What would it take to kill the recovery?
What would it take to kill the recovery?
“The pandemic is not over until its over everywhere” the epidemiologist Professor Peter Piot told us in mid-2020. His words look very prescient as we face the threat of Omicron, a new variant of Covid-19. Its rapid spread in South Africa, a country that has experienced high levels of infection, suggests that it may be able to evade existing immunity - whether this come through previous infection or vaccination. The social and economic impact remain unclear. However, the modest sell-off we saw in early December suggests that investors are still taking a relatively optimistic view.
Despite the pullback, 2021 was another strong year for global equities (at least as of mid-December). The performance is not entirely surprising. The successful deployment of vaccines, along with ongoing support measures from governments and central banks, helped the global economy to rebound by 5.6%, the strongest growth in decades. It might have been even stronger had it not been for the supply bottlenecks that limited production over the summer and autumn.
This recovery set the stage for an dramatic rebound in corporate earnings: we expect companies to report 2021 profits that are around a third higher than in 2019, based on constituents of the MSCI World Index. This benchmark is also higher than its end-2019 level by a similar amount. While equities are by no means cheap, this does suggest that some of the anxiety about unjustifiably high share prices is misplaced.
US equities continued to lead the way in 2021, emerging markets lagged
Equity market performance, rebased to 100
Source: Cazenove Capital, Refinitiv Datastream
The strength of the economic recovery allowed investors to look past threats that might otherwise have been more unsettling. We have not had a repeat of the “taper tantrum” that accompanied the unwinding of central bank stimulus measures in 2013. Western markets have also proved resilient in the face of repeated shocks from China, as Beijing has sought to impose sweeping social and economic changes. In the heavily indebted property sector, these have led a number of big firms – notably Evergrande - towards default. However, the ensuing slowdown in the Chinese economy is one factor that has contributed to the weaker performance of emerging markets over the past year.
Policy becomes less supportive for investors
Even before the emergence of Omicron, there were two reasons to think that the recovery would slow from the very strong levels we saw in 2021.
The first of these is lower government spending, as the various pandemic support schemes come to an end. Spending will remain high, as recent political developments make clear. In the US, Joe Biden’s $1.7 trillion Build Back Better bill, which focuses on childcare, education and energy transition, is moving towards approval. In Germany, Olaf Scholz’s new coalition government has set out plans to increase spending on infrastructure, adding to the boost from the EU’s NextGeneration plan. Nevertheless, the mix of government spending and taxation is set to change in 2022 – and in some countries, such as the UK, it is clearly being funded in the near term with tax rises.
The other big shift is the inflation outlook and what it means for monetary policy. For much of the decade before Covid-19, inflation was persistently below central bankers’ targets. 2021 was the year when this finally changed. Depending on which measure you look at, inflation is currently running at between 4 - 7% in many major economies, the highest level since the 1980s. While some inflation is welcome as economies grapple with huge debt burdens, there are many reasons why too much is harmful. It can erode consumer and corporate confidence, which has always been a key concern for central banks. It can also lead to lead to greater inequality, which is a more recent area of focus for politicians and policymakers alike.
We still expect price rises to moderate over the course of 2022, as the shortages that made headlines last year ease. Prices for memory chips and shipping costs have declined by some 30% from last year’s peaks and energy prices fell sharply in response to news of the Omicron variant.
Even so, broader inflationary pressures remain, with wages and housing costs rising rapidly in many markets. We are watching wage growth closely as it is a indicator of more entrenched inflationary expectations.
US inflation to decline from very high levels in 2022
Contributions to the US Consumer Price Index
Source: Schroders Economics Unit
After striking a more relaxed tone for much of 2021, central banks are now turning more hawkish. In testimony to Congress at the start of December, Federal Reserve Chair Jerome Powell admitted it was time to retire the description of inflation as “transitory” and suggested the Fed may bring forward interest rate rises. There are even murmurs that the European Central Bank, which still has negative interest rates in place, may be forced to change tack.
Markets have largely defied the pessimistic forecasts made about how they would respond to less stimulative monetary policy. Global bond yields have risen modestly, but remain at low levels. The weaker performance of more speculative markets that are more sensitive to liquidity conditions - such as cryptocurrencies and loss making early stage technology – are perhaps the main harbingers of stress.
Consumer and corporate spending will be key
Consumer spending in the US – a key driver of both the US and global economy – has quickly recovered to pre-pandemic levels. Savings built up during the pandemic should continue to support demand: Schroders economists forecast that this will provide a spending boost of around $575 billion in 2022, compared to total consumer spending of around $13.5 trillion.
So far, the recovery in consumption has been very lopsided, with demand for goods increasing far faster than demand for services, such as leisure and travel. This means that pent-up demand for services could be a significant tailwind for the next phase of the recovery, though much will depend on Omicron of any further variants. Inflation is a threat, however. Prices of many goods and services have been rising faster than wages, eating into disposable incomes and hurting confidence. While consumers have been continuing to spend, recent surveys suggest they are becoming slightly more worried about economic prospects. This could lead them to save more than they might otherwise.
Prospects for corporate spending could be brighter. Rising costs and the difficulty of finding workers are both encouraging companies around the world to invest more in automation. And in the wake of a pandemic, it is politically more acceptable to invest in plant and equipment than return cash to shareholders. These recent developments are adding momentum to long-running trends. The cost benefit of outsourcing production to China has long been dwindling, well before shipping costs spiked in 2021. And before anyone had heard of coronavirus, “trade wars” and geopolitical tensions were prompting many big companies to reappraise their organisations and bring supply chains closer to home.
Climate spending to accelerate…
There’s another important factor that will be driving corporate spending over the next few years: climate change. To take just one example, mining giant Rio Tinto has said it will spend $7.5 billion by 2030 to reduce emissions.
Despite the high profile COP26 summit in Glasgow, 2021 was a mixed year for investors in many popular climate change themes - such as renewable power equipment. Prices for many of these investments rose too far, too fast in 2020 as investors rushed into the sector without thinking about fundamental considerations like competition and margins. They were reminded of both last year and careful investment selection will remain essential.
While COP26 did not deliver significant binding agreements that would accelerate climate change investment, additional momentum could come from last year’s spike in fossil fuel prices. It was a clear indication that the current pace of investment in renewable energy has not yet been enough to reduce our dependency on traditional, carbon-intensive forms of energy. Spending will need to accelerate.
..and politics could become more fractious
2022 brings a number of important elections – with a French presidential vote in April and US mid-terms in November.
While pandemics can bring people together early on, history suggest that they have often gone on to cause significant social unrest. Downing Street’s Christmas “meetings with cheese and wine” certainly don’t help matters. But the big worry is inequality: while inflation erodes disposable income for the less well off, the wealthy are perceived to have become wealthier over the past eighteen months through increases in asset prices. This suggests that the lure of populism will continue to remain alive and well. Governments are attempting to see off the threat through initiatives such as “levelling up” in the UK and “common prosperity” in China. This year’s French election will be an important test of the appeal of populist politics in Europe.
There are also plenty of potential international flashpoints, with Ukraine currently the focus of attention, but Taiwan and Iran being followed closely. The long-running tension between the US and China will continue to remain a threat to global growth in 2022 and beyond. While it is unlikely that we will return to the mud-slinging that characterised relations during the Trump presidency, scepticism of China remains high among Americans and the Biden administration. As we saw in 2018, trade and technology tensions between the world’s two largest economies can be a significant headwind to global economic activity.
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