The global economy is growing right now, and the inflation rate will remain relatively high in the medium term. In particular, the Federal Reserve forecasts dollar inflation at 4.2% in 2021 but expects it to fall to 2.2% in 2022. In Russia, inflation in 2021 could be 7.4-7.9%, but in 2022 it will fail to 4-4.5%.
The general investment trend is to focus on stocks rather than bonds. Emerging market assets, cyclical sectors, value stocks, and small-cap companies should perform well in the current environment.
But, as usual, what to choose in a portfolio depends on an investor’s characteristics: goals, risk appetite, etc.
Macroeconomic situation
The global economy has shown a rapid V-shaped recovery from the 2020 recession. The U.S. and, before that, China have already surpassed pre-crisis GDP levels.
Other advanced economies, including those in Europe, are catching up. Developing countries like India and Brazil are in the rearguard, in particular, because of lower vaccination rates.
Global demand is growing, but the situation remains complicated by coronavirus restrictions and disruption of global supply chains. As a result, price pressures on goods and services are rising. In addition, the situation may become more complicated with the emergence of new strains of the virus and recent lockdowns.
A recent Schroders report noted a slowdown in U.S. GDP growth, but consumers are showing high confidence levels. The Fed is not abandoning plans to phase out quantitative easing, and elevated inflation is considered temporary.
In the second quarter of 2021, China declined in GDP growth to 7.9% year-over-year, down from a record 18.3% in the first quarter. In 2022, economic growth is projected to slow further to about 5.5%. Meanwhile, inflation in China is expected to be low: 1.07% in 2021 and within 2% in the coming years.
In the U.S., the economy is also projected to slow down. GDP growth is forecast at 5.7% for 2021 and 4.1% for 2022. And for the first time since 2007, growth in the European economies may be higher than in the U.S. A detailed analysis of the current U.S. economic situation and further likely scenarios can be found in the September report from S&P Global.
It is also expected that in December 2021, the Fed will start to tighten monetary policy: it will reduce asset purchases, and by the end of next year, it will begin to a systematic increase of the interest rate. After all, it makes little sense to stimulate demand in an economy that is experiencing supply disruptions. It promises only further increases in inflation.
In contrast, GDP growth in Europe is expected to be 5% and inflation 2.2% in 2021, and 4.6% and 1.7% in 2022, respectively. No key rate hikes are foreseen. At the same time, as of October 2021, annual inflation in the euro area was 4.1%, but the ECB considers it a temporary blip.
As for Russia, the Ministry of Economic Development forecast for GDP growth in 2021 – 4.2%, for 2022 – 3%. The IMF believes that GDP growth could be 4.7%.
September inflation forecasts were as follows: 5.8% in 2021 and 4-4.5% in 2022. However, as of October 18, 2021, annual inflation reached 7.79%, and on October 22, the Central Bank said in a press release that inflation is expected to be in the range of 7.4-7.9% by the end of the year. By November 1, according to Finanz, citing data from the Ministry of Economic Development and Rosstat, annual inflation reached 8.14%.
Also, rising oil prices may affect the further growth of global inflation. In September, the oil quotes tested the psychologically important level of $80 per barrel, and in mid-October reached $85. Analysts at Bank of America have warned that oil prices could rise to $100 in the next six months if the winter is colder than usual.
Oil prices serve as a driver of inflation, as many goods and services are tied to the transportation component. Thus, oil can further push up prices.
At the same time, the high cost of energy resources is a plus for producing countries like Russia. Domestic oil producers are reaping huge profits, and quotes like Lukoil and Rosneft were rewriting historic highs in October. And this rally may continue.
Equity markets
Given the current low-interest-rate environment, government bonds of developed countries are becoming irrelevant. First, their yields are below inflation, i.e., they produce actual adverse outcomes. Second, bonds will become cheaper as the vital rate rises.
In his recent review of the markets, Blackrock suggests that the focus should be on stocks rather than bonds both tactically and strategically. In addition to Blackrock, it makes sense to read other macroeconomic and market analyses, such as Vanguard, Amundi, and JPMorgan.
Blackrock is neutral on U.S. equities and believes that more growth potential lies in other developed economies, such as Europe and Japan, as well as emerging economies. A strong growth momentum of business activity and corporate profits is expected there.
Also, it is possible to start looking at bonds of some emerging economies in national currencies, where rates are becoming increasingly attractive in the medium term. In Russia, for example, the critical speed is already at 7.5% and could be higher than 8% in 2022. This could lead to an outflow of private capital from the stock market to bank deposits.
Blackrock is also moderately positive on Chinese stocks, as regulatory and monetary policy shifts toward easing can be expected in response to a slowing economy.
As for U.S. stocks, the market is high on forwarding P/E and CAPE, with values of 21.8 and 40, respectively, as of early November 2021. I discussed how high CAPE is likely to affect U.S. stock returns in the current decade in an article about the CAPE ratio.
The other risk for U.S. stocks, besides overvaluation, is if the Fed starts to tighten the screws too much: stopping all monetary stimulus and raising rates sharply. This could happen, for example, if inflation gets out of control. In that situation, a bear market could start in the stock markets.
Researchers at Vanguard found that over the past decade, U.S. stocks have risen an average of 8 percentage points better than global stocks. That’s due just as much to the high valuation of the U.S. market. According to their projections, international stocks will likely outperform U.S. stocks by 2030, with an expected return of 8.1 percent per year versus 4.7 percent.
If we compare the valuation of U.S. stocks to other markets, the Forward P/E of all developed markets other than the U.S. was 15.6 in early November 2021. For the global market without the U.S., the figure was 14.7.
As for emerging markets, the figure is 13. In particular, for China, it was 13.6, and for the Russian market, it was 6.5. Thus, betting on emerging markets allows you to capture the cost factor, as well as the cyclicality factor, given the predominantly commodity-based nature of these economies. More on this below.
Inequities, it now makes sense to focus on the value factor and small-cap companies and cyclical sectors. Cyclical sectors are sensitive to economic conditions, meaning their profits follow the ups and downs in the economy. Since the economy is now picking up, cyclical companies should benefit from this. For more on which sectors and industries are protective and cyclical, see the article on the sector division of the economy.
All of the factors listed to benefit from the current environment, including high inflation, as evidenced by their performance in 2021.
What’s the bottom line
For the U.S. economy, growth is high but could pass its peak, especially if the Fed starts to tighten monetary policy. A stagflation scenario is not out of the question for the global economy, where rising inflation will be accompanied by falling GDP growth.
Many analysts agree that betting on stocks, including emerging market, value, cyclical, and small-cap stocks, is now justified.
Government bonds in developed countries generally don’t cover inflation and will get cheaper as key rates rise. But in some emerging markets, where the regulator is ahead of the curve, as in Russia, bonds could be an attractive asset in the medium term.
Despite the predictions of professional analysts, the future is unknown, and the best way to protect capital from any scenario is to diversify widely across asset classes from different countries. Therefore, in addition to stocks, a portfolio can hold a particular share of bonds, gold, cash, and cash equivalents: short government bonds, deposits, etc.
All investment decisions, including portfolio composition, should be based on financial goals and risk tolerance. Everything said in the article, and analysts’ forecasts are not investment advice.
