Compounding, sometimes described as the eighth wonder of the world, is often cited as a major tailwind for investors over time.
But this phenomenon , which can dramatically boost returns in the long run, can also work against investors just as dramatically on the downside.
Even though compounding has worked in favour of those who’ve remained invested through the March 2020 lows – with many stocks doubling and tripling since then – it can also exacerbate the downsides moves if the tailwinds of the past two years disappear.
Since the March 2020 lows, most stocks have ripped upwards on the back of enormous monetary stimulus combined with strong earnings growth driven by a swift economic rebound.
But after such a rapid recovery in 2021, investors need to be careful in a market where expectations have been dragged up so high, according to FE Alpha Manager Zehrid Osmani, manager of the Martin Currie Global Portfolio Trust.
“We think 2022 will be a year of much slower growth because the base effect is sizable,” he said. “It has been a much stronger year in terms of growth, much stronger than everyone expected.
“From memory, the market was expecting 21% growth at the start of this year. The market now expects 46% growth in 2021.”
The stark difference – more than double – of the earnings growth expectation and the earnings growth reality in 2021, shows the magnitude of the surprise most investors experienced this year.
Performance of MSCI World index year-to-date
Source: FE Analytics
“Next year in 2022, you've got a very high base effect of 2021,” Osmani continued. “Expectations are 6% growth year-on-year. For investors, that means the market will have much lower growth and therefore arguably, will be less supported.
“On top of that, you've got valuations which have travelled some way.”
Therefore, he argued it is very important to stay disciplined in where investors look for value. If expectations fall short while valuations are stretched, some companies could see a double whammy of falling multiples combined with falling earnings.
This is where compounding can work against investors. For example, if a company’s stock price falls by 50%, it must double in value just to get back to its original price.
The difficulty in regaining deep losses underscores the importance of entry points, according to Osmani.
“Don't just pick stocks that have got attractive growth profiles, that are in supportive structural growth trends in industries that are well behaved,” he said.
“Some structural growth themes are very powerful and can excite the market. If you don't have the valuation discipline, you can end up with getting into the wrong entry point and not having the return you might have expected or hoped for.
“We are looking for companies that have consistent, high growth profiles, as opposed to companies with very short cyclical growth in 2021 that might be running out of steam in 2022.”
Another reason why investors should heed caution going into 2022 is due to potentially more persistent inflationary pressures.
“Clearly inflation has been much stronger than everyone expected, both ourselves and central banks,” Osmani said.
“We're still of the view that inflation is frictional and related to supply chain disruptions and logistics bottlenecks, pushing prices higher.
“For us, that frictional inflation is something that we expect at some point next year will start to ease.”
However, he said that the easing of inflation might not come until the summer of 2022 because supply chain disruptions and logistics bottlenecks could continue.
More importantly, the result for many investors is that despite the strong inflationary pressures in 2021, Osmani said companies have been able to navigate those pressures through the benefits of scale economies and a sharp rebound in economic activity.
The margin pressure from inflation as a result will not have been as apparent or will have been “masked” by this operational leverage, he explained.
“In 2022, because you've only got a 6% growth expected, that operational leverage is not going to be as strong and therefore will not have the ability to mask the inflationary pressures on margins as much as it did in 2021,” he said.
“That means in 2022 we will see much more separation between companies that have pricing power that can protect their margins despite the much stronger inflationary trends, compared to companies that don't have the pricing power, where the margin pressure from this higher inflation could come to bite.”
In recent months, markets have experienced bouts of volatility due to growing anxiety over the actions of central banks amidst rising inflation.
Osmani however isn’t fazed by the volatility because he is of the view that markets are moving from a period of recovery to a period of expansion.
“In a period of expansion, typically what happens is that monetary policies move from being accommodative to normalising,” he said. “That shift in monetary policies tends to lead to more volatility in markets – this comes from different views on monetary policies.”
Some investors think that monetary policy is behind the curve in their efforts to fight inflation and that central banks will need to ‘slam on the brakes’ and increase rates very rapidly.
Others fear that central banks will act too early in tightening because underlying economic growth is still fragile and over-tightening will hurt long-term economic growth.
Osmani however, thinks that central banks are simply doing what needs to be done at this stage – which is normalising.
“We don't think that there's a tightening or over tightening, but rather normalising of monetary policies. If you actually look at the underlying real rates, they are still very low.
“In our view, this should still be supported for equity markets, even if next year we don't foresee sizable return potential as we have seen in 2021.”