2022 Market Outlooks on Equites, Fixed Income, Real Estate
San Mateo, CA, December 15, 2021 – Five of the specialist investment managers of Franklin Templeton, a global asset management firm, provide their annual outlooks for the global economy and key asset classes. They include the following:
- Brandywine Global Investment Management provides its global credit outlook and its macroeconomic outlook. Headquartered in Philadelphia, Brandywine Global looks beyond short-term, conventional thinking to rigorously pursue long-term value. It has $67 billion in assets under management (AUM) as of September 30, 2021.
- Clarion Partners provides its views on U.S. commercial real estate. Clarion Partners is a leading U.S. real estate investment manager headquartered in New York with approximately $65.9 billion in total AUM as of September 30, 2021.
- ClearBridge Investments provides two outlooks: U.S. equities and global infrastructure. Headquartered in New York with $196 billion in AUM as of September 30, 2021, it is an authentic active global equity manager with a legacy dating back over 50 years.
- Royce Investment Partners, a small-cap specialist since 1972, has $16.2 billion in AUM. It is headquartered in New York.
- Western Asset Management provides its global fixed income outlook. Western Asset is a globally integrated fixed-income manager, sourcing ideas and investment solutions worldwide. Based in Pasadena, CA, it has $483.5 billion in assets under management as of September 30, 2021.
Brandywine Global: Global credit outlook by Brian L. Kloss, JD, CPA, Portfolio Manager
Given expectations for a vaccine and the tremendous policy responses at work, we see a very high likelihood of a cyclical recovery” was how we started our commentary a year ago in December of 2020. It does feel as if we could start this year’s commentary with a similar outlook. That being said, looking out to 2022, one can expect some events to be similar while others are going to be quite different. Vaccines, therapeutics, Delta, Omicron, Pfizer, Moderna—the list of pandemic nomenclature goes on, and all these terms will continue to be focal points for markets as we as a global community continue to deal with that virus we all wish we could forget—COVID-19. As we move into the third calendar year managing and living with COVID, markets continue to adjust and adapt as scientists and policymakers continue to make significant inroads, all while the virus eventually moves from a pandemic to endemic.
However, the unprecedented monetary and fiscal policies we discussed last year are now transitioning to the next stages as the role they played during the pandemic begins to revert back to a more “normal” or conventional policy. Fiscal policy will be expansionary but nowhere near what the markets saw in the previous two years. Meanwhile, regulatory and tax burdens will be increasing. Most importantly, monetary policy will become more restrictive as the U.S. Federal Reserve (Fed) embarks on ending its quantitative easing program, possibly on an accelerated basis. Embarking on tapering first will allow Fed policymakers to assess market conditions before they move to raise the federal funds rate. These tightening conditions should arrest the spread tightening that we have seen in corporate credit over the last eighteen months. However, economic conditions should remain supportive of credit spreads, and we anticipate minimal defaults across global credit assets.
While they may not rise to the extent of 2021’s record-breaking year, corporate profits in 2022 should continue to surprise to the upside, especially in the first half of the year. There are two strong tailwinds working in their favor and supporting the market heading into the new year. First, supply constraints may have peaked, which should relieve cost pressures across multiple sectors. Second, companies continue to exhibit a high degree of pricing power due to strong demand from consumers. Consumers, in aggregate, possess an enormous amount of savings ready to deploy as the economy continues to renormalize. The second half of the year becomes a bit murkier as global central banks may become less accommodating if inflation persists.
Therefore, we remain constructive on risk assets, expressing that view across corporate credit markets by utilizing our strong, proprietary underwriting model and deploying a very nuanced allocation to select credit instruments. Our focus continues to be on basic industries, capital goods, energy, and other cyclical sectors in both developed and emerging markets. We favor those industries that have a more cyclical tilt, like autos and mining, which should see marked improvement as the economy rebounds from the lockdowns but will be very mindful to the risks we discussed above around tightening monetary and fiscal conditions. Similar to last year, we believe higher-quality assets offer the best risk/return profile and should remain supported even if there is risk around monetary policy. We are generally avoiding both ends of the credit-quality spectrum, with high quality offering limited total return potential, and lower-quality bonds still susceptible to hiccups in the global economic recovery.
