By Alex Tedder
There are clear risks to global equities next year, especially since valuations are relatively extended, particularly in the US, and pricing power will be key from an investment perspective.
Supply chain disruption should diminish in most industries in 2022
The significant disruption to supply chains in 2021, largely linked to Covid-19-related capacity shutdowns and transportation bottlenecks, is likely to diminish as we move into 2022.
Supply chain backlogs historically adjust rapidly after periods of stress, as the market responds to higher demand and re-builds inventory. We see no reason to assume this won’t be the case in 2022, and indeed freight shipping rates have started to fall.
Global shipping indices signal easing supply pressures
However, energy prices are likely to remain elevated. The economic recovery is boosting demand for oil and gas while supply growth is static.
As governments have encouraged energy companies to spend more money on renewables, spending on traditional exploration and production has been cut. As a result of this, supply is not only tight but in many cases set to shrink quite rapidly, particularly if emissions targets are to be met.
There can be little doubt that, in the future, oil and gas reserves in the ground will be worth a fraction of their implied value today. But, for the time being, traditional energy may generate super-normal cash flows and profits. We don’t believe this is a consensus view.
Inflation remains a concern
Fund managers have been concerned that inflation will prove to be more than “transitory” and, so far, the omens are not good.
October US producer price inflation of 8.6 percent was a shocker and reflects the impact of price rises across the spectrum: from higher energy and commodity prices through to rapidly rising labour costs.
The latter phenomenon has caught many economists by surprise: a meaningful proportion of the workforce in the US and in Europe has yet to return to work.
The labour shortage has put upward pressure on wages, with average hourly earnings in the US now growing at 5 percent and set to accelerate as workers respond to higher fuel and housing costs by escalating wage demands.
Overall, despite some moderation in supply shortages, price pressure is acute and the rise in consumer price inflation in October to 6.2 percent, the highest rate since 1982, was no surprise to us.
It is hard to see a rapid change of direction in price pressures, particularly given that the recovery momentum appears to be strong in all major regions globally.
Margins will be under pressure in many industries
Corporate earnings growth in 2021 has been strong. Record monetary and fiscal stimulus has supported the rapid turnaround in business activity after Covid-19 vaccines were approved late last year.
US companies in the S&P 500, for example, are on track to deliver $225 per share of earnings in 2021, or a 65 percent increase compared to 2020.
The fact that earnings have been so good in 2021 makes it likely that there will be significant challenges in 2022. Not only are US margins back at record highs, but the full impact of higher input costs has also yet to be felt.
With the tight labour market creating competition for qualified workers across multiple industries, there will be further pressure on margins, particularly in the service sector.
Pricing power is likely to be a key factor over the next 12 to 24 months
There are clear risks to equities next year, especially since valuations are now relatively extended, particularly in the US. The old maxim that bull markets don’t die of old age certainly seems to be holding true at present.
It is also conceivable that companies will be able to muddle through the next 12 months by passing on higher prices to consumers, whose household finances are mostly in good shape and who may find a 5 percent price hike for consumer goods tolerable.
However, many companies, especially those in fragmented industries with little or no product differentiation, will not be able to pass on higher costs.
Consumer staples and industrial sectors would appear most vulnerable to higher input costs given the sharp rise in base commodities such as grains and sugars or steel and copper. These industries are generally also highly competitive.
But there are exceptions: Nestlé was able to raise prices by more than 4 percent compared with 2020 in the third quarter of 2021 on the back of its powerful global coffee franchise, while other companies in the sector, such as Unilever or Proctor & Gamble, have struggled to raise prices.
Perhaps the best examples of positive pricing power are found in the technology sector, particularly among dominant so-called mega-cap platforms. Software companies such as Microsoft or Adobe, which provide essential tools to companies, governments and households, can increase subscription charges each year.
Similarly, a handful of very large internet platforms, notably Google-parent Alphabet, dominate the digital advertising market, which in turn is becoming the dominant channel for advertisers. In the first nine months of the year, Google revenues grew 45 percent compared with a year earlier, helped by strong pricing.
Many other software, internet and semi-conductor companies can build in regular price rises while keeping cost growth muted. These areas will be fertile ground for growth in the coming year.
Mega-trends continue to gather pace
There are a number of structural drivers likely to have a material impact on equity markets over the next decade and beyond.
Most of these trends are far from new. Climate change, energy transition, demographic change, healthcare innovation, digitisation, automation and urbanisation have been relevant for many years. However, their relevance is increasing exponentially as populations grow. In some cases, the pandemic has accelerated the process of change.
Although there are challenges that need to be addressed on a global scale, and quickly, there are plenty of reasons to believe these can be tackled. As evidenced by the production of a revolutionary vaccine just nine months after the emergence of Covid-19, we are living in a golden age of innovation.
The convergence of multiple technologies from processing power, connectivity, bandwidth and memory all the way to power delivery and software is resulting in a wave of innovation across multiple industries.
The Covid-19 vaccine could not have been developed without DNA sequencing technology. Similarly, the process of energy transition is possible because of the progress in battery capacity, renewable electricity generation and grid technology. Global transformation is ongoing, and is broad-based, pervasive and long-lived.
From an investment standpoint, the opportunities are immense. If we are right about the mega-trends, then investing in the companies exposed to them could offer markedly superior returns than a traditional equity index.
Final word: it pays to engage
It is surprising how often both investors, and the management teams they invest in, fail to interact.
Traditionally, public equity investors have chosen to exercise their views primarily via the proxy voting system. As a rule, they vote with company management.
A regular and constructive dialogue between the providers of capital and their investees seems essential. Investment does not stop at buying a share. Active engagement is a must.
Alex Tedder is Head and CIO of Global and US Equities at Schroders
BUSINESS REPORT