Equities in 2022: higher volatility but still good returns ahead | Generali Investments' Focal Point

Written by Michele Morganti, Senior Equity Strategist, and Vladimir Oleinikov, CFA, Senior Quantitative Analyst at Generali Investments.

• The current environment still looks beneficial for equities in 2022. Fundamentals remain robust as global and EA GDP growth will stay above potential (above 4%) and real yields contained. Solid pricing power and growth should keep margins relatively safe.
• Thus, equities will be supported by continued solid earnings growth which we cautiously estimate at +10% (EA and US). This considers higher wage growth and lower momentum in capacity utilization.
• All in, we forecast a positive total return of around 7% over the next 12 months, assuming some further PE compression and a drag from a diminishing policy support.
• That said, sticky high inflation triggers a higher uncertainty regarding the monetary response to future macro data. Furthermore, the risk premium usually gets more volatile in periods of higher inflation and eroding confidence indicators (e.g., PMIs). Finally, bond volatility has increased, which historically has fanned the risk of lower equity risk-adjusted returns vs bonds and spikes in equity volatility.
• Thus, we maintain a cautious OW in equities, recommending a slight OW in EMU vs. US and a style and sector barbell strategy: OW Value and defensive growth. We see a neutral stance on EMs warranted in the short term.

Positive returns, yes, but be aware of higher volatility. Equities still have legs in our base scenario as fundamentals remain rather solid. GDP growing above potential and lingering low yields are surely two good starting points. These underpin a fair value target in one year above current one (S&500 worth 4,700-5,200 range) and, which, adding dividends and assuming a further modest compression in PE, provides a total return of 7%. Tactical indicators are also rather neutral and both corporate cash and increasing buybacks insure against abrupt and prolonged drawdowns. That said, the difficult aspect of the next year’s assessment is represented by an increased un-certainty and consequently possible higher volatility. Let’s see why.

Good fundamentals to be reflected in positive total returns

Earnings growth and low real yields. GDP growth will stay at about 4% in 2022, and, coherently to our proprietary models, we expect earnings to grow at around 10%. As a rule of thumb, please note that the earnings multiplier for a given real GDP growth has historically been around 3X. Our estimate incorporates the assumption of slightly decreasing margins in the next quarters. They are expected to remain solid on ac-count of both high CPI/ULC ratio and upbeat companies’ statement. Indeed, firms see reasonable pricing power due to strong demand and are using workarounds and tech investments to enhance productivity to offset cost increases.

Having said this, we see increasing pressure from less strong momentum in capacity utilization, high-for-longer input costs, wage lifts and lower deficit spending vs 2021. For this reason, we prefer not to exploit all the potential (+12%-15%) from high nominal GDP growth. Indeed, US Q/Q growth ex-energy has already been -1% in Q3 and Q4 revisions have been slightly negative since the Q3 season started. We dive into cross-asset returns through the cycle, looking at the yield curve, nominal and real rate “levels”: equity returns adjusted for risk should outperform fixed income in 2022, given current and targeted 10-year yield levels (the 10-year Treasury at 2% in 12 months). Indeed, the CAPE yield gap versus real yield remains quite higher when compared to past pre-crisis levels.

The problem is the increased volatility of future returns

To begin with, volatility of fair value is associated with the less predictable response of monetary policy to high-for-longer inflation. Secondly, confidence indicators have peaked, adding to the uncertainty caused by a lower fiscal and monetary support. As a result, financial conditions and excess liquidity are normalising, pointing south, while PEs most probably will continue to shrink next year, after their compression by 10% already achieved year-to-date (average of EMU and US). Volatility should also drift higher.

Furthermore, during a higher inflation range, the average risk premium de-manded by investors did not change significantly in the last decades. But the standard deviation of the same risk premium did, increasing by nearly 40 bps, which corre-sponds to a ±5% in fair value. Finally, recently surged bond volatility has reached a level at which historically equity return vs. bonds starts suffering. In sum, we recom-mend a cautious OW on equities, favouring a barbell (Value + defensive growth). Fi-nancials and energy benefit from higher yields and inflation, decent GDP growth and undervaluation. We also OW defensive growth sectors as confidence is peaking and policy support declining. They deserve structurally high total return adjusted for risk – Sharpe ratio. OW: banks, insurance, cons. durables, energy, food, HPP, and pharma. UW: RE, div. financials, telecom and utilities. Our OWs all score well in terms of cycle phase, quant model results, valuation and revision trends. We also slightly OW EU vs. the S&P 500 given the very high spread recently reached in relative valuation.

Overweight EA vs US, Value and defensive Growth

For the reasons mentioned above, we recommend a cautious OW in equities. Regionally, we see an increasing number of arguments in favour of the EA vs the US. The EA is significantly undervalued vs the US in terms of PBV-ROE and conventional PE (Z-score of -2.2). This remains valid even after having modified the PE with the expected long-term growth (PEG), beta and ROE. This adjusted PEG ratio is unusually lower for the MSCI EMU than that for the US. Furthermore, the trade-weighted EA seems beneficial for EA earnings, even after considering the difference in the real GDP growth rates between the two regions. Finally, the lower EA macro surprise index looks well discounted.

As for EU sectors, we favour a barbell strategy (Value + defensive growth). Financials and energy benefit from higher yields and inflation, decent GDP growth and undervaluation. We also OW defensive growth sectors as confidence is peaking and policy support declining. They deserve structurally higher total return adjusted for risk – Sharpe ratio. OW: banks, insurance, cons. durables, energy, food, Households (HPP), and pharma. UW: RE, div. financials, telecom and utilities. Our OWs all score well in terms of cycle phase, quant model results, valuation and revision trends. The HPP’s revisions are bottoming out, while market multiples are about average. Furthermore, Households, representing a global, defensive growth, performs well in the environment of increasing uncertainty/volatility. The sectors put on underweight, on the other hand, are negatively correlated with inflation, have average relative valuation and earnings revisions but weaker EBITDA margin revisions YTD (RE and Telecoms). Diversified finance and utilities are overvalued based on quant models. And while utilities have good revisions similarly to banks, the sector has the highest negative correlation with inflation.

EM equities: neutral stance warranted

?EM macro surprises seem to have bottomed out and should be supportive for the EMs in the short term. Additionally, there is a positive gap between EM performance and US financial conditions. That said, we continue to see weaker earnings and fur-ther headwinds that are represented by slowdown in China and high real interest rates. On the positive side we see extreme underperformance vs. the MSCI World (Z-score of -1.85), low relative valuation (0.9 stdev below average) and future better do-mestic growth plus higher policy support. Increasing Korean export growth and China’s RRR cut bode well for Korea and Chinese A-shares (both OW, good country score). We stay neutral on MSCI China.

Conclusions

In this report we highlighted good equity fundamentals which we expect to continue in 2022. Global GDP growth above potential will trigger earnings growth of nearly 10%, thus offsetting further declining market multiples and backing total returns of around +7%. Sustainability of high market multiples will be guaranteed by low-for-longer yield, especially in real terms (albeit higher from current levels). That said, we described the factors causing higher uncertainty and volatility next year. It is not only the lower monetary and fiscal support, and consequently lower financial conditions, but also the ramifications from a sticky high inflation. First, monetary response gets less predictable. Second, the range of risk premium oscillations usually widens when inflation trend increases and, thirdly, bonds volatility has reached a level which makes the risk of equity setbacks more probable. All this translates into a cautious OW on equities, with a small preference for EMU vs. US, and a sector barbell where Value (Financials and Energy) are OW together with secure global growth like staples, Durables and Pharma.