CIO views outlook: top 3 investment picks in 2022

Asia fixed income: property challenges and yield opportunities 

• Risks in China’s property sector are now known. The drawdown in Asia credit markets caused by China’s real estate sector has been an unprecedented ‘left tail’ event from an investor perspective. What started with concerns about idiosyncratic company situations such as Evergrande¹, morphed into extreme weakness in the entire sector. This has been caused by an extraordinary liquidity squeeze, which resulted in the USD offshore market being essentially shut for Chinese property developers. Recently, we have seen some signs of policy easing and, as such, markets have shown a strong recovery. While challenges remain, we believe there is opportunity in the higher quality part of the market, while the lower end of the ratings spectrum may continue to see further pressure. 
   
• Valuations reflect market weakness. Yields in the Asia credit market are now significantly higher compared to last year, offering a more attractive starting point for investors. While challenges remain in the China high-yield (HY) real-estate sector, yields in the Asia HY USD-denominated market are at double digit levels² and investment-grade (IG) spreads vs US Treasuries are wider compared to the beginning of the year.
   
• Default rates to peak, Asia IG attractive. As a consequence of the turmoil and extreme price movements, the market has seen 20 issuers default on ~USD15 billion of bonds year-to-date, both of which represent record levels³. Since China’s real estate is largely a high-yield sector, this also resulted in the Asia HY market’s worst performance since 2008. However, the knock-on effects have resulted in wider spreads in the Asia IG market as well. Going forward, as default rates look likely to peak into 2022 and sentiment continues to recover in the broader market, the higher quality area of the market, including Asia IG credit (in USD), looks attractive², especially when compared to US credit.

Sources

1. Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or securities. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of the securities discussed in this document.
2. Yields are subject to change and can vary over time. Past performance is not an indicator of future results.
3. Source: JP Morgan. 5 November 2021.

Equities: 3 themes to tap

2022 will be pivotal for the recovery. Are labour shortages, supply-chain bottlenecks, inflationary pressure, wage growth, Europe’s energy crunch and China’s real-estate woes likely to ease or persist? And how will monetary-policy tightening by central banks affect growth?

In our view, investors should respond by focusing on stock-specific stories that are more resilient to cyclical forces and which are aligned with three themes:

• Less stuff, more services: consumers will likely buy fewer goods – such as IT hardware, apparel and furniture – in favour of services like travel and hospitality. New cars could prove an exception should the semiconductor shortage ease.
• Digitalised and lean enterprise: the pandemic forced many companies to discover different and more efficient ways of doing business. Many will continue to invest in the digitalisation and dematerialisation of their processes and operations.
• Accelerating industrial capex: with the fragility of just-in-time supply chains exposed, businesses are seeking local producers of critical components. Should re-localisation align with US, European and Chinese green-stimulus deployment plans, industrial capex spending could stage a comeback.

In addition, we encourage investors to keep watch for the impact of central-bank tightening on growth stocks.

Growth barbell

How central banks respond to current inflationary forces is critical: tighten too hard as inflation and growth recede, and the era of negative real interest rates could end.

In an environment of lower growth, a barbell approach to portfolio construction can help to capture opportunities by focusing on:

• Lower growth, high-quality stocks that are attractively valued after being ignored amid the market’s 2019-2020 focus on unfunded growth, and which tend to outperform during a financing crunch
• Growth stocks which can fund their own expansion, enabling ongoing participation in the fervour for growth while mitigating drawdown risk.

Multi asset: matching opportunities to scenarios 

From a multi-asset perspective, portfolio allocators seem unanimous: overweight equities and underweight bonds is the overwhelming positioning in the industry⁴. Growth is robust (the IMF projects the global economy to grow by 6% in 2022) and corporates remain broadly confident they can pass on increased costs to their customers. As a result, earning growth remains solid and valuations should normalise in the next few quarters, supporting equity markets.

On the other hand, greater inflation and a tightening bias from central banks should lead to higher rates, which will hurt (nominal) bonds. At LOIM, we believe in disciplined, process-driven asset allocation and will always include possible scenarios that may perhaps too easily be discounted by the market. For example, if inflation proves stickier than the transitory advocates would have us believe. In such cases, we believe commodities, and inflation-linked instruments (better suited than their nominal cousins) should remain part of a core asset allocation.

Another example would be a renewed recessionary shock induced by a novel, uncontrolled variant of the SARS-Cov-2 virus, or a central bank policy mistake stifling the recovery. This would typically have deflationary consequences, which (nominal) sovereign debt would be well positioned to capture (10y US yields are after all, higher today than they were at the outset of the COVID shock in February 2020). However, we are also cognizant of the fact that the future will never be a perfect repeat of the past and hence new solutions must be continuously sought for hedging our portfolios. Thus, we continue to see scope for “diversifying the diversifiers”, for instance through convex strategies such as long volatility trades, or trend-following strategies, or just the philosophical open-mindedness to embrace cash as a pretty simple shock absorber.