Brandywine Global: Macroeconomic outlook by Francis A. Scotland, Director of Global Macro Research
The defining characteristics of the economic outlook for 2022 could be more about the composition of global growth than its trend. As long as the threat persists, a return to normalcy from pandemic trauma still seems off in the future rather than around the corner. However, some of 2021’s more anomalous economic developments look set to ease, which is encouraging for an extension of the global expansion into 2022. If these anomalies were to reverse completely, which is not impossible, the outlook might even start to look like a case of economic whiplash.
The biggest anomaly of 2021 was inflation. Global in nature, the extraordinary surge in prices was caused by supply chain disruptions and strong policy stimulus measures in the developed world. American programs supporting income and demand were the most aggressive in the world. Correspondingly, the U.S. was the only major economy to see nominal personal consumption eclipse its pre-pandemic trend with inflation reaching 30-year highs. In contrast, the rebound in European nominal spending remained short of its pre-pandemic trend, and core European inflation moved relatively modestly to about 2.5% from 1%. Marching to a completely different drummer, China’s economy decelerated all throughout 2021 as its policymakers took advantage of the U.S.-led global rebound to crack down on domestic property sector leverage. How the economic giants reacted to the ebb and flow of viral infections only seemed to exacerbate the extremes: China’s tendency to shut down factories and production colliding with government-supported U.S. spending.
A number of factors suggest 2022 could be very different. The worst of the supply disruptions may be over. Order backlogs are improving, inventories are growing again, and executives of key supply-compromised industries are sounding more optimistic. U.S. households may be shifting their consumption back to services after a nearly two-year hiatus, supplanting the online binge of consumer durable goods that—along with higher food and energy prices—drove the bulk of the spike in inflation. Rising prices have slowed real consumption and energy costs remain a headwind. Asset inflation supports consumption, but U.S. monetary policy is turning hawkish. On the other side of the world, Chinese macroeconomic policy is only starting to turn dovish.
What do these trends imply for 2022?
Based on surveys, many investors expect to see U.S. inflation retreat next year but only to a level that remains well above the Fed’s inflation targets. The surprise could be a bigger drop. If so, global nominal gross domestic product (GDP) would slow significantly while real GDP growth remains firm or even edges higher, bolstered by continued re-openings and stabilization in China.
The composition of global growth could shift as well—less U.S. and more rest of the world. In the U.S., the pivot would be from goods to services.
Instead of fretting about the Fed being too stimulative, the risk in this scenario is the U.S. central bank putting on the brakes too hard just as inflation retreats. Alternately, the Chinese authorities might not stimulate hard enough in order to ease through the country’s property market setback.
The U.S. mid-term elections and geopolitical hot spots are all added risk factors. In particular, determined compliance with ESG goals on the part of countries and companies could sustain upward pressure on oil and gas prices, leading to another version of 2021’s supply shock. However, Omicron’s arrival as the latest mutation in the COVID pandemic is another reminder that the biggest uncertainties in the outlook are the virus itself and how people and policymakers react. Embedded in the base case is the assumption that the pandemic evolves into more of an endemic that the world learns to live with.
To read more about Brandywine Global’s outlook on equities, fixed income, structured credit and currencies, click here.
Clarion Partners: U.S. commercial real estate by Tim Wang, Head of Investment Research
Inflation has been a top concern for investors over the past several months. In October, the U.S. Consumer Price Index (CPI) spiked to 6.2% year-over-year, the highest level in over 30 years. A strong and synchronized global demand recovery has caught many distributors and retailers by surprise. Supply chain disruptions, labor shortages, increases in rents, and a general surge in energy prices have all contributed to the current high inflation rate, which has no immediate solutions in sight.
It is well-documented that real estate can – at least partially – hedge against inflation. For one, landlords generally have the ability to raise rents under better economic conditions, which in turn increases property value. Second, many real estate leases have contractual rent bumps that are linked directly to annual inflation rates. And third, higher inflation suggests higher replacement costs, including construction materials, labor, and land parcels. Such factors make new development projects more expensive, which should limit new supply and give more room for existing assets to grow rents and appreciate in value.
Historical precedent suggests and Clarion Partners believes that private real estate can effectively hedge inflation. An analysis of the 43-year history of the NCREIF Property Index performance under different economic scenarios suggests that private real estate total returns were strong during the years of high/medium real GDP growth and high/medium inflation. The latest case in point was the twelve-month period through Q3 2021, when the annual real GDP growth rate and inflation rate were 4.9% and 5.4%, respectively, while the NCREIF Property Index returned a robust annual rate of 12.1%.
