Interest rates are close to zero, all asset valuations are high and inflation is running hot. How does the macroeconomic environment look like in 2022? Will it continue to be supportive for risk-taking in the markets? What’s ahead of us in 2022?
2021 was yet another strong year for equity investors. Despite the corona pandemic and soaring inflation main stock indices in the developed world closed the year at record high levels. In the US equities delivered returns of close to 30% and in Europe 23%.
Emerging markets had a tougher year, with stocks showing slightly negative total returns. In China indices fell markedly during the year as the zero tolerance policy toward coronavirus dampened economic activity, the government’s tough stance on tech entrepreneurs led to repricing in the markets and uncertainty and concerns around the construction and real estate sectors remained elevated.
For bond investors last year was one of the weakest in decades. Low running yields in sovereign debt markets combined with falling bond prices, i.e. higher yields, pushed total returns below zero in many markets.
The biggest macro theme of the last year was the return of inflation. Ultra-loose fiscal and monetary policies continued to boost demand in developed markets. It is staggering that central bank rates are at zero while inflation is running at levels not seen in decades. The waves of new coronavirus variants caused serious supply chain disruptions in global trade, and labor market tightness led to wage hikes not seen in many years. The current high inflation story builds on both strong aggregate demand supported by economic policy measures and dampened aggregate supply caused by coronavirus containment measures and behavioral changes caused by the pandemic.
The data released on Wednesday showed that inflation hit 7% in the US in December, which is the highest inflation figure for 40 years. Core inflation, which excludes volatile items such as energy and food, was up by 5.5%. This tells us that price increases are widespread across a range of goods and services in the US. Wages increased in December on average by 4.7%, which is another sign of broad inflationary pressures.
In the Eurozone, inflation reached 5% in December, which is an uncomfortably high figure both for central bankers, and more importantly for consumers. Core inflation was at 2.7% implying that price increases are being driven by energy prices. Wage increases are more contained than in the US, with the sluggish collective wage setting processes in Europe seeming to limit wage increases and help to contain broad based inflation pressures.
Well, that’s all about last year. The starting point for the current year is very peculiar. Interest rates are close to zero, all asset valuations are high and inflation is running hot. Pretty scary set-up, don’t you think? How does the macroeconomic environment look like in 2022? Will it continue to be supportive for risk-taking in the markets?
The current macroeconomic forecasts for 2022 seem to be fairly optimistic. The latest GDP projections by the Fed for the US show growth of 4.0%. The ECB projection for Eurozone GDP growth is currently at 4.2%. The World Bank released just this week a forecast predicting that developed economies will return to the pre-Covid GDP growth trend by 2023.
As the Omicron variant ravages societies on both sides of the Atlantic inflation has reached levels not seen in decades. The purchasing power of households is eroding rapidly with the current inflation levels, which poses a clear risk to continued economic expansion. The risk of high inflation to economic growth has been clearly acknowledged by the Fed in its recent communications. The ECB, however, is still worryingly silent about the perils of high inflation.
Fiscal policy will tighten in the developed markets during this year, as the emergency programs launched during the pandemic are terminated. This implies that household disposable incomes will be squeezed relative to last year.
The biggest change will happen in monetary policy. The Fed’s rapid turnaround at the end of last year has already raised treasury yields especially at the short end. The 2-year yield, which is particularly sensitive to changes in monetary policy stance, has increased substantially and is closing on 1%. The Fed now sees three rate hikes during the current year, and its asset purchases will be terminated already in March. Quantitative Tightening (QT), the downsizing of the Fed’s balance sheet, will most likely start right after the first rate hikes.
The Fed’s recent communications sound very hawkish. The Fed is certainly ‘behind the curve’ and should have started the tightening cycle much earlier. Will the Fed tighten monetary policy as rapidly as they now communicate? I would say, ‘it depends’. The day the US stock market starts to show signs of marked weakness, the Fed will be tempted to ease on the tightening cycle.
What can be expected from the ECB in terms of policy tightening in 2022? Well, not much. The emergency purchasing program (PEPP) launched in the beginning of the pandemic will be terminated in March, as was expected. The monthly purchases of the ‘standard’ asset purchasing program will, however, be raised to compensate for the termination of the emergency program. During the pandemic, the ECB and the national central banks of the Eurozone have bought all net issuance of Euro Area government bonds. As fiscal deficits are shrinking in 2022, smaller purchases by the central banks will suffice to keep demand for government debt high in relative terms.
If the macroeconomic outlook proves to be too optimistic, then analysts’ earnings expectations for listed companies may also look too strong. With equity valuations already stretched, this poses a risk to stock markets valuations.
This year has started with volatile trading in stock exchanges as the Fed’s more aggressive policy towards inflation worries investors. Analysts’ expectations on the 2021 Q4 earnings season are bullish. In the US earnings are expected to increase, on average, by 22% year-on-year and in Europe by close to 50%. Strong earnings expectations imply that at least analysts believe that companies have been successful in passing higher costs to the customers of their products and services.
This year’s earnings growth estimate for the US is just above 5% and for Europe it is close to 11%. These figures are fairly moderate relative to the macro outlook, especially for the US, which gives some comfort to current equity valuations.
So, in this highly uncertain environment, plagued with the coronavirus and rampant inflation, what’s ahead of us in 2022?
Well, as it comes to any forecasts of GDP, inflation or of market prices in particular, I would refer to the old Roman wisdom - ‘caveat emptor’! No-one knows what is going to happen, not me or you, or any mighty central bank or large investment bank.
Here are my humble predictions for 2022:
i) GDP growth in developed markets will fall short of the current projections due to the Covid pandemic and soaring inflation.
ii) The Fed, despite being behind the curve, will navigate skillfully through stormy waters, tightening monetary policy gradually and succeeding in bringing inflation to lower levels without a major stock market crash.
iii) The ECB will continue with an ‘all in’ policy with steering rates at zero, trusting that inflation is transitory, and that energy price inflation and supply bottlenecks will ease. The ECB policymakers will continue to refer to the ECB’s own macroeconomic projections, which show convergence to below 2% inflation in 2023 and 2024. This is the ‘caveat emptor’ moment. Trust me, I was a member of the group producing those forecasts for years.
iv) Total return in global stock markets settles at mid to low single-digits – at best.
v) What about the huge global bond market? Running yields are low and interest rates are on the rise. But on the other hand, rapid price falls seem unlikely in many markets. Total yields will be close to zero, as they were last year. Only those institutions, which need to invest to bonds for liquidity or regulatory reasons, such as banks, insurance companies and pension schemes will continue to invest.
vi) This is the safest bet: Geopolitical tensions will rattle the markets during the year. It may be Ukraine, Kazakhstan, Taiwan, US-Russia relations, or new conflicts which we cannot even imagine now.
So, caveat emptor! It’s going to be an interesting year for us investors once again!
Senior Advisor / Chief Economist