The path for markets and the global economy in 2022

At Crestone’s most recent investment forum, we asked panellists to share their views on the likely path of markets and the global economy in 2022.

In particular, we asked to what extent risks from the recent Delta outbreak, stickier inflation, and signs that central banks are starting to withdraw stimulus could derail the recovery.

Overall, our panellists believe the recovery remains on track, underpinned by a transition to living with COVID. In this scenario, the will to go back into lockdown is pretty low, and pent-up activity should continue to drive a pick-up in growth. Ample spare capacity should see inflation pressures ease ahead, even as bond yields trend higher.

Australia’s recovery is widely viewed as delayed not derailed, while relatively attractive valuations are likely to see capital flows eventually return to emerging markets—albeit in a more selective manner.

An ongoing search for yield is favourable for credit markets, and equity markets are also likely to be supported by low-interest rates, with the rise of non-price-focussed market participants flagged as a factor driving sector and stock trends. The pandemic is also seen to have accelerated the push to decarbonisation.

Four key themes emerge

  1. The will to return to lockdowns is low. A sustained economic recovery is the most favoured outlook, and COVID-19 is seen increasingly as a pandemic of the unvaccinated. With plenty of spare capacity and pent-up consumer buying power, policy is likely to remain accommodative with growth to advance at an above-trend rate—particularly in the developed economies.
  2. Attractive valuations should see capital return to emerging markets. More activist China policy and low vaccination rates have seen emerging market equities underperform. Non-China economies are in much better shape than in 2013, which is when the last US tapering occurred. However, investors may increasingly see emerging markets as a selective opportunity set, with a view toward non-China markets.
  3. There are still some challenges ahead for domestic equities. Investors are increasingly able to look across the chasm to a likely solid economic recovery in 2022. However, after a strong earnings reporting season, cost and wage pressures are starting to emerge and company outlook statements are weak. However, rates are not seen rising before strong growth is once again observed.
  4. Tapering is a headwind to fixed income, but tail risks are mispriced. Risk premia have congregated at the low end of historical averages in fixed income markets, suggesting an over-confidence in the consensus view. This is largely due to the strength of the improving economic outlook. And for this reason, bond yields are expected to keep rising, but not much above 2% in the US or Australia.

How likely is a sustainable global recovery next year?

While global growth has recovered at a record pace in the year following the 2020 pandemic-led recession, the world economy is likely to be passing peak growth in H2 2021. A few challenges lie ahead.

Not only is the world adjusting to living with Delta and ongoing flare-ups of the virus, but a likely default by Chinese property developer Evergrande is also weighing on risk appetite. With tapering on the way, will the global economy be able to transition without upsetting the recovery?

Scott Haslem, chief investment officer at Crestone Wealth Management, opened the conversation, highlighting some of the key considerations for investors in the current environment and sharing Crestone’s views. He explained that “as we move into 2022, growth is likely to normalise at a healthy pace and a recession in the next 18 months seems relatively unlikely”.

David Bassanese, chief economist at BetaShares, feels it is very possible the recovery could be sustainable. We have enjoyed a best-case scenario of a V-shaped recovery in growth. Despite COVID-19 dealing the world an incredible shock, and supply-side challenges in the US, he explained that there is still plenty of spare capacity.

Wages are pretty dormant and we are still in an early to mid-stage of a new cycle. When US unemployment drops closer to 4%, he would be more inclined to say we are in a later-cycle environment and should exercise more caution. However, there is still plenty of capacity for growth to advance at an above-trend rate without causing inflation.

“We also have policymakers remaining accommodative. COVID-19 is increasingly a pandemic of the unvaccinated, particularly for the northern hemisphere. US death rates are now back to last year’s highs but the will to go back into lockdown is pretty low now. All up, we are looking at a reasonably positive outlook.”

Will capital return to emerging markets?

While all nations entered the pandemic together, we are now emerging from the pandemic at different speeds, depending on inoculation rates. In emerging markets, several regions have been battling renewed outbreaks of the Delta variant And in China, growth looks set to slow further due to policy tightening, and downside risks to the outlook have risen. 

Haslem explained that emerging economies (ex-China) remain on track for a solid rebound over the next couple of years, although concerns remain that the global industrial cycle is passing its peak. “While we are positive on emerging markets, for some investors it just seems like a difficult place to be.”

Projit Chatterjee, managing director and senior equity strategist at UBS, feels the recovery has been a little more nuanced for emerging markets for a number of reasons. Firstly, emerging markets were slower to vaccinate and were consequently hit harder by the second wave of the pandemic. With vaccination rates now expected to reach 70% by year-end, he expects the pace of recovery to speed up.

