- 2022 view, as it stands today: 2022 will likely be very difficult. One of the most important risk factors is the US Federal Reserve’s path to normalization which, we believe, is not yet fully priced in (hence, will lead to further higher cost of capital). We believe the Fed has now got a single objective – to reduce the uncomfortably high inflation. We see more pain in the asset markets before we will get a great entry point into risk assets.
- 2021, in hindsight: 2021 turned out to be a strong year for risk assets. Bonds and Gold were weak while Equities, Corporate Bonds and Real Estate had very strong returns. Inflation surprised massively on the upside while GDP growth momentum remained strong. The US Federal Reserve kept its focus on supporting growth despite high inflation.
- Our Macro Approach: We believe precise macro forecasting is difficult. Our team constantly evaluates the environment we are currently in and have a blueprint of how we think it might pan out. However, we are aware of the shortcomings of any analysis. The world is a complex place with lots of moving parts. We humbly accept Ray Dalio’s approach of “What we don’t know may be more important than what we know”. We change when facts change.
- Our Investing Approach: We follow a global, multi-asset approach where we have exposure to most asset classes through our SAAM portfolio. This portfolio is designed to keep earning risk premiums regardless of the environment we are in. Over and above, we apply our tactical allocation to express our views and analysis.
2021 – Another strong year for markets
- 2021 is behind us. We can now look at the one path (out of millions of possible paths) that the market took. Bonds and Gold were weak while Equities, Corporate Bonds and Real Estate had strong returns. Inflation surprised massively on the upside while GDP growth momentum remained strong. The US Federal Reserve continued to be supportive despite high inflation.
- S&P 500 was up 28.7%, Bond market went down 4.7%
- GDP growth and earnings growth remained very strong in 2021.
- Inflation was one big surprise. At beginning 2021, street expectation was for 1.7% inflation at end-2021. Actual number came at 4.4%. However, the bigger surprise, in our view, was US 10 Y yields still at 1.51% at year-end 2021.
- USD went up despite a massive increase in US monetary aggregates
- China, yet again, was very weak. India, however, had a strong trajectory
- Gold was down despite high inflation. Of the many variables, real rates (which we define as 10Y Treasury Yield minus 10 Y Breakeven) going up defined the movement in gold.
- However, there were a lot of surprises in the year
- We expected, given vaccination momentum etc., Covid will likely be a non-issue by June/July 2021. Clearly, that is not the case.
- Our call on inflation coming out higher by end-2021 was right. However, we were surprised by US 10 Y yields still at 1.51% by end-2021.
- We expected Fed to change its stance mid-year in the wake of high inflation. However, they remained accommodative for the large part of 2021.
2022 – Mid-cycle growth and rising cost of capital; The year when Fed turned
What we don’t know is sometimes more important than what we know. 2021 epitomizes this ethos. With this caveat in mind, we hazard our guess on how 2022 will shape up. However, we continually evaluate the environment and will change our view as facts change.
We think 2022 is a year where inflation will likely keep surprising on upside while growth remains good (with a chance of negative surprise). As we move, we will likely see several headwinds that could lead to weaker markets
- Real Rates – the key variable to watch: We had been cautious for a large part of last year due to our expectation that Tapering by the Fed (i.e., Fed starting to reduce their asset purchases) will lead to higher rates. This didn’t materialize in 2021. However, we saw a complete recalibration in the market in the first week of January 2022 onwards. Real rates (which we define as 10Y Treasury Yield minus 10 Y Breakeven), went up by a staggering 33bps. However sharp, this recalibration only brings us to the half-way mark of where they could eventually end up. These increasing real rates will likely put pressure on all asset classes (albeit a few – commodities, real assets and probably a few sectors within equities that benefit from strong pricing power)
Real Rates are still well below they could be
- GDP Growth: We believe demand is likely going to be strong throughout 2022. However, supply could be a bottleneck in 2022 as well. As per our conversations with industry participants, we see supply remaining constrained across several sectors. Also, China’s continued “zero Covid” policy has the potential of further disruptions.
US GDP Growth Estimates for 2022
- Inflation: We expect analysts (and the Fed) to be surprised by higher inflation. As can be seen in the chart below, Torch expects inflation to remain higher than street expectations for the remainder of 2022. This, we believe, is going to continue to increase Fed’s resolve to tackle inflation and act even strongly.
We expect inflation to remain elevated in 2022
In Essence, the economic environment is moving from a Reflation scenario (where we are in the early part of the cycle where growth is very strong and some inflation surprises start happening) towards a Stagflation scenario (where growth slows but inflation remains strong). This is not great for asset prices as one of the main participants (The US Central Bank) becomes an adversary instead of a friend.
