Risky assets rallied strongly during 2021, with the Global MSCI World equity index recording a gain of 22%. The global Covid-19 vaccine roll-out and accommodative policies supported favourable conditions and a strong recovery in corporate earnings. This occurred despite headwinds from supply chain issues, a surge in inflation, and the reintroduction of restrictions to contain the pandemic spread towards year end.
Overall, expectations for 2022 remain positive, supported by a year of continued global recovery, albeit growth and policy conditions normalising. Among the many drivers for market returns, there are four key overarching catalysts for the year ahead.
The Covid-19 pandemic remains a developing risk, but concerns over the Omicron Covid-19 variant are somewhat easing. Despite the staggeringly high number of cases, on a higher rate of transmissibility, milder severity continues to be confirmed. The Covid-19 pandemic is expected to have a limited economic impact from the covid-19 pandemic in 2022, as economies benefit from higher population immunity and restrictions ease. The increased infections, availability of vaccines and new therapeutic discoveries support the view of higher population immunity and therefore, a return to more global mobility.
Inflation is the second key market driver for 2022. The high level of inflation experienced so far was attributed to the economic reopening and the surge in aggregate demand, driven by the unprecedented level of stimulus. The resulting supply-demand imbalance led to the strongest surge in prices, with US inflation in December hitting highest level since 1982. While monetary policy tightening and easing supply pressures are expected to tame inflation, tight labour markets and higher wages are a key upside risk for more persistent inflation expectations in 2022.
The strong surge in inflation numbers has set hawkish tones from major central banks last December. During the December meetings, the US Federal Reserve doubled the pace at which asset purchases will be tapered, ending the program in March, and provided indications for earlier and more rate hikes in 2022. The FOMC minutes further indicated a faster pace of balance sheet size normalisation compared to the past. An actual rate hike was decided during the Bank of England’s Monetary Policy Committee meeting, raising the bank rate by 15 basis points to 0.25%. Meanwhile, despite that the ECB remained most accommodative out of the three, the ECB meeting surprised markets with a lower amount of monthly asset purchases going forward. ECB President, Christine Lagarde announced a more patient tapering and an end to the Pandemic Emergency Purchase Program by March 2022.
As a result, expectations for monetary policy normalisation during 2022 have heightened. The withdrawal of stimulus is essentially indicative of the strength of the economic recovery from the pandemic crisis. However, more volatility is expected while markets adjust for the reversal of central banks liquidity.
Expectations for central bank stimulus reduction sets the path for an increase in the level of yields in 2022. Although key 10-year sovereign yields have already shifted higher since the start of the year, yields have further upside to run. However, as monetary policy expectations shift the short end of the curve higher, the market continues to weigh out the growth-policy trade-off. The yield curve is expected to re-steepen during 2022, particularly in the US, as confidence in the economic recovery strengthens. Subsequently, returns in the bond market are more likely to be dependent on income rather than price movements.
From a credit perspective, strong fundamentals should support spreads to remain tight with limited further upside, on already high valuations. In this scenario, fixed income assets with a shorter duration are expected to show lower sensitivity to interest rate changes. Meanwhile, expectations for the high yield market remain positive, reinforced by above-trend economic growth, and low default rates.
On the other hand, equity markets are expected to continue to absorb monetary policy tightening if economic growth remains resilient and corporate earnings stay strong. On this basis, cyclical exposed sectors are expected to benefit the most from a continued global recovery. The key downside risk here, is that of a faster pace of monetary policy tightening on higher inflationary concerns. This highlights the importance of continued earnings growth as the fourth key catalyst for financial market returns in 2022.
The better-than-expected earnings growth was a strong theme for 2021, which is expected to carry on through the year ahead. This view is supported by positive economic growth expectations, which although are slower, remain above trend, particularly for certain regions like the US. While household savings rates have moderated, the level of excess savings remains high and provides support for higher consumer spending as global mobility increases. Moreover, further strength across labour markets, as well as accommodative fiscal policies and stabilisation in China, are all key drives for upside to earnings expectations.
Rachel Meilak, CFA is a portfolio manager at BOV Asset Management Ltd.
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