With regards to tapering, Chatterjee believes that emerging markets are in better shape than they were in 2013. Current account data is a good indicator of this, and most emerging market countries are expected to post surpluses this year, as opposed to in 2013 when most were in deficit.

Four of the 2013 ‘fragile five’ (which includes India, Brazil, Indonesia, South Africa and Turkey) are in better shape today. While tapering might have an impact, it should be much less than the taper tantrum of 2013.

Does China present an opportunity?

Sonali Pier, director at PIMCO, finds it difficult to extrapolate the situation in China more broadly. For example, she sees foreign direct investment likely to struggle in China (due to Evergrande and Macau gaming) and would not extrapolate that to other emerging markets. However, she does see that some lending by China could impact other emerging markets.

Pier also noted there are hazard trades investors should be aware of. For example, the belt and road initiative has actually led to more direct investment in countries outside China.

Pier highlighted that there are certain issues that may make investors wary of investing in China, such as concerns about whether they will be paid out if there is a default, as well as issues in the property and gaming sectors, and the desire of the Government to reduce illicit money by cutting dividends without actually working with individual companies.

Nevertheless, she feels that memories can be short when valuations are attractive.

Chatterjee feels China can take a longer-term view to tackling certain structural challenges and objectives than most countries which may have elections every four to five years, and many of these issues are driven by the vision and agenda of China’s top leadership. There is, therefore, a structural element to regulatory issues in China—although regulation does still tend to come in waves.

“The intensity comes in cycles and it’s difficult to say how long this cycle will last. We are probably somewhere in the middle or maybe a bit closer to the end. There is probably more to come but most sectors and companies will likely adjust to the new normal.”

The opportunity set that China presents in terms of quality companies and new investment areas is likely to remain. Therefore, UBS does not expect investors to stay away from China. He explained that some institutional investors have even taken this as an opportunity to top up exposure, while wholesale investors have withdrawn capital in more recent months

Will Australia's growth recovery be delayed?

Kate Howitt, portfolio manager at Fidelity International, explained that Australia’s latest reporting season has been strong, with cashflows and dividends the high points. She noted that banks have been writing back potential bad debts and the iron ore price had delivered some very strong earnings for companies in Western Australia. However, she also sees cost and wage inflation starting to emerge: 

“With borders closed, this has meant companies aren’t getting enough workers, and the workers they do have are flexing their pricing-power muscles.”

Howitt explained that, while outlook statements have been weak, this is not surprising as we are exiting a period of substantial government stimulus and investors have become wary of trying to predict the future. One area of concern is the potential impact on domestic growth if Australians resume spending overseas and tourists and overseas students are slow to return to Australia, particularly if the iron ore price remains deflated.

With regards to back-stops that Australia has historically depended on during risk-off environments, Haslem acknowledged that the Australian dollar has not provided much protection recently: “Typically when you see global markets down, the Australian dollar is a relief valve”.

What does this mean for fixed income markets?

The investment world is increasingly coalescing on a consensus view that the economic recovery will remain on track. The recovery is expected to be supported by loose policy and inflation is not expected to be a structural threat.

Gopi Karunakaran, co-chief investment officer at Ardea Investment Management feels the investment world is drawing a clear distinction between tapering and rate hikes. This means that risk premia broadly in fixed income markets have drifted down to the very low end of historical ranges: “If we look at things like term premia in government bond markets, credit spreads, high yield credit, and market pricing of volatility have all congregated towards the low end of historical ranges.”

Karunakaran explained that because risk premia is so low, investors are not being paid enough to bet on those base cases. He feels the ‘blunt’ beta in fixed income does not look that compelling.

However, he noted that whenever a strong consensus view forms, other scenarios are often de-emphasised and become under-priced—potentially quite substantially. This is something Ardea Investment Management is seeing in rate markets currently, given transitory inflation.

The right tail, which represents the scenario of inflation rising, and the left tail, which represents the scenario where we slip into a disinflationary environment, are not being priced. When you look at a broad measure like the ‘Move Index’, which is the VIX Index equivalent for rate markets, Karunakaran explained that this is sitting in the bottom quartile of where it has been historically.

Dig a bit deeper and spot rates for interest volatility are actually very low. This is set against a background of demand and supply tension i.e. bond supply on one end and tapering on the other. A similar picture is developing at the front end of Australian swap rates. He explained that these asymmetric-type opportunities are cheap in rate markets currently.

Karunakaran explained that one way you can enhance yield is to sell optionality either outright or embedded optionality in various structures. Yield-seeking inflows are suppressing the value of volatility and the side effect of this is that risks associated with those segments of markets are being under-priced.

This wire is an extract of Crestone's Around the Table 'Living with Delta'. To read the full article, click here.

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