High real GDP growth indicates stronger demand for commercial space, while favorable supply and demand market conditions typically allow landlords to pass higher costs to tenants in the form of higher rents. Private real estate has typically performed worst when real GDP growth was low, and inflation was either very low (recession) or very high (stagflation). As we expect GDP growth to remain elevated in 2022, we do not believe that the current economic expansion resembles either of these two scenarios.
Overall U.S. property fundamentals have been strong, powered by industrial, multifamily, and life sciences. The top-performing Industrial/warehouse sector’s strength has been driven by ongoing supply chain disruptions and inventory rebuilding as well as the continued e-commerce boom. With record levels of demand and a historically low vacancy rate of 3.6%, strong rent growth will likely persist for the foreseeable future. Multifamily fundamentals were remarkably resilient during the pandemic and have continued to strengthen throughout the recovery, with vacancy rates averaging 2.9%, the lowest level since 1994. Robust job growth and a significant rebound in household formation, especially from the Millennial and Gen Z populations, are expected to drive rental demand in 2022 and beyond.
2022 will mark the second year of this new real estate market cycle after double-digit total returns for the NCREIF Property Index in 2021. Demand is expected to continue to improve across most markets and property sectors, as rising occupancy and higher effective rents should drive higher net operating income and thus allow real estate to effectively hedge inflation. Barring unforeseen circumstances, the private real estate sector should perform well in 2022.
To read Clarion’s complete outlook, click here. Find its latest thought leadership on leading sectors in the U.S. real estate market, including U.S. Multifamily Investment Opportunity Post-COVID, on its web site.
ClearBridge Investments: U.S. equity outlook by Scott Glasser, Chief Investment Officer
U.S. equity markets are on track to deliver a third-straight year of double-digit returns, boosted by ample monetary and fiscal support, which has been offsetting the negative economic impacts of the COVID-19 pandemic. As we close the books on 2021, the recovery has progressed to the point where the Federal Reserve is poised to begin tapering its quantitative easing program, which will reduce the liquidity available to the financial system. Liquidity is one of several key factors we are monitoring closely to gauge the likely trajectory of stocks in 2022. While the current bull market seems poised to continue, we expect volatility to increase as the year progresses, which could temper equity performance.
Inflation will continue to be a primary risk to equities. As 2021 began, consensus inflation expectations were only +2%, but with the October Consumer Price Index coming in at +6.2%, the market is confronting real inflation risks for the first time in years, decades even. Fragmented global supply chains, negatively impacted by reductions in activity related to COVID-19, have struggled to meet resurgent demand, driving inflation for many goods that remain in short supply. That said, inflation has broadened out over the last six months from areas like used cars to other goods and services. Notably, wage inflation has also spiked and could be more persistent than is currently expected, forcing the Federal Reserve to act more aggressively.
So how are we thinking about inflation as investors? In general, we prefer companies with strong pricing power or expense passthroughs and lower labor intensity to mitigate the risk of a persistent inflationary environment. Higher inflation should favor commodity-driven sectors like energy and basic materials and hurt labor-intensive areas like consumer discretionary.
Energy is the best-performing sector year to date, and while commodities remain strong, we don't expect to return to a 2014-like commodity super cycle. However, we do see the potential for a mini upcycle in commodity stocks as we enter 2022. Beyond energy, sectors that have traditionally done well during inflationary periods include financials, industrials and consumer durables. Areas of the market less able to pass on costs to consumers — defensive sectors like food and certain areas of retail and utilities — have performed the worst during these periods.
With respect to inflation, what’s interesting is how technology stocks have fared. Tech companies generally have very high gross margins, which provide a lot of flexibility in terms of absorbing cost pressures. Traditionally, they have also done a good job of raising prices, as many technology contracts have built-in price escalators. In our view, technology sits in the middle of the pack in terms of inflation risks.
As we enter 2022, we believe investors should stay the course in equities. We continue to recommend a balanced approach to the markets, including both growth and value stocks and with an emphasis on quality companies. Market breadth remains generally healthy with the participation of small caps a key indicator to watch. We believe the path of inflation going forward will be the key driver of stock performance in the year ahead, especially in terms of its impacts on the rate of tapering and the pace with which liquidity is removed from the financial system. While markets are poised to rally into the new year, we believe more caution will be warranted as we enter the second half of the year if we begin to see inventory imbalances and a less accommodative liquidity environment.