Economy moving from Reflation to Stagflation scenario
Our Return Expectations for various asset classes in 2022
We are likely to see the following positive forces:
- Strong EPS growth: Due to a continued strong demand as well as company’s ability to pass through prices
- Strong liquidity conditions: Balance sheets remain strong and there is a lot of cash in the system
However, there are the following negative forces:
- Monetary normalization: The US Fed was the single biggest buyer in the US Government Bond market. They were single-handedly able to keep rates low at both the short and the long end. They are currently reducing their purchases at a dramatic pace. At some point in the year, they will likely increase interest rates. Also, more significantly, they might start reducing their balance sheet. This is the single-biggest risk to asset prices
- Inflation: Inflation will likely run higher than the Fed target of 2.0% for the entire 2022 (see our note which explains how housing inflation, which will start coming into inflation numbers only as of 1Q 2022)
- Coronavirus: While Omicron variant has turned out to be a non-issue, the sharp increase in cases leads to the possibility of another variant which may be vaccine resistant.
To sum up, there is a strong negative force counterbalancing strong economic growth.
Our S&P 500 expectations: We expect a flat-to-down market in 2022. S&P 500 is trading at 21x forward earnings. If rates go up, the valuation will likely see downside. At the same time, EPS growth will likely remain strong.
Key risks as we enter 2022
“Failure comes from failure to imagine failure”– Josh Wolfe (Twitter)
2022 will likely be the year where the Fed policy starts to normalize. The pace and extend of the normalization are few of the major factors that will impact almost everything. We enumerate several risks to asset prices into 2022. While this might make depressing reading, we would rather be aware of the risks than be surprised by them (of course, we will still be likely surprised by something else that might come out of the blue)
- Fed Policy Mistake: Fed’s 20th December 2021 meeting minutes have shown a clear focus on targeting inflation. This is a big change. Bond market has re-priced to factor this in. However, a super-hawkish Fed (which could become worse if we have higher-than-expected inflation in the coming months), could lead to a premature slowing of the economy and a sharp sell-off in risk assets
- Risk-Free rate (US 10-year bond yields) could rise further: US 10Y bond yields have already risen sharply in the first week of January from 1.51% to 1.8%. But there is a likelihood that year end-2022 10Y yields may be further higher. Fed’s absence as a buyer of treasuries and its continued hawkish commentary may lead to much higher market-clearing 10 Y bond yield. This could lead to a sharp sell-off.
- Increased Inflation: US inflation came in at 7.0% in Dec 2021. This was way above what we and most of street (including the Fed) had expected at the beginning of 2021. So far, we expect inflation to start coming off over the next couple of quarters. However, there are signs that there could be persistent supply chain problems for longer. One such sign is China’s “zero covid” policy, which is leading to shutdowns. This would make the Fed more hawkish, which will lead to a market sell-off
- China slowdown: So far, signs are that Chinese economy is coming back. However, there are many reasons why there is downside pressure on GDP growth – demographics, deleveraging and defaults. If the Chinese government is unable to ensure controlled deleveraging, we could see a sharp slowdown in Chinese growth. This will subsequently impact the world GDP growth.
- Higher corporate taxes: Biden government has clearly flagged increase in corporate taxes. While the extent of these is unknown, there is high likelihood of this happening. Most likely, the economy and companies will be likely able to handle it. Also, it is well flagged and known to analysts. However, experience suggests that when the event happens, it still has an impact on the market.
- Geopolitics: This is a constant risk factor that we need to monitor. Below are some of the possibilities we can think of
- US-China War Risk: As Ray Dalio of Bridgewater highlights, whenever a rising power (China) challenges the incumbent power (USA), there are frictions that could lead to a full-blown war. Shortof a full-blown war, we see various other wars (Capital War, Technology War, and Trade War) likely to persist into 2022.
- China-India War risk: This is a real threat to the stability of the South-Asian region. India & China has been bickering over many issues for more than a decade, which has been exacerbated in recent times. This has the potential to cause a full-blown war between two nuclear superpowers, which will be extremely negative for global growth and prosperity.
- China and Taiwan situation: This is a low probability high impact event. Taiwan provides world’s semiconductors. Any attempt to annex or integrate into mainland China will likely lead to significant global issues.
- Deflation of Bubbles Risk: While we saw several bubbles burst in 2021 (SPACs, Cryptocurrency, Retail-driven names), valuations remain high. There is still a lot of retail participation and leverage in the system.
