certain environment. That might change.

She says: ‘40% of the gains of the S&P 500 have been from dividends since the 1930s. Today, dividends are depressed, but we are forecasting that dividends grow twice as fast as earnings in 2022.’

Although there are still supply chain and inflationary pressures, most companies will no longer be worried about severe Covid-related disruption and so they might have more confidence to raise dividends in 2022.

‘Companies are in a good position to deploy their excess cash in any number of ways, including investing in their businesses, making acquisitions, paying down debt, buying back shares or distributing more to investors via dividends,’ comments Sue Noffke, head of UK equities at Schroders. [DC]

The outlook for mergers and takeovers in 2022

We’ve just had a banner year for global mergers and acquisitions as the world economy bounced back from pandemic-induced lockdowns in 2021 and these animal spirits look set to persist well into 2022, with technology and asset management among the most sought-after industries.

Theta Global Advisors’ Chris Biggs sees 2022 being ‘a historic year’ for mergers and takeovers as a large amount of uncertainty melts away that has lingered from Covid and Brexit. He says: ‘It is a perfect storm of returning optimism, loosening restrictions and undervalued firms.’

Alex Wright, manager of Fidelity Special Situations (B88V3X4) and Fidelity Special Values (FSV), points out UK equities remain significantly undervalued compared to global markets and reasonably valued in absolute terms. He comments: ‘This has been reflected in a meaningful uptick in M&A activity.’

In 2022, he believes we are likely to see more bids if valuation discounts compared to overseas companies do not close.

Shares expects to see additional bids for constituents of the FTSE 250 index, known for being the most dynamic segment of the UK stock market and going through an exceptionally busy period for M&A. [JC]

What’s the outlook for US stocks in 2022?

The US stock market has derated this year, despite appearances, and growth next year could be slower while inflation continues to rise.

Despite all the challenges thrown at the US this year – supply chain issues, soaring inflation, a Chinese crackdown on tech stocks and signs of the end of easy money – the S&P 500 index still managed to post a 20% advance between January and October.

Meanwhile, earnings have risen almost 30% this year, ahead of forecasts and ahead of the stock market, which means US shares are actually cheaper than they were a year ago.

Operating margins for the S&P 500 are expected to have hit an all-time high of almost 13% in the third quarter, so is this as good as it gets?

Analysts at Bank of America are forecasting a 2022 year-end level for the index of 4,600, meaning no change from today’s level. Beneath the surface however, they see earnings rising 6.5% and dividends rising at twice that rate, with industrial spending taking over from consumer spending as the main driver of the economy.

Consumers have plenty of cash, but they have already splurged on ‘stuff’ and higher energy costs will crimp future spending, whereas companies have under-invested for over a decade and need to invest in supply chain improvements and technology, in particular automation given the sharp upward trend in labour costs.

Berenberg states that US mid-caps now look more attractive than large caps, saying they are cheaper, have higher earnings per share growth and surplus free cash flow.

Across the entire market, autos, travel and leisure, energy and technology have the strongest earnings per share growth expectations over the next one to three years. [IC]

What’s the outlook for UK stocks in 2022?

There’s no doubt the UK equity market is cheap, yet while the S&P 500 has soared 27% this year, the FTSE 100 is up just 11% so far, meaning the valuation gap between UK and US stocks has widened even further.

According to Sue Noffke, head of UK equities at investment manager Schroders, the UK stock market is now trading at a discount of more than 40% to its global peers, the biggest divergence in over 30 years.

Valuation by itself isn’t a catalyst – what’s needed is for companies to deliver strong earnings growth. The good news is they have plenty of cash to invest in their businesses and grow, the bad news is the FTSE is laden down with large stocks with low growth prospects.

Mid-caps are likely to see better growth, as they have historically, and the wave of M&A which has swept the UK this year shows that corporate insiders and outside investors think the market is still cheap, especially with sterling weakening.

The key to sentiment is inflation and interest rates. If supply side challenges ease and the Omicron variant depresses consumer demand, inflation should ease and the Bank of England may hold fire on raising rates until later next year, giving investors the green light to buy equities. [IC]

What’s the outlook for European stocks in 2022?

According to data from Barclays the CAPE ratio – a metric devised by economist Robert Shiller which divides market prices by 10-year earnings – for Europe at the end of October was somewhere inbetween the UK (17.5) and the US (39.1) at 24.

Putting the obvious risks posed by Covid variants to one side, the first half of 2022 could see the momentum in European stocks continue, with quarterly earnings likely to continue to grow compared with a disrupted start to 2021.

However, things could get trickier as the year progresses as the European Central Bank tightens the purse strings and earnings comparisons with the second half of 2021 prove more demanding.

There is the potential for help from already sanctioned government stimulus. Invesco’s head of European equities John Surplice says: ‘In Europe, the disbursement of EU “recovery” funds has only just begun and can be much more meaningful in 2022.’ [TS]

What’s the outlook for emerging market stocks in 2022?

Many investors are bullish about emerging markets for 2022, hoping to play a vaccinations-driven catch-up trade and that sentiment towards China will improve amid further easing measures and that we’ve seen the worst of regulatory interference.

There is also optimism with regards to India, which is benefiting as companies seek to reduce risk by diversifying supply chains beyond China and with the Indian government now prioritising growth over reform.

However, Gary Greenberg, Federated Hermes’ head of global emerging markets, is more cautious on emerging markets for several reasons. He points out monetary tightening in the US looks increasingly possible, which would strengthen the dollar and weaken those emerging economies reliant on foreign portfolio inflows.