To read more from ClearBridge, click here.
ClearBridge Investments: Infrastructure outlook by Nick Langley, Managing Director, Portfolio Manager
In an uncertain macroeconomic environment, the certainty of future earnings and growth will be key: infrastructure and utilities significantly outperform other equities on this measure.
Given our base case of slowing growth and higher inflation, our playbook for infrastructure portfolios broadly is to watch for a transition from a growth orientation to a more defensive positioning as growth fades and utility underperformance unwinds.
Generally, user-pays infrastructure and utility returns are positively correlated to inflation, but results differ by sector and region; meanwhile, climate inflation looms and is underappreciated at present.
Utilities, generally the defensive play, performed poorly early in 2021 amid a sharp cyclical rally and have traded sideways since. Electricity, gas and water companies have continued to invest in their asset bases and regulators have continued to set attractive allowed returns (roughly 8%–11% nominal ROE, in our assessment), resulting in highly predictable earnings growth over multiyear horizons. However, expectations of rising bond yields (particularly real yields) continue to weigh on the sector, and traditionally utilities have lagged the market until the first rate hike is announced and the path of rate hikes becomes more certain. As a result, utilities could lag for the first half of 2022.
Transportation infrastructure generally offered a mixed bag in 2021: toll roads recovered quickly from the initial stages of the pandemic and did well amid subsequent waves of COVID-19 as people decided against public transport and commuted in cars. Airports remain challenged as additional lockdowns loom. Ports and rails have lagged as snarled supply chains have reduced utilization and volumes. Transportation infrastructure should see a strong start to 2022 as growth returns to the economy and supply chain constraints ease (likely over the course of the year).
Communications infrastructure such as tower companies struggled in 2021. We expect communications to perform well in 2022 on continued negative real rates and high growth, driven by increased bandwidth needs as 5G buildout increases. The 5G network buildout will continue at pace in 2022 and beyond as users (mobile handsets) increase in number and data continues to trend higher with more macro and micro sites required. This will support 5G network speeds; however, more work is required to reduced latency.
After a strong 2020, renewables had a poor 2021 until the runup to COP26 as focus returned to the enormous policy support for renewable energy. The passing of the U.S. infrastructure bill and ongoing revisions of global emission reductions targets supports renewables, so we expect the sector to carry strength into 2022. Higher fossil fuel prices will assist the transition to renewable energy as projects that were marginal become economically justifiable.
Energy infrastructure, while generally not directly correlated to energy prices, benefits from future growth in production activity. The development of gathering networks and gas and liquids transportation provides ample opportunity for investment and attractive returns in a world of higher energy prices. Meanwhile investments in green hydrogen and carbon sequestration activities may assuage those investors concerned about the long-term viability of these (largely and currently) fossil-fuel-focused networks.
To read more from ClearBridge, click here.
Royce Investment Partners: Small cap equities by Francis Gannon, Co-Chief Investment Officer
We are optimistic about the prospects for small-cap stocks and expect them to regain the leadership they assumed over their larger siblings from March of 2020 to March 2021, though small-caps have lagged large caps since then. As measured by the Russell 2000 Index, small caps remain ahead of their large cap siblings, as measured by the Russell 1000 Index, since the market low on 3/18/20, up 126.1% versus 100.2% through 11/30/21. Still, many investors have likely also observed that large cap recaptured the relative performance edge in 2021’s second quarter and has held it ever since, making the current year a relatively disappointing one for small caps. However, our assessment of the current valuation picture and economic conditions strongly suggest to us that small caps are well positioned to resume market leadership
Within small cap, value has dominated in 2021. (Interestingly, the Russell 2000 Value and Russell 1000 had similar year-to-date returns through the end of November, with respective gains of 23.2% and 21.5%.) The Russell 2000 Value Index has easily held its advantage over the Russell 2000 Growth Index, up 23.2% versus 2.4%, respectively, through 11/30/21. However, we anticipate that small-cap value will continue extending its leadership position over growth for reasons similar to those that underscore our confidence in small cap as a whole—relative valuations and increasing economic strength. We expect that leadership for small-cap value will likely persist at least through 2022. In fact, as investors consider their allocations for the coming year, we think it’s important to note that small-cap value has only recently recovered from its longer-term relative underperformance periods versus small-cap growth.