Sources

4. Consolidated equity positioning at the 88th percentile according to Deutsche Bank research

Alternatives: moving away from the Goldilocks economy

Our overarching expectation is for a move away from the previous ”Goldilocks economy” and the risk premium compression that accompanied it. As such, we expect the following investment themes to arise:

• Investing in volatility in a broad spectrum of strategies could prove to be a very complementary allocation to traditional investing, in our view. We expect greater dispersion and factor rotations as the real economy continues to follow structural trends, such as embracing sustainability and the continued trend of technology; and amid ongoing short-term dislocations, such as continual switching between economic reopening and lockdown measures.
• Scarce natural resources (water, farmland and rare earth, for example) are likely to experience structural appreciation. We see potential outperformance in value investing as well as sustainable investments in this context, compounded by the trend of countries turning more inwards and an increasing cost of capital.
• Tail hedging. As the economy becomes less robust, less global, more unequal and with greater geopolitical tensions, tail risks could potentially increase. Within asset classes that appear expensive, efficiently priced markets mean that investors must continue to increase their risk profile to achieve anticipated returns. They should also compensate for tail risk occurring.

To learn more about investment trends shaping the current decade, click here.

Convertible bonds: strong dealflow and characteristic convexity to persist in 2022

We expect equities to generate positive returns in 2022, credit markets to be supportive and convertible bonds to perform well – especially on a risk-adjusted basis.

For our market, three major performance drivers remain in place:

• Primary strength
  Since early 2020, primary issuance has increased the market capitalisation of the asset class by more than 70%. Not only has this added new companies and sectors, it has contributed to greater convexity in our investable universe. New deals tend to be issued with balanced profiles, where the upside participation with equities and downside protection⁵ offered by bond characteristics are, in our view, optimal for an asymmetric return profile. We believe new-issuance volumes should remain comfortably above the 2012-2019 annual average of USD80bn, offering further opportunities to improve portfolio diversification and incremental performance.
   
• Continued equity upside
  Vaccination programs are gradually reducing the risk of broader confinement, GDP growth is normalising, central bank policies remain largely accommodative and earnings appear likely to underpin share prices well into the new year. We expect underlying equity performance to boost convertible bond returns in 2022, albeit possibly to a lesser degree than in 2021. Idiosyncratic volatility should remain high as the market rewards companies which have adapted to the post-Covid world and are engaged in the climate transition. This will lead to dispersion, which benefits active managers.
   
• Defence against rising rates
  The first steps in monetary policy tightening are expected in the main developed economies during 2022, which has already dampened returns for longer dated bonds. Convertible bonds tend to perform well in a rising-rate environment, where there is moderate inflation and strong underlying growth, leading to higher earnings. The shorter maturity and equity exposure of the asset class offset the negative effect of duration, enabling investors to maintain bond allocations while preserving returns as rates rise.

Sources

5. Capital protection is a portfolio construction goal that cannot be guaranteed.

Sustainability: Which trends could gather traction after COP 26?

COP26 has now ended and while new pledges that emerged are not yet aligned to limit global warming to 1.5°C as per the Paris Agreement, we expect the following key investment themes to remain in focus:

• There has been significant emphasis on the need for an accelerated phaseout, or phasedown of coal. Over 40 countries have pledged to phase out coal in the 2030s, for richer nations, or 2040s, for developing countries. This provides further impetus for investments in renewable energy.
   
• The Glasgow Breakthroughs is an initiative seeking to accelerate the development of key technologies, to drive cost reductions, economies of scale, and faster uptake, specifically focusing on clean power, zero emission vehicles, near-zero steel, clean hydrogen, and regenerative, sustainable agriculture.
   
• COP26 featured increased focus and interest in the role of nature, and nature-based solutions. Supported by stronger mechanisms, trade in carbon credits is likely to intensify. This in turn will also drive interest in real assets including forests, and investment opportunities linked to forest management.
   
• The Glasgow Financial Alliance for Net Zero (GFANZ) now has members with assets totalling USD 130tn. Members are seeking to decarbonise portfolios, which will drive increased interest in forward-looking assessments that may help identify climate leaders. We believe this will drive interest in companies that we refer to as ice cubes, or companies in climate-relevant sectors, committed to rapid decarbonisation.
   
• The need for investment in climate adaptation once again came to the fore. As climate damage is likely to increase even in a best case scenario, increased investment in preparedness and resilience will be needed. This will include investment in construction and engineering, infrastructure adaptation, early warning systems, and environmental advisory services.