Vaccination progress is also likely to remain pedestrian in many emerging market countries, holding back economic progress. Greenberg also warns that ‘many of the most attractive business models in emerging markets are highly rated, and vulnerable to derating if US interest rates rise (as are their global peers)’.

Also cautious on emerging markets is Jeremy Podger, manager of the Fidelity Global Special Situations Fund (B8HT715). ‘Unlike developed markets, they have not seen a rise in underlying profitability over the past several years and most EM countries have not had the fiscal flexibility to boost their economies through the pandemic,’ says Podger. ‘They appear relatively cheap, but not to the extent seen at the height of the tech bubble in 2000.’ [JC]

Where should you invest your money in 2022?

Having spoken to a wide range of experts for this article, there were some shared views among many of the commentators with regards to where investors might want to put their money in 2022.

For equities, a preference has been given to quality companies which are generating lots of cash today, rather than in the future.

‘Quality is the best hedge against volatile markets, and a Fed hiking cycle means that cash is moving from being worthless to worth something,’ says Savita Subramanian, equity strategist at Bank of America. ‘Our preferred sectors generally sport high free cash flow and high quality. Within large companies we would focus on those with stable and growing dividends that will benefit rather than be hurt from inflation.’

She likes the energy and financial sectors for dividends and healthcare for secular growth at a reasonable valuation.

Technology companies that provide products and services to help automation could be interesting places to invest. Companies may well spend more on capital expenditure and the current inflationary pressures will have spurred boardrooms to discuss the long-term benefits of automation.

Be careful with technology stocks that do not make a profit as there is a growing view these could fall out of favour with investors next year.

Bank of American favours value over growth, referring to when you can pay a cheap valuation to access companies that offer more modest levels of growth today rather than paying up to access potentially faster levels of growth in the future.

JPMorgan also sees an opportunity with value stocks. It says: ‘Investors should avoid recency-bias. The performance of growth stocks dominated the last cycle. But the macro backdrop looks more akin to the 2000s cycle than the post-Global Financial Crisis cycle. We should remind ourselves that in the 2000s cycle it was value that outperformed.’

The asset manager says investors should not abandon growth altogether. Some technology stocks will continue to benefit from structural trends such as digital and technological transformation. ‘But investors must remain wary of stocks trading on high valuations that have been primarily driven by the plentiful liquidity conditions that central banks have provided. In a world where the tide of liquidity begins to turn, these names are likely to struggle the most.’

We’re in a rising bond yield environment and that could trigger a rotation in the market with investors switching out of certain sectors and into others. JPMorgan says financials, industrials, energy, materials and consumer discretionary tend to outperform the broader market (as measured by the MSCI AC World index) when bond yields are rising. Technology, healthcare, utilities and consumer staples are among the sectors that have historically underperformed in this environment, along with real estate.

Interestingly, Invesco argues that real estate investment trusts have the potential to make the best returns in 2022. ‘(Real estate) may suffer a loss of demand for office and retail space as a result of Covid-19, but we find the yields to be attractive and expect growth to resume as economies recover,’ says the asset manager.

WHAT SHOULD YOU OWN IN DIFFERENT SCENARIOS?

Invesco has created a list of assets to own depending on the backdrop, as well as the likelihood of each scenario happening in 2022.

Its base case is moderating growth and transitory inflation which, in its view, favours owning emerging market assets, real estate, credit (mainly high yield bonds) and a mixture of quality andcyclical equities. [DC]

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Invesco’s view: what to own in different scenarios

BASE CASE: moderating growth and transitory inflation

Probability: 60% 

Favoured assets in this scenario include: emerging markets, real estate, credit, equities (price momentum and quality factors, technology, financial services, basic resources, retailers)

STAGFLATION: recession and high inflation

Probability: 15% 

Favoured assets in this scenario include: inflation-linked bonds, equities (gold miners, low volatility), gold

BENIGN DISINFLATION: high growth and low inflation

Probability: 15% 

Favoured assets in this scenario include: equities (consumer discretionary, technology, growth, quality), real estate, high yield credit

RECESSION: recession and low inflation

Probability: 5% 

Favoured assets in this scenario include: government bonds, gold, defensive equities (utilities, low volatility)

BOOM: high growth and high inflation

Probability: 5% 

Favoured assets in this scenario include: industrial commodities, emerging market assets, real estate, equities (industrials, basic resources, banks and value)

Source: Invesco, November 2021

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What are the risks to the consensus outlook?

The consensus view seems to be that markets will muddle through next year, navigating higher inflation and higher interest rates while earnings growth – which has surpassed all expectations this year – returns to a more normal level.

Among the more obvious risks to this scenario are further lockdowns due to new, more virulent Covid strains, unexpectedly weak corporate earnings which cause markets to derate, a credit crisis in the Chinese property sector as banks withdraw lending in the wake of Evergrande, and a full-blown conflict over Ukraine or Taiwan.

However, the strategists at Saxo Bank have their own, more outrageous suggestions, which not everyone will like.

Most striking is the call that US inflation could top 15% by 2023 due to double-digit wage hikes as companies struggle to replace workers lost during the pandemic.

In a repeat of the late 1960s, the Federal Reserve may misjudge how ‘hot’ it can let the labour market run before it raises interest rates, resulting in a dramatic wage-price spiral. When it does finally react, it will have lost credibility.

Just as troubling, the Saxo team suggest that the US mid-term elections next November could end with no clear winner, creating a constitutional crisis which without question would send US Treasury bills, stocks and the dollar crashing. [IC]

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