We also expect higher-quality stocks to set the pace and see a market increasingly led by differentiation in companies’ results and outlooks. This condition would offer savvy active managers numerous opportunities to outperform passive indexes. There is, however, one important caveat: Though we are optimistic about the prospects for small caps in the current market and economic environment, we also expect results for all equities to moderate from the most recent five-year annualized period for the Russell 2000—which was 13.5% for the period ended 9/30/21 versus its long-term rolling monthly five-year annualized average since inception of 10.6%.
We expect small-cap value to continue leading within small cap for the same reason: Small-cap value has enjoyed a pronounced tendency to outperform small-cap growth when nominal economic growth has been above average. In our studies, nominal GDP growth provides not only a more promising signal of small cap beating large cap but is also a more revealing sign than real GDP growth when analyzing style leadership. Our hypothesis is that small-cap value is both more cyclically sensitive than its growth sibling and a greater beneficiary of inflation for relative earnings growth and valuation.
We looked back over the past 20 years and discovered that in one-year periods with at least 5% nominal GDP growth, the Russell 2000 Pure Value Index outperformed the Russell 2000 Pure Growth Index 70% of the time by an average of 150 basis points. In contrast, when nominal GDP growth fell between 3-5%, the small-cap value index outperformed only 32% of the time and lagged small-cap growth by an average of 100 bps. Keeping in mind the bright forecasts for the global economy we mentioned above, this pronounced edge for small-cap value looks particularly timely.
To read more about the outlook for small cap stocks by Senior Investment Strategist Steve Lipper, click here.
Western Asset: Global fixed income outlook by Ken Leech, Chief Investment Officer
Pandemic panic and fear remain a constant source of health anxiety. The omicron variant is the latest example of this, with new travel restrictions already being enacted in response. And yet, learning to live with Covid will be the major theme for 2022. As vaccination rates inexorably improve around the globe, a return to more “normal” economic activity appears in prospect. Large segments of the global population will emerge from being shut in—and the sources of both supply and demand will be largely increased.
Presently, the markets have taken the inflation bait as proof positive that an accelerated and persistent Federal Reserve (Fed) tightening campaign is in the offing. The completion of Fed tapering and six 25 basis point rate hikes are expected by the end of 2023. This expectation for an accelerated timeline for tightening in the US has helped elevate the dollar, and combined with China’s current economic soft patch, has put pressure on emerging markets (EM). EM countries haven’t helped themselves recently either. Turkey’s currency and other markets have seen volatility that is truly unsettling. Russia has anxiety over the Ukraine back in its focus, and in Mexico, Andrés Manuel López Obrador, commonly known as AMLO, has spooked investors over the potential politicization of their central bank. As investors brace for the widely expected elevated inflation prints of the next few months, expectations of Fed hiking continue to accelerate. In essence, global financial markets are in thrall of the Fed. But while that path is not implausible, should that level of fear really constitute the base case?
Interestingly, the path ahead for EM central banks may prove less challenging. The challenge of Covid, the fear of Fed tapering and the inflationary surge of higher commodity prices (particularly food costs) has caused anticipatory tightening to have already begun in earnest. As previously noted, fears of a pronounced Chinese slowdown are also weighing on EM assets. Higher US rates combined with weaker global growth evokes memories of 2018, which was very difficult for this asset class. Our view is that global growth will downshift from present levels but remain firm. We also believe that Chinese policymakers will begin to stimulate in very short order, and that supply chains will come back reasonably swiftly. Most importantly, our view is that the improvement in vaccination rates will reopen the economies of many EM countries.
Historically, broad-based commodity prices are a coincident indicator of global growth. As can be seen in the graph, the level of EM local currency debt has moved in virtual lockstep with commodity prices and by extension, global growth. Weak growth and low developed market (DM) interest rates in 2016 were followed by a strong bounce and Fed tightening in 2018, and then the relapse and recovery of 2020. EM local currency debt moved in lockstep until this year. Currently, the real yield differential between EM and DM rates stands at 15-year wides. As the global recovery blossoms and Covid recedes as a frontline worry, EM economies and currencies should rapidly recover. We believe investors will increasingly look to EM for substantial yield improvement over historically low DM yields.
To read more insights from Western Asset, click here.