Richard Dunbar: All eyes on the three ‘I’s – infection, inflation and interest rates
Richard Dunbar, head of multi-asset research at abrdn, discusses the outlook for 2022.
Ongoing inflationary shocks, questions around interest rates and the emergence of the new Omicron Covid variant are all making navigating uncertainty more challenging. Nonetheless, when we look beyond the headlines, there remain some reasons for optimism going into 2022. The themes we believe will be drivers for the year ahead begin with “the three ‘i’s” – infection, inflation and interest rates.
We are encouraged by the global progress on Covid. The vaccine rollout has been a success, particularly in developed markets. Emerging markets have lagged on vaccination, but the recent surge in uptake in China is encouraging. The latest variant, Omicron, has given reason for pause. Infection rates of the variant continue to increase globally, but current data suggests that the link between infections and hospitalisations appears to be weaker.
Omicron is a reminder that the world is only as good as the weakest link in the vaccination chain. This evident truth should concentrate the mind of global leaders in the year ahead and allow the continued re-opening of the global economy.
Inflation continues to be a key theme and we believe levels will remain elevated as we enter the new year. However, there are signs that in the US in particular, raw materials availability is improving, transport bottlenecks are opening up and shipping ports are now running 24/7. Inflation mathematics make it most likely that inflation will peak in the first or second quarter of next year. Forecasts are now also factoring in a slightly greater ‘down-draft’ as commodities and supply-chain issues ease.
The labour markets feel like the inflation battleground now. Will the millions who have exited the workforce return, fixing the supply-side damage inflicted by Covid? Or will we see wage demands broaden away from sectors disrupted by Covid (and, indeed, Brexit)? Inflation is also quite plainly becoming a political as well as an economic problem, adding more complexity to the mix.
Our third ‘i’ is somewhat related to the second in that while investors are certainly watching inflation, central bankers are watching it with an even closer eye. Federal Reserve Chairman Jay Powell has recently been vocal in his reminders to investors of the inflationary concerns of the Fed. These concerns have also been echoed at the Bank of England. Even the more optimistic forecasts for the path of inflation in the US and the UK have it persisting at levels that are likely to make central bankers increasingly nervous. While some of this interest rate hiking is already reflected in market expectations, it is not hard to see scenarios where central banks may have to pursue policy that is less market-friendly.
But what else will investors be keeping an eye on in 2022?
Chinese equity and bond markets endured further weakness and volatility at the end of 2021 thanks to additional regulatory interventions by the Chinese authorities, the deepening woes of the broader real estate sector and the drag from the country’s zero-Covid strategy. While there appear to be some signs of redress appearing in the Chinese real estate market, it is clear that an adjustment in real estate will not happen without an adjustment of the whole economy, given the scale and importance of the sector.
That said, China’s economic growth will continue to outpace the global average – albeit not by the rate that we have become accustomed to. It also remains the home to many high quality companies and a broad and deep bond market – both of which continue to offer opportunity.
With the timing of tapering and policy-rate adjustment at the front of investors’ minds and the peak of the fiscal impulse having been seen, the private sector will need to pick up the growth baton. Company earnings exceeded expectations by some way last year, so corporate liquidity is improving quickly, and survey evidence on investment intentions may presage further growth in activity. The rising price of labour, shortening supply chains and changing IT requirements may also prompt greater investment. While elements of this activity would be in our central case for 2022, it is an area where one might look for upside surprise
The emerging market complex tends to be more sensitive to adverse moves in global interest rates and, unfortunately, as was noted above, its ability to respond to the Covid crisis has not been as effective as in most of the developed world. However, emerging market central banks have been much quicker than their developed market peers to raise interest rates to try and dampen inflationary pressures. In addition, emerging markets, on many measures, offer value relative to many developed markets
Pulling all of this together, where does this leave us for the year ahead?
The house view remains risk facing, but less so than when we entered the year just passed. We would note a new phase in markets, characterised by underlying growth peaking and slowing (but still above trend and with the likelihood of a near-term pick up in some key economies like the US and China as Delta variant headwinds fade), sticky inflation (albeit, still expected to peak over the coming quarters and then moderate), tighter but still supportive liquidity conditions, and a better, but still highly uncertain, epidemiologic environment. The risks around our central economic and policy mix are firmly tilted towards stronger short-term inflation, weaker growth and tighter policy – a combination that risk markets can potentially cope with, but nevertheless a less palatable cocktail than the one we saw at the start of last year.
Equity is still the preferred asset class, where we expect modest but positive returns in the year ahead supported by reasonable earnings growth and a continued low discount rate. As with 2021, we believe ongoing regional divergence to remain and we have a preference for the US, quality and growth. In the bond markets our view remains that real yields should be on a rising trend on a 12-month view – either driven by the solid recovery in the base line, central banks tightening policy more rapidly if inflation pressures do not cool sufficiently, or mechanically if negative demand shocks weigh on inflation. High Yield continues to offer selective value – albeit the returns are rather meagre relative to history and embed a (not unreasonable) assumption of a benign bad debt cycle. Real estate remains attractive. We see value emerging in some of the previously less popular areas of the market such as retail where prices are starting to clear. In addition, rising construction costs are likely to limit future supply across the market. While stock selection continues to be important across all sectors, we are forecasting returns of 4-7% across UK real estate, which starts to match the long-run expectations of equities. Some of the discussions on inflation noted above also highlight the potential attractions of real assets in a portfolio.
Omicron has been a reminder of the uncertain journey that investors will have to navigate in the year ahead. More than ever, this points to diversified portfolios and careful security selection so that portfolios can cope not just with the bumps expected on the road ahead, but also those that are unexpected.