Investment opportunities for markets in transition

Editor’s note: This is a portion of Santander’s 2022 Global Outlook. Click here for the full report.

The investment community has savored risk asset returns over the past 18 months but remains concerned about the returns on risk-free assets, rising inflation, and slowing growth. Shifting economic and market paradigms are forcing investors to look for investment solutions to tackle the challenges of the transitions in which major financial assets are immersed.

Investors focused on capital protection and income have recently added an additional concern to the scarcity of returns in fixed income markets: The possibility that the inflation spike may be less transitory than initially thought. In this context, we continue to emphasize the need to remodel investment portfolios that diversify beyond traditional fixed income and incorporate a more active management component.

For investment mandates with higher risk tolerance, the concern centers on high levels of valuation and leverage, coupled with the slowdown in corporate growth and earnings. In this context, a global geographic focus and increased diversification with exposure to private markets and alternative assets are increasingly essential. The transition to sustainability also implies significant investment opportunities, as well as innovation favored by the continuous disruptive environment of new technologies.

Top opportunities

Stay invested as long as growth is above trend

Economic momentum is decelerating but our forecasts still point to GDP growth significantly higher than average. Risk assets (credit and equities) are very sensitive to economic activity and should continue to outperform safer alternatives (cash and government bonds). The recovery is incomplete, and it is still too early in the cycle to de-risk portfolios, but at the same time, the most rewarding phase of the economic cycle for markets is already over. The world has moved beyond peak economic and earnings growth and peak policy support, and therefore, it is too late to increase risk. Investors should concentrate on transitioning towards defensive positions going forward (that should be reinforced in the event of an immunological setback).

Increase inflation protection of portfolios

Economies are not going back to the 70s, and we do not believe the world is heading into stagflation. However, we expect inflation to be significantly higher than in the recent past. Breakeven inflation expectations for the next decade are above central banks' targets and real rates are priced to remain negative every year over for the same period. Investors should focus on real returns and explore real assets and investment diversification searching for inflation protection.

Search for flexible fixed income solutions

Be prepared for volatility in bond markets as monetary policies transition into gradual tightening. We maintain our preference for credit risk (corporate defaults are expected to remain very low), but we foresee the need to pivot towards other types of risks as the cycle progresses and spreads tighten (high-yield risk premiums are already low). Searching for yield and managing complex markets for bonds requires a lot of expertise, so we would consider flexible fixed income solutions that can profit from the potential increase in volatility.

Consider companies with pricing power

The not-so-temporary spike in inflation is creating winners and losers in terms of the ability to defend all-time high profit margins. We recommend an overweight in sectors like financials that benefit from the trend towards rising rates and favor companies that have pricing power built on the ability to pass on input costs to the consumer. Innovative companies face less competition, and technological disruption is opening many interesting opportunities for revenue growth. Investing in energy transition and sustainability could offer great potential to capture growth in the shift to a lower growth environment.

Focus on sustainability as an opportunity

Regulation and society are demanding a strong commitment to achieve net-zero targets. Sustainability is probably the single most important trend and opportunity on our radar, as investment flows from public and private sectors are going to be significantly affected by environmental factors and social considerations. It is an opportunity to focus on companies creating solutions and adapting their business models to the new environment.

Incorporate alternative investments

Investors are transitioning into private markets in order to broaden the opportunity set and capture the illiquidity premium. Flows, deal-making, and returns remain robust. Private equity and private debt portfolio managers have the flexibility and can help exploit multiple opportunities in the environment of markets and economies in transition that we envision for the coming years. The scarcity of yield in listed securities is forcing investors to look beyond traditional asset classes and listed markets.

To learn more about 2022 market trends and insights, read the full 2022 Outlook Report and reach out to a Santander Investment Services financial consultant to help guide your vision.