As we look ahead to 2022, our base case is for positive global growth and elevated inflation in the near term. Though we see inflation moderating during the year, there are upside risks to our forecast.
We believe growth assets, such as equities and credit, will tend to deliver positive returns over the next year. However, we expect greater dispersion in performance across sectors and regions, a common feature of mid-cycle periods.
Indeed, in our Asset Allocation Outlook, “Opportunity Amid Transformation,” we discuss fundamental shifts occurring at the “ground level” of the economy that we believe will have implications for top-line growth and inflation, but also create distinct investment opportunities in a number of sectors and regions. Specifically, we discuss disruptive, and potentially transformative, trends in labor, technology, transportation, and energy.
Investment implications
With fuller valuations, risk assets are more vulnerable to exogenous shocks and policy missteps. In our view, the risk of a policy mistake has increased as monetary and fiscal stimulus recedes and authorities attempt to engineer a growth handoff to the private sector. This creates the potential for “fatter tails” (more divergent positive and negative outcomes) that highlight the importance of selection – within and across asset classes.
The outlook for equities
We remain broadly constructive on equity market risk. We expect to see substantial differentiation across regions and sectors, which warrants a more selective and dynamic approach.
Within developed markets, we remain overweight U.S. equities, and have positioned our overweight in cyclical growth sectors. We also have exposure to Japanese equities, which tend to have a valuation cushion along with beta to cyclical growth. We view European equities as more challenged due to a combination of unfavorable sector composition, energy price headwinds, and growing unease around the COVID-19 outlook.
In emerging markets, we continue to be constructive on select exposures within Asia. Simultaneously, we are closely monitoring regulatory developments in China and evolving geopolitical tensions in the region. We remain overweight emerging Asia, with an emphasis on hardware technology and equipment that will be foundational to regional as well as global growth.
From a sector perspective, we retain a preference for secular growth trends like digitalization and sustainability. In particular, we believe that semiconductor manufacturers, factory automation equipment providers, and green energy and mobility suppliers all stand to benefit. We complement this with exposures that may benefit from a more inflationary environment; these are companies that we believe have significant barriers to entry and strong pricing power that can potentially harvest inflation through price increases, such as global shipping companies.
Rates, credit, and currencies
We expect government bond yields to trend higher over the cycle as central banks raise rates, but in a multi-asset portfolio context, we believe in the role duration can play as a diversifier. Consequently, we continue to maintain some duration exposure. We maintain a modest overweight position on U.S. TIPS (Treasury Inflation-Protected Securities) in multi-asset portfolios. Although inflation breakevens have moved significantly higher, in our view they still do not fully price in an appropriate inflation risk premium.
We find corporate credit appears fully valued. As such, we see little opportunity for spread compression outside of unique opportunities identified by our credit analysts. Securitized credit, on the other hand, still offers attractive value in our view, particularly in non-agency U.S. mortgages, where a strong consumer balance sheet and housing market underpin improving credit quality at spreads that we see as cheap relative to corporate bonds.
Lastly, on foreign exchange, the U.S. dollar still screens rich on our valuation models, particularly against emerging market (EM) currencies, but we should not presume the dollar is destined to weaken in an environment where EM economies and central bankers continue to face challenges.
Erin Browne is a managing director and portfolio manager in the Newport Beach office, focused on multi-asset strategies. Geraldine Sundstrom is a managing director and portfolio manager in the London office, focused on asset allocation strategies.
© PIMCO
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