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Global equities: balancing a broadening recovery with inflation concerns

16 Dec 2021

The trajectory of inflation and policy makers’ response to it, along with a marked shift in who is trading stocks, are likely to influence markets in 2022, Co-Head of Equities George Maris argues.

Key Takeaways

  • With an economic recovery continuing, the potential exists for small caps to perform well in 2022 among both growth and value stocks.
  • While inflation has captured investors’ attention, they should also be mindful of an evolving – and relatively untested – market structure.
  • Equities investors should respect the risks posed by uncommonly concentrated markets and from not having a long-term investment approach.

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I think the predominant theme that is going to influence frankly most all asset classes, particularly equities, but I think everything, will be whether or not inflation is persistent or transitory. We have seen pretty substantial increases in inflation in 2021. The question is, to what extent do those persist into 2022 and beyond?

Whether or not inflation is persistent will impact markets significantly. In particular, it will impact policy decision making, whether by central banks or by fiscal agencies. We are already seeing bifurcated approaches globally from the leading central banks. The U.S. Federal Reserve, Bank of England and Bank of Canada are already adopting a more hawkish approach, signaling tapering and raising rates, compared to the European Central Bank and other dominant central banks that are taking a much more relaxed approach, wanting to see if inflation truly does run, and run persistently, given some of the issues we have with supply chain bottlenecks and the like. So inflation is the predominant theme that will drive markets globally.

I think the second critical theme to pay attention to for equity markets globally relates to market structure. One of the things that we have seen, partly as a function of changing behavior due to COVID and more stay-at-home type of activity, but we have also seen as a consequence of easy money policies around the world, is a dramatic change in terms of who actually trades on equity markets. It used to be that you would have the long-only community or fundamentally oriented hedge funds that would be the predominant actors on equity exchanges. Today that is flipped. You are seeing systematic trading activity, whether it is via systematic algorithmic activity, or the commodity trading accounts that do this, or advisors that do this, or the retail sector have become a much greater proportion of trading activity. These actors tend to act in a much more short-term truncated way, create much more volatility in the markets and have been heavily promoted via not only free trading but highly leveraged trading. If rates go up, we could very well see this potentially unwind, and how that manifests itself will be a critical determinant of equity returns in 2022.

I think there are opportunities that present themselves in a whole different variety of flavors if you are looking for them. But I think given the crowdedness that we have seen in equity markets in 2020 and 2021, opportune areas are going to be in smaller cap. I think you will actually be able to find great opportunities, whether of the secular growth variety or a deeper-value cyclical variety in smaller cap names. But I think as you get into names that look less and less like the index, you will find greater opportunities for excess return. In addition, I think regionally the United Kingdom looks quite interesting. It is the cheapest market on a per-growth unit basis globally, and to me I think that there isn’t a lot of long-term rationale for that dislocation, and I think that represents an opportunity for positive reversion.

I think most people would argue that COVID and COVID developments would be the largest risk for equity markets in 2022. I will take a different stance. I actually think that COVID risk will be more short-term. I think most people and economies have learned to live with it and live with the volatility associated therewith. For me, the biggest risk that is unappreciated in ’22 will be relating to market structure. The fact that we have had so much money come in on a leveraged basis supported by very loose-money central bank policies, several of which are likely to reverse, could very well cause significant technically oriented trading volatility in markets. That deleveraging could cause a dramatic increase in illiquidity; that illiquidity could cause substantial stepdown in markets. I think they will be short-term oriented, but that is an area of highly underappreciated risk. The positive here is what you want to do is look less and less like an index and be less and less crowded.

I think there is one particular chart that I would like to highlight that really exemplifies the risk that we have in equity markets, and that is with respect to crowding. Right now, five stocks represent 23.7% of the market cap of the S&P 500 – that is a historical high. That also shows a very unhealthy narrow market and exemplifies the risks of looking like an index right now. In addition, there is another chart that I would like to highlight. It really talks about the need for people to stay fully invested and to stay the course over long periods of time. If you look at the period from 1995 until the end of November 2021, so a little over 26 years, you have a period of 8.9% compounded returns in the S&P 500. If you skipped the 30 best investment days over that period of 26-plus years, your compounded return drops from 8.9% to 2.0%, an extraordinary drop in return. What it highlights is the need for investors to stay fully invested, to stay the course and not sell at dramatically painful moments. And it also highlights the need to have active investors who are staying committed to their process and not chasing trends back and forth.

I think the most important consideration for someone either invested in equities or considering an exposure to equities in 2022 is the real concern that indices are not a safe place. Given the increase in activity of systematic trading actors and the retail participants, what we are seeing is a heavily crowded nature into particular securities, involvement in meme stocks and the like. All of those things are quite, to me, quite dangerous. They are dislocated from fundamental reality, and it creates a danger in being like the index, because the index is replicating those bad behaviors. So looking different from the index is critical.

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16 Dec 2021