Main market drivers
Over the last twenty-four months financial markets have been driven by a combination of health, political, economic and policy issues. All will remain important in 2022, alongside the valuation of assets. The last couple of years have also seen bonds benefit from low policy rates and a flight to quality, while equity markets enjoyed a solid performance, particularly in the US.
Sterling, meanwhile, remained relatively cheap over this time, adding to the recent attraction of UK assets and companies for international investors, and helping fuel a mergers and acquisitions boom.
Health and geopolitics may never be far from the focus of markets this year and they have the potential to trigger extreme outcomes. High rates of vaccinations in the UK may suggest we are past the worst of the pandemic, but low rates of vaccinations globally pose the risk of new variants.
Politics and geopolitics can always dominate markets for short periods and 2022 should be no different, with geopolitical hot spots expected to include Ukraine, Iran and Taiwan. In addition, China has its 20th National Party Congress in October, the once every five-year event at which the new top echelons of the leadership are announced, including this year an extension to President Xi’s leadership. This is in addition to its annual Two Sessions meeting in the spring. Post pandemic, geopolitical tensions between the US and China may come to the fore.
There may also be particular attention this year on local UK elections in May, the French presidential election in April (which may also have a bearing on UK-EU talks), and US mid-terms in November.
Economics and policy to dominate
Yet, this year it is likely to be economic and policy developments that dominate in setting the tone for markets.
On the positive side, growth globally and in the UK should be stronger, as economies continue to rebound from the pandemic. Indeed, an underlying story of recent decades has been the resilience of the global economy. Despite the pandemic and 2008 global financial crisis, the size of the world economy has continued to grow: from $32 trillion in 2000, to $63 trillion when the financial crisis hit, and will exceed $100 trillion this year.
Globalisation and the digital revolution have been drivers of this, the latter boosting tech stocks. Although, as the year begins, rotation within equity markets is evident into other sectors.
However, the major challenge – particularly in the first half of 2022 – is what will happen to one of the other key supports of markets in the last three decades: low inflation and low interest rates. We discussed this in detail last year, asking which ‘p’ would it prove to be? Would this rise in inflation pass-through, persist or be permanent?
The Bank of England, and others, wrongly expected it to pass-through quickly; our view has been that it would persist and so it is proving. The trouble is that once the inflation genie is out of the bottle, then it may settle at a higher rate, not helped by the ultra-loose monetary policy that we have become accustomed to.
Inflation has already trended higher globally, but in most major economies the market expectation is that it will peak in the first half of the year. The question then is how elevated it will remain. As we have noted before, if we are witnessing a shift in the inflation climate, then market expectations may be slow to react, as was the case in the 1990s when there was a shift from high to low inflation, or in the 1970s when oil price shocks proved the trigger for a move to a high inflation climate.
In all likelihood, inflation will settle at higher levels post-pandemic than before, although much depends on how policy responds and on whether there is a wage-price spiral, as firms pass on higher costs and wages rise. Oil prices, too, could remain stubbornly high, and covid restrictions in China could yet trigger further supply shocks.
Monetary policy focus for markets
Central banks, meanwhile, will need to exit from their cheap money policies. For markets, the focus will on the three S’s: the speed, scale and sequencing of such monetary tightening. The US is key and will set the tone for markets globally.
The speed of rate hikes is likely to be gradual, but the scale could be significant and spread over this year and next. Meanwhile, the sequencing will be particularly important for markets, as tightening will not just be about raising rates but how central banks reduce the size of their balance sheets and reverse quantitative easing (QE), which has helped support financial markets, through quantitative tightening (QT).
UK interest rates are far too low. But this has been the case for some time. Furthermore, there was unnecessary and excessive QE last year, helping suppress bond yields. The challenge this year, though, is that the UK economy will have to cope with both monetary tightening via higher UK rates and QT alongside a tighter fiscal stance as taxes rise.
So, the start of the year will see markets focussed on the prospect of tighter monetary policy – led by the US. Then, as we move through the year, the underlying tone of markets may well be set by prospects for 2023, and where growth and policy are expected to settle post-pandemic. Will we see a return to the sunlit uplands of strong growth and low inflation? Or will the legacy be secular stagnation of low growth and high public debt and financial markets vulnerable to a new crisis as a consequence of cheap money policies?
More likely it will be somewhere in between, supporting a diversified and globally focused asset allocation. After 4.5% this year, UK growth may settle at 2.5% next, while UK inflation may peak around 7% this spring and then settle at 3%-4% in 2023, thus remaining well above the 2% inflation target this year and next. While such an outlook may point to higher rates and yields it would be a favourable backdrop for reducing the UK’s level of debt to GDP.
Additional worries
What are the worries? Higher US rates and a stronger dollar, combined with a low rate of vaccinations globally may expose some emerging economies. Also, China’s focus on a zero-covid policy may hold back its recovery. Another worry is that central banks and governments may mishandle their exit strategies from current cheap money and high debt policies. They could, for instance, hike too aggressively.
Additionally, the UK faces the challenge of a simultaneous tightening of both monetary and fiscal policy. This is already expected to add to a cost-of-living squeeze this spring. Sterling, despite being cheap, could prove to be the shock absorber, either because UK rate hikes do not match those in the US, or if they do then because alongside the tougher fiscal outlook, the economic recovery may falter and need the helping hand of a weaker pound.
Digital currencies and the next phase of the green agenda will also be high on the agenda, particularly as energy prices remain high.
The opportunity in markets in 2022 is to continue to benefit from economic growth while shielding from inflation and higher rates.
Please note, the value of your investments can go down as well as up.
