After two years of a pandemic, it might seem strange to warn that the next 12 months are likely to be more difficult for equity investors than the period we’ve just been through.
To understand why we believe this, think of 2022 as a year of major inflection points. Some critical technical and fundamental underpinnings of the economy, which have been in place for years or even decades, look set to shift, and it’s likely financial markets will be more volatile as they digest these shifts.
Here are the ones we consider most significant.
European and U.S. inflation started to build toward the end of 2021. Last week confirmed U.S. year-on-year headline inflation hit a 40-year high of 7% in December, while core inflation exceeded expectations at 5.5%.
We think 2022 will confirm that this transitory inflation shock will leave a more persistent inflationary echo. Prices will rise faster and be more volatile in this cycle than at any time since the 1980s, in our view.
Pandemic-related supply bottlenecks could ease, but more structural supply-chain adjustments, the clean-energy transition, skills mismatches and other imbalances in the labor market are likely to feed into longer-term wage, fuel and housing inflation. The most recent U.S. non-farm payrolls report revealed just how tight the labor market has become.
Policy and Liquidity
The current rate of inflation has left the real fed funds rate even lower than it was through the 1970s.
That has added significant pressure onto the major central banks: Fed funds futures are now pricing for a near-certain rate hike in March, from a near-zero probability as recently as October. The volatility that struck in the first week of the year followed the release of the minutes of the Federal Reserve’s December meeting. These revealed that policymakers were not only determined to get asset-purchase tapering done by March—they were also urging a quick pivot to actively running down the Fed’s balance sheet.
There remains a lot of cash that could find its way into goods, services and equity markets. Analysts have estimated that U.S. consumers have saved between $2 trillion and $3 trillion more than they would have, given pre-pandemic trends. Most measures of institutional equity allocations are still below their peaks from the last cycle.
Nonetheless, this new central bank policy stance implies rate hikes and liquidity withdrawal at a much faster rate than markets have seen before. Add in the fading away of pandemic-related fiscal support, and we face a major tightening of liquidity conditions.
That pace of change adds meaningful risk of policy error—particularly the risk that the Fed raises rates faster than expected to slow inflation. This would likely lead to a major slowdown in economic activity.
Energy and China
Another transition for 2022 and beyond is in the world’s energy mix.
Momentum began to build behind national and corporate net-zero emissions pledges in 2020 and 2021, but following COP26 in November and the U.S. rejoining the Paris Agreement, we anticipate a tipping point in policy, corporate planning and capital allocation.
As we have already seen, that transition can be inflationary when it runs up against the energy demands of a recovering economy experiencing above-trend growth. It’s also tricky for central banks to manage: Some of them talk about managing the macroprudential risks posed by fossil-fuel exposure in the financial system; last week, the European Central Bank’s Isabel Schnabel became one of the first policymakers to warn that this might conflict with price-stability mandates.
In the past, major energy transitions like these have led to instability in their associated commodity markets. Climate change is an enormous risk for the long term, but as investors, we also need to keep a close watch on the near-term dynamics of our mitigating actions.
Finally, we highlight China.
The world’s second-largest economy, and the most important contributor to global growth over the past 20 years, is now being managed for “common prosperity”—slower but more evenly distributed growth. It’s difficult to overstate how significant that inflection is.
To make that even more challenging in 2022, this long-term transition may conflict with a cyclical transition to looser monetary and fiscal policy and slightly stronger growth. It’s worth noting that, just as U.S. inflation hit a 40-year high last week, China’s began to ease, undershooting expectations. These crosscurrents driving the two largest economies in the world only add to our expectation of more volatility this year.
A Taste of What’s to Come
Inflation, policy, liquidity, energy, China: This is where we see a handful of major inflection points to keep equity investors busy through 2022.
These may not blow the economic recovery off course, nor meaningfully disrupt corporate earnings or raise credit default rates. Economic growth can and has coincided with tightening cycles in the past.
That said, inflections like these can generate a lot of price volatility, and they generally raise the level of risk and uncertainty. Equity markets may well end 2022 higher than they are today, but we think the whipsawing ups and downs of the first two weeks of the year are probably a taste of what’s to come.
In Case You Missed It
- U.S. Consumer Price Index: +0.5% in December month-over-month and +7.0% year-over-year (core CPI increased 0.6% month-over-month and 5.5% year-over-year)
- U.S. Producer Price Index: +0.2% in December month-over-month and +9.7% year-over-year
- U.S. Retail Sales: -1.9% month-over-month in December
What to Watch For
- Tuesday, Jaunuary 18:
- NAHB Housing Market Index
- Wednesday, Jaunuary 19:
- U.S. Housing Starts and Building Permits
- Thursday, Jaunuary 20:
- Eurozone Consumer Price Index
- Japan Consumer Price Index