- Coronavirus: Our base case is that coronavirus will likely get downgraded to an endemic, where we get used to it like a typical flu, but life goes on. However, more cases will most likely lead to a higher change of virus mutation. Virus mutation might lead to ineffective vaccines or increased transmission or both.
As you may see in the table below, we spend a lot of time thinking about risks. Returns can take care of themselves.
Torch Risk Assessment Table 2022
|RISK CATEGORY||SPECIFIC RISK FACTOR||PROFITABILITY (By End 2022)||IMPACT||RISK COST (For S&P500)|
|Bond Yield Rise Risk||Sharp rise in Bond ylds to 2.5% end 2022 – Due to higher-than-expected inflation||40%||-20%||-8.00%|
|Bond Yield Rise Risk||Slow rise in Bond ylds to 3.0% by YE 22 – Due to Treasury Market Demand-Supply||20%||-30%||-6.00%|
|Bond Yield Rise Risk||Sharp rise in Bond ylds to 2.25% by YE 22 – Due to Fed Tightening||70%||-17%||-11.90%|
|Stagflation Risk||GDPg 3-4% in 2022; Inflation running >6% Policy Hawkish and continues to remain so||70%||-17%||-11.90%|
|Stagflation Risk||GDPg <2%; Inflation running >5% – Policy remains hawkish||15%||-25%||-3.75%|
|Stagflation Risk||GDPg <2%; Inflation running >5% – Policy turning accommodative||30%||-15%||-4.50%|
|Dollar Devaluation Risk||Slow USD Depreciation||10%||5%||0.50%|
|Dollar Devaluation Risk||Sharp (25%) USD Depreciation||5%||5%||0.25%|
|Credit Blowup Risk||Credit event in US (incl. US Govt debt downgrade)||5%||-20%||-1.00%|
|Credit Blowup Risk||Credit event in China||20%||-10%||-2.00%|
|Credit Blowup Risk||Deleveraging in China||60%||-5%||-3.00%|
|Policy & Regulation|
|Policy Error Risk||Fed continues to remain hawkish into a weak economic growth env||15%||-25%||-3.75%|
|Policy Error Risk||Fiscal policy being tightened too quickly||5%||-10%||-0.50%|
|Regulation Risk||Higher Corporate Taxes||80%||-5%||-4.00%|
|Regulation Risk||Legal/ policy actions against big tech||70%||-5%||-3.50%|
|Geo-Political Risk||US China trade war||20%||-2%||-0.40%|
|Geo-Political Risk||US – EU trade war||10%||-1%||-0.10%|
|Geo-Political Risk||China Invades Taiwan||10%||-30%||-3.00%|
|Geo-Political Risk||US – Iran War||2%||-3%||-0.06%|
|Geo-Political Risk||US- North Korea war||1%||-10%||-0.10%|
|Geo-Political Risk||European Discord||3%||0%||0.00%|
|Geo-Political Risk||Middle East Geopolitics||10%||-1%||-0.10%|
|Covid Risk||New variant bypassing vaccines||50%||-5%||-2.50%|
|Covid Risk||Further COVID waves||50%||-3%||-1.50%|
|Asset Price Bubble Burst|
|Deflation of Bubble||SPAC bubble burst||10%||-2%||-0.20%|
|Deflation of Bubble||Retail Investors over-hyped names||50%||-10%||-5.00%|
|Deflation of Bubble||Retail Investors lose on margin calls||40%||-10%||-4.00%|
|Deflation of Bubble||Oil price crash||10%||2%||0.20%|
|Bubble Risk||Oil price > US$100||50%||-5%||-2.50%|
|Asset Class Contagion||Minsky Moment – sudden collapse in asset prices||20%||-20%||-4.00%|
|Asset Class Contagion||Cryptocurrency bubble burst||50%||-5%||-2.50%|
|Asset Class Contagion||FAANG valuation correction with rates going up||50%||-10%||-5.00%|
|Asset Class Contagion||New tech bubble burst||50%||-5%||-2.50%|
|Asset Class Contagion||VC Bubble Burst||20%||-3%||-0.60%|
|Algo Risk||Everyone exits with less buyers on the other side||15%||-10%||-1.50%|
|Liquidity Risk||Lack of Market Liquidity in key markets||10%||-5%||-0.50%|
|Volatility Risk||If vols increase, risk parity funds will be forced sellers||40%||-10%||-4.00%|
|Cybersecurity Risk||Cyber Threats||80%||-1%||-0.80%|
|Terrorist Risk||Terror Attacks||5%||-5%||-0.25%|
|Social Risk||Social Dissent||20%||-3%||-0.60%|
|Natural Disaster Risk||Weather/Alien Activity/Earthquakes etc||1%||-3%||-0.03%|
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