The latest Covid variant of concern, how high interest rates ultimately go and the valuation of US stocks are some of the key issues that investors should be watching as markets move into 2022, according to Vanguard. 
In the final weeks of 2021, the asset management giant has revealed which of 2021’s hot topics it thinks will continue to affect markets in the new year and Vanguard strategists below offer more details on how investors should react to them.
Will Omicron become the dominant Covid strain?
Vanguard had worried that the developed markets in the northern hemisphere were headed for “a difficult winter” even before the Omicron variant of concern, because of diminishing vaccination immunity combined with slow progress in booster jabs.
However, it had maintained that countries would be less likely to reimpose lockdowns than they were in 2020 as they took confidence from high levels of infection-acquired immunity and the fact that fatality rates had fallen after each coronavirus wave.
But the emergence of Omicron – which is the most heavily mutated Covid-19 variant yet – has put this view at risk. There are concerns that the variant is more transmissible than other strains and is better at evading vaccines, although it will be some time before this is discovered to be true or not.
“Omicron may yet change our views on the global economy in 2022. It remains unclear whether Omicron will outcompete the Delta variant,” Vanguard’s strategists said.
“If the Delta variant remains the predominant strain, our economic forecasts are likely to remain intact. But we still don’t know whether the new variant is more transmissible than Delta and the extent of its immune evasiveness.”
While the impact of a Covid strain that outcompetes Delta would be felt around the world, the effect would be especially pronounced in Asia. The vaccination programmes in both developed and emerging Asia have the benefit of being relatively recent and therefore offering high levels of protection, but this would disappear with a Covid-19 strain resistant to current vaccines, while Asia’s low levels of infection-acquired immunity would increase the risk.
Are US stocks heading towards a correction?
Vanguard has argued for several years that US equity valuations are starting to look “stretched” and their continued strong performance in 2021 – which has been driven more by valuation expansion than by increased profits – makes US stocks “more overvalued than at any other time since the dot-com bubble”.
This was based on the findings of the most-recent Vanguard Capital Markets Model (VCMM), which examines equity valuations relative to their fair value, conditional on interest rates and inflation. When it was run in September, the model put US stocks well above their fair-value range.
US equity valuations vs fair value
Source: Vanguard
The solid red line in the chart, which shows US equities’ cyclically adjusted price/earnings ratio, has jumped out of the fair-value range band – similar to how it did for an extended period in the run-up to the 2000 bursting of the dot-com bubble.
“Although our model provides a 10-year outlook for equity returns, it doesn’t provide insight as to when and how a return to fair value may occur. An overvalued market can continue on to greater highs, as it did in the late 1990s; then, the deviation lasted five years before it returned to fair value,” the firm’s strategists added.
“Vanguard’s VCMM research team has observed that past reversions from overvaluation to a fair-value range have been a function more of prices falling than of earnings rising, and that market corrections of 10% or more have occurred with greater frequency when equities were overvalued as opposed to when they were valued fairly.”
The take-home point is that investors should be asking whether the recent run-up in equities has caused their asset allocation to drift out of sync with their risk comfort level.
How high will interest rates go?
While plenty of attention has been focused on when central banks in developed markets will raise interest rates, Vanguard said how high rates will ultimately go – known as the ‘terminal rate’ – is just as important.
One this, the asset management house argued that the markets are underestimating the US Federal Reserve’s terminal rate and how it relates to the neutral rate, or the long-term equilibrium that would mean monetary policy is neither accommodative nor restrictive.
The market’s expectations for the terminal rate is around 1.5%, which is more than one percentage point above the Fed’s current federal funds rate target of 0% to 0.25%.
But 1.5% is well below the 2.5% neutral rate estimate from the Federal Reserve. Vanguard estimates the neutral rate to be somewhere between 2% and 3%.
“We emphasise that the neutral rate has fallen for several decades, in part a function of global savings and investment relationships. We don’t anticipate a return to interest rates higher than those that prevailed before the 2008 global financial crisis, and the journey to the terminal rate could take several years,” the firm said.
“The risk exists that run-ups in inflation and tight labour markets could cause the Fed to raise rates not only sooner than anticipated, but somewhat more sharply, which could spook the markets. This highlights the importance of investors remaining disciplined and focused on their long-term goals.”
Will Chinese housing developer defaults affect the wider market?
Chinese private housing developers are being closely watched as Evergrande and other firms struggle to pay their debts, creating fears that this could lead to global financial market contagion. However, Vanguard has several reasons why is this is unlikely to be the case.
The default rate for Chinese private enterprises hit 7% by the end of October 2021, up from 5% at the start of the year and largely down to defaults from property developers. But this is not too high by historical standards – the default rate for private enterprises in China got to 8% in 2018 at the peak of a deleveraging cycle.
Vanguard continued: “The risk of defaults may grow in 2022 as principal repayments become due for some of the largest private developers and as policymakers structurally shift toward a new policy regime that is dependent on more sustainable growth drivers. However, we think policymakers will do enough to prevent excessive contagion in the financial system.”
In addition, the firm said contagion concerns could be alleviated by composition of property-related loans. While these accounted for more than one-quarter of outstanding bank loan balances in 2021’s first half, most are mortgage loans, which carry lower credit risk thanks to high down payment requirements. Only 4% were in non-public housing developer loans.
“The takeaway for investors is to remain disciplined and not to read too much into headlines about defaults that may be inevitable,” the strategists finished.