Policy conundrum
High inflation and Omicron are combining to make things difficult for central banks. The US Federal Reserve has said it plans to quicken the “tapering” of its stimulus measures and may raise interest rates faster than expected. The Bank of England also looks likely to continue to tighten monetary policy over the next few months. Meanwhile, the ECB has decided to discontinue its pandemic purchases by the end of March, while increasing its ‘normal’ bond-buying programme as a partial offset.

After 12 months of twists and turns, the year ahead looks set to be another eventful one for markets. Inflation is likely to continue to grab the headlines, and geopolitical tensions could also cause periods of volatility. Some structural trends are likely to reassert themselves along with new ones that got a boost from the pandemic – from the ‘build back better’ overlap between infrastructure projects and sustainability to ongoing innovation across industry sectors.

Economic and company earnings growth are past their peaks, but we believe the business cycle has much further to run. As it matures, returns from risky assets will probably normalise from the stellar levels they achieved in 2021. Yet there is still plenty of room for equities and corporate bonds to outperform low-yielding government bonds.

We’re maintaining our moderate ‘pro-risk’ tactical allocations. US equities remain the region with the best momentum and most attractive mix of industry sectors. Emerging market sovereign bonds provide decent carry, while Asian high yield debt should benefit from tighter spreads.

Renewed restrictions in Germany, the Netherlands and Austria are putting the brakes on growth in Europe but the impact is not substantial so far. Omicron poses an additional risk to the recovery not only in Europe but also in the US, where Delta infections have surged recently too. The positive news is that although new virus strains are more easily transmitted, they are less deadly. Widespread vaccination rates and economic adaptability are also helping.

We believe the economic cycle will continue to head towards a mid-cycle phase. Although slightly reduced, the pace of growth should remain relatively solid throughout 2022 as global patterns of trade recover from the disruption caused by the fall in demand during the lockdowns. Inflation has been persistently high for the past year but we continue to believe it’s not a self-sustaining spiral and so it will begin to subside next year.

Inflation is high for various reasons and the main cause seems to be strong demand pressing against constrained supply. To determine when it’s likely to fall, we’re monitoring inventories and sales. The ratio spiked when sales collapsed during the initial lockdown and then fell to a decade low. As factories ramp up production and supply bottlenecks ease, we expect the rebuilding of inventories to support economic activity in 2022 and put downward pressure on inflation.

The pandemic has disrupted our daily rhythms and changed our sense of time. Just as we were beginning to settle into some new patterns, the Omicron variant brings the renewed risk of restrictions on socialising and international travel. Christmas parties have been downgraded or cancelled, and investors have started to worry about the short-term outlook for the economy and financial markets.

We believe this new strain of the virus is unlikely to throw the recovery off course for very long. Many of the key macroeconomic drivers of the past couple of years should move past the peak over the next 12 months – from economic growth and inflation to policy stimulus and the impact of Covid waves. We describe this process as a maturing cycle and you can read more about our outlook for the year ahead in our Counterpoint 2022 publication.

The economic recovery is heading towards a mid-cycle phase, which usually provides a positive backdrop for investment returns

Getting more mature

COUNTERPOINT JANUARY 2022