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Inflation ‘is the biggest risk for markets’ going into 2022: Strategist

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Merrill and Bank of America Private Bank Head of CIO portfolio strategy Niladri Mukherjee joins Yahoo Finance Live to discuss stocks declining after reports of the first case of the Omicron variant.

Video Transcript

ALEXIS CHRISTOFOROUS: Want to stick with the markets now, the broader markets, and bring in Nil Mukherjee. He is head of CIO Portfolio Strategy for Merrill and Bank of America Private Bank. Nil, good to have you here. We are seeing this direct correlation between news that we have the first confirmed case of Omicron in the US and this pullback in the market. Although, we are still higher, well off our highs of the session. Do you think that Wall Street is overreacting a little bit to this Omicron news?

NILADRI MUKHERJEE: [MUTED] with the price action you're seeing now--

ALEXIS CHRISTOFOROUS: I think you may be muted, sir. There you go.

NILADRI MUKHERJEE: The price action-- can you hear me now?

ALEXIS CHRISTOFOROUS: Yes, we can.

NILADRI MUKHERJEE: OK. Well, thanks for having me. I think the price action you are seeing now really shows that the market lacks conviction in-- on the upside. Since-- in the last couple of weeks, we've had two major uncertainties being injected into the marketplace. One obviously was the news of the new variant, which we know very little about right now. And the second is the possibility of a more hawkish Fed.

And you've seen on different days-- on some positive days, you've seen a recovery in some of the value and cyclicals, which do well when the economy does well. On other days, you've seen the secular growth-oriented sectors outperform, like technology doing better than the S&P 500. And then today, obviously, you're seeing a pullback in some of these travel-related stocks.

So, you know, we think that uncertainty will be with us at least in the near term, till we learn more about the virus, its severity, its transmissibility, how much it is evading the vaccines, et cetera. But as we go into 2022, the bigger environment will be that which is really dictated by the Fed's path to monetary policy normalization, notwithstanding the fact that we could have a wave now, which is very difficult to speculate on. But it looks like the environment we're going into in 2022 is one of good growth for the year as a whole, but also tighter monetary policy.

- Niladri, this is typically, traditionally, a quiet time for the markets, time for it to rally. We talk about Santa Claus rallies. But this is anything but a normal sort of situation here. It seems to me that there are three conditions that the markets are looking at. One is the variant, one is inflation, and one is supply chain issues. Which is the biggest threat at the moment?

NILADRI MUKHERJEE: Well, in the very near term, the biggest threat is the headlines related to the virus. We do believe that as we go into 2022 and as we get to the other side of the pandemic, as vaccine boosters are further administered in developed markets, as vaccine penetration improves in emerging markets, the arrival of antiviral pills, et cetera, that society just learns to live with what could eventually be an endemic. But as we go into 2022, I think inflation is the biggest risk for the markets as a whole.

Inflation is looking awfully persistent. Obviously, we've had six, seven months of CPI printing above 5%, now 6%. I wouldn't be surprised to see even higher prints going into January, February, especially if the virant-- the variant actually leads to further closures in factories around the world and less mobility. But I think that's going to be the major factor which determines asset prices and where they go from here.

So we're still remaining fairly positive on the equity markets. I think in 2022, equity markets are likely to grind higher. It's going to be a gritty year for equities. It's going to take its shocks. There's going to be episodic volatility, especially as the Fed begins to hike interest rates perhaps towards the middle of next year. But the corporate earnings story is extremely powerful.

We think that corporate earnings could rise about 10% next year. Margin story is still healthy. And nominal growth environment is very, very strong. So if you get 4% real GDP growth, and you put another on top of that 4% in inflation, you're looking at a nominal growth picture of about 8% to 9%, which will feed into revenues, feed into corporate earnings. And that will hold equity's hand, and equities should finish the year higher.

ALEXIS CHRISTOFOROUS: But how do you view valuations amidst that kind of a scenario, where you have strong GDP? You're talking about double digit growth for earnings next year. We're already pretty frothy in lots of sectors in this market right now. Are you afraid that valuations are just going to hit it-- hit an even more unrealistic area and that investors should be careful?

NILADRI MUKHERJEE: Yeah, it's a great question. It's a question that our clients ask us all the time. You know, I would say that there is no doubt that if you look at absolute levels of valuations, like you take any metric-- PE, price to sales, market cap, and GDP-- they all look quite elevated. But on a relative basis, valuations for equities are not that elevated. If you look at the earnings yield of the S&P 500, it's still way above where bond yields are, and it's also above where yields for corporate bonds are. So we feel that the biggest competing asset class for investor dollars for equities is fixed income. And in that respect, equities are still in a pretty good shape.

But here's something else to chew on and to consider as well. Even though, yes, with interest rates going up, with inflation looking a little bit more sticky, there's no doubt that you'll see a little bit of a compression in valuation multiples. But what I would pose to you is that valuations can perhaps stay in a higher trading range going forward than they have been in recent cycles. And the reason for that is, if you look at US indexes, they have a lot of exposure to secular growth-oriented names. These names are leveraged to secular areas like the digital revolution that we are all living through right now. So a faster growing, higher growth year index should attract long-term investors more. And hence, valuation should be more sticky.

The other is, US companies are also extremely high quality in nature. So they've proved their resilience through the pandemic. They have shown that they have high quality balance sheets. They have shown their ability to innovate, and innovation has accelerated as a result of the pandemic, which has kept margins higher. And again, in a profitable group of companies with high value, high quality should get a better valuation metric from the market as well. So if you take the combination of these things, valuation is still not a deterrent for equities to be moving higher. Yes, valuations will compress a little bit, but they should stay higher from a secular perspective. And then earnings growth should be the biggest driver of equities going forward.

ALEXIS CHRISTOFOROUS: All right, Nil Mukherjee, of Merrill and Bank of America Private Bank, thanks so much for sharing those insights with us today.

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