1H22F Outlook – Late cycle rotations

■ We expect the US to underperform Europe and Japan in 2022 on earlier turning of its policy cycle.
■ EM will be dragged by low vaccination rates, high inflation, and interest rate pressures, but Chinese equities should benefit from policy easing.
■ US Dollar decline could resume on negative real rates.

Expect lower US returns next year

The triple peaks in economic growth, earnings growth and policy stimulus will likely result in lower returns for US equities in 2022, in our view. Persistently high inflation – likely running hotter in the US than in Europe and Japan – will cause greater volatility as US equities are put on tenterhooks over rate hikes. The US currently has deeply negative real rates which are at around the levels of 1975 (Figure 1), with the Taylor Rule Model suggesting the appropriate Fed Funds Rate should be 5.5%-6.0%.

US likely to underperform Europe and Japan

We believe US market’s greater exposure to growth stocks will make it more vulnerable to earnings duration risk than other developed markets (DM). European and Japanese equities are more defensive given lower rates of inflation, likely leaving them with zero rates and yields for longer. Their lower valuations and greater exposure to value stocks could also help, in our view.

China stocks could be on cusp of reversal amid policy easing

China’s policy restraint – while DM central banks were engaging in unprecedented policy stimulus during the pandemic – means it can now engage in counter-cyclical stimulus as the US starts tightening.

US$ could weaken on inflation than strengthen on higher yields

The secular decline in the US Dollar Index, which we believe started in 2017, is likely to resume. We believe higher inflation in 2022 is likely to outpace the increase in US Treasury yields.

EMs usually do better amid US$ weakness

In both absolute and relative terms (vis-à-vis the US market), the MSCI Emerging Markets Index tends to do better during periods of dollar weakness. However, this time, the combination of generally low vaccination rates, high inflation, and upward pressures on interest rates could leave most EM economies with less policy space to manoeuver, in our view. This leaves us with China as the preferred proxy, as it has more fiscal and monetary space than most others within EM.