Perspectives 2022 by Eliana de Abreu, Chief Investment Officer of Crédit Mutuel Asset Management

2021 was marked by a stronger and faster than expected recovery, a return of inflation to levels not seen for several decades, the start of normalisation of central banks, a persistent pandemic with the steady appearance of new variants, strong concerns about the future of the Chinese model...

On the markets, this translated into very good performances on the equity markets of the developed countries and a rise in rates in Europe and above all in the United States.

However, the year was not a linear one for equities, either in terms of evolution or style, but equity markets were particularly resilient each time with better than expected earnings reports. Some equity markets, such as the S & P 500 or the CAC 40, have even reached record levels.

As for rates, it must be pointed out that, despite higher volatility, they have held up particularly well against the combination of high growth, very high inflation and the beginning of normalization of monetary policies.

Of these, many will still be relevant in 2022.

In terms of the pandemic, although the last variant (Omicron) is less dangerous than its previous ones, it is, on the other hand, due to a much higher contagiousness than others, more disturbing for the management of hospitals and for the economic activity affected this time again by the restrictions on activity and the resulting labour shortages of quarantine contacts. The recovery of the economy will continue but will therefore be put on hold again in many countries as we enter the year and the improvement in supply chains is likely to be further delayed. This complicates the task for central banks to start normalizing their monetary policies in a more inflationary environment.

Inflation trends will therefore be closely monitored by the markets. Despite the spike in inflation (7% in the US and 5.0% in Z € in the latest published figures) and the Fed's decision to abandon the transitory nature of these inflationary pressures, we nevertheless expect a gradual normalization from the second half of 2022. Long term inflation forecasts by the markets also remain measured (about 2.5% in the US and 1.8% in Z €).

Inflation and reduced central bank support should therefore remain the main concern in 2022. In the current environment where central banks know their mission is to scale back support gradually while accompanying recovery in a pandemic context, starting to normalize monetary policy is not necessarily bad news, but rather a sign that they believe growth is robust enough today to be able to do so.

• In the United States, the Fed has strong arguments to start cutting back its support. Growth is high, inflation is above 2% for 5 years. Even though inflation is likely to fall with the improvement in supply chains, the FED nevertheless believes that the risk of persistently higher inflation has increased and that part of the price rise exceeds the simple effect of the pandemic. Indeed, the labour market has clearly improved and wage pressures are undeniable. The Fed must act, and it is doing so. The markets have also integrated in their expectations an end to tapering and a subsequent start of an upward rate cycle, with between 3 and 4 expected increases in 2022 and 3 expected increases in 2023. The gradual withdrawal of monetary support has now been put on the table; the main question relates above all to the speed of this withdrawal and, above all, the pace at which the Fed's balance sheet has been reduced. It will not wait two years to start reducing its balance sheet, as in the previous cycle. This factor is not yet well integrated by the markets and risks fueling turmoil. Nevertheless, the Fed will keep all the flexibility necessary to adapt its monetary policy to the economic context, notably health care.
• In the eurozone, the ECB is not at the same stage. The procurement program will continue, but with reduced procurement volume and a partial transfer of procurement from the PEPP pandemic emergency program (which will end at the end of March 2022) to the traditional JPA program. The European markets still do not anticipate an increase in rates in and expect an increase at the end of 2023. The ECB's inflation forecasts show that inflation will fall below 2% in 2023 and 2024. The ECB therefore has to keep monetary policy accommodative and maintain favorable financial conditions.

China's growth trends will also be monitored, particularly in the event of a shock on the construction sector. Nevertheless, the recent fall in bank reserve requirements and the loosening of refinancing conditions in the real estate sector are reassuring factors.

Allocation

In sum, among the positive points for risky assets, we have a level of activity that remains very high despite the current slowdown in the global economy, and which is ready to pick up once the restrictions are removed. Furthermore, we have central banks that are aware of the need to maintain favorable financial conditions to support the recovery and ecological transition. Faced with the latter, we have the health risk that will blur the visibility of the economy's growth prospects, corporate earnings and impact investor confidence. The risk of an unexpected rise in rates and Central Banks that are too restrictive after too high inflation is also a risk factor.

Despite the mounting short term uncertainties, the trajectory of equity markets remains bullish in the medium term, in our view. Nevertheless, it will not be a smooth ride. We began the year with a neutral position in the European and US equity markets, an underweight position in emerging countries and an underweight one in sensitivity in fixed income pockets. In the current context, equity markets will continue to be supported by the fact that exiting the equity market often means reinvesting in negative real yield investments, and that we need to remain invested in equities, keep them and benefit from corrections. The effects of the lack of an alternative (TINA ‘There Is No Alternative’), the fear of missing the latest gains (FTUS ‘Fear of Missing Out’) and ‘Buy The Dip’ should continue.

Equity Markets

After an overall rise of more than +20% in 2021, despite the disappointment of emerging markets and the weak recovery of the Japanese market, these three effects helped push the winners even higher. Apple passes 3000 bn of market cap, Tesla 1000 bn...

In 2021, however, many things changed and lay out the 2022 readings.

• Listed companies have not changed much intrinsically on average, with good financial structures and rising margins, but they are moving in an uncertain context, in addition to the endemic health situation, a few elements of which are already identified if not well quantified in scale and sequence:
• The consequences of the Covid impact supply chains and create shortages that result in price increases or unavailability. Sometimes alternative solutions can affect product quality;
• Energy prices jumped +70%;
• The rise in production costs is almost certain and if margins remain stable, it is that sales prices will have moved... not all companies are, or will not be, able to pass them...

In terms of market dynamics this means that the massive positive exogenous impacts experienced in 2020 and 2021 will no longer be supportive. The intrinsic quality of companies must therefore be taken into account. This leaves a lot of potential as 2021 was a strong year overall but with a lot of differentiation. The flagship US index was up +25%, as was the iconic technology index, while the midcaps gained +8.5%. While the CAC did almost +27%, French small caps did 10% less. At sector level, the gaps are equally impressive. Automotive, technology or banks topped +30% when transportation or utilities remained below 5%.

The fact that there is no alternative creates tomorrow's risk, but constrained investors made a realistic choice and did not buy indiscriminately. Valuations of technology flagship companies will of course be tested on their results, but other sectors and, above all, other companies will emerge. The unprecedented wave of mergers and acquisitions and the new market arrivals (IPOs) that have enriched ratings favour a renewed arbitrage space. While the quality of listed companies did not deteriorate - unique after a crisis - the profound transformations of their activities and responsible behaviour deserve particular attention and the perspective of their trajectories. The quality of the selection will be rewarded.

Bond markets

We are still maintaining a positioning with an underexposure in sensitivity. Indeed, we think there is still upside potential in short term rates, despite the recent upward pressure on long term rates, although it is now more limited. We are maintaining pockets of inflation indexed bonds (mainly in the context of a rise in rates that would be induced by an increase in inflation expectations), which we may have to reinforce in the coming weeks. We think that the steepening of the yield curves could continue in the short term, which leads us to maintain steepening positions in portfolios at this start of the year. Peripheral European bonds retain - on only short and intermediate durations - an attractive risk/return trade off and carry. The same holds true for credit, with a preference for A ratings over IG and BB ratings over High Yield. These rating segments should behave better in the event of a compression of credit risk premiums. We are also favouring short to intermediate maturities (which would be more resilient in a steepening of the credit curves), particularly in a context of monetary normalisation and M & A volumes expected to increase in Europe this year. Finally, we are still maintaining a defensive positioning on our emerging debt exposures.