Inflation uncertainty leaves central banks with a dilemma

Growth of advanced economies revised slightly lower, largely due to supply disruptions


While 2022 starts amid a benign backdrop of continued economic recovery, there remain a raft of uncertainties. Will the Omicron variant or higher inflation derail economic growth? Will central banks successfully tread the fine line between managing inflation and sustaining economic recovery?

At the same time, valuations across financial markets appear elevated and therefore vulnerable. These are choppy waters for investors to navigate in the year ahead.

Much will depend on the trajectory of inflation. It has already outpaced central banks’ expectations, forcing the Federal Reserve and others to taper their quantitative easing programmes sooner than originally expected At the end of 2021 the Fed dropped its view that programmes sooner than originally expected. At the end of 2021, the Fed dropped its view that inflation would be ‘transitory’, citing wage growth as a particular concern.

Janus Henderson director of research Matt Peron says: “Inflation has become the key risk to the market cycle in 2022. But while higher prices are likely to persist in the near term, some of the major drivers of inflation, such as rising wages and raw material costs, could begin to moderate.

“Pay gains, for one, could slow after an initial step up as people trickle back to the labour force, employers compensate with other benefits, such as work-from-home, or job functions are replaced with technology.”

The labour participation rate is likely to be an important indicator. There are signs that the pandemic has changed behaviours, pushing people into early retirement or reducing their incentive to work through stimulus payments. The more people that remain outside the workplace, the more wages will have to rise to secure the right labour, particularly among lower paid jobs.

Schroders chief investment officer and global head of multi-asset Johanna Kyrklund (pictured)  believes this will lead to structurally higher inflation over the next decade compared to the last, “driven by rising wages, deglobalisation and decarbonisation”.

“In the shorter term we expect inflation momentum to peak as supply bottlenecks ease, but central banks are still likely to raise interest rates,” she says.

In other words, there will either be some inflation or a lot of inflation, but either way, the environment has changed.

The central bank dilemma

This uncertainty over inflation leaves central banks with a dilemma. Move too soon on interest rates and they risk cutting off the still-nascent economic recovery. Leave it too long and they risk inflation becoming embedded. Ultimately, this might force a sudden, sharp rise in interest rates, which has often been a precursor to recession.

Central banks are already taking action. The Federal Reserve has accelerated the tapering of its quantitative easing programme, which is now set to end in March. It has also brought forward its projections for rate hikes.

In its recent forecast paper, Netherlands- based firm ING said: “The Federal Reserve is now projecting three 25 basis point rate hikes for 2022, up from the one that was in their dot plot in September.

Most in the market expected them to be more tentative given uncertainty surrounding the economic impact from Omicron.

“The Fed continues to project three additional hikes in 2023, but now forecasts only two rate hikes in 2024 versus the three is had in September. The long-run forecast for Fed funds remains 2.5%.”

Will the rest of the world follow suit? The UK has already seen a small rise in rates, with the Bank of England saying that further “modest” rises will be needed in the months ahead to keep inflation in check.

The eurozone, in contrast, is still unlikely to see a rate rise in 2022, though asset purchases under the pandemic emergency purchase programme have come to an end. The European Central Bank said it still expects inflation to undershoot its goal even at the end of 2024. This suggests rate rises may be several years away.

Coping with Covid

The emergence of the Omicron variant showed that Covid-19 still has the capacity to surprise. That said, it has also demonstrated the relative resilience of economies as they become more adept at dealing with the threat.

Henderson’s Peron says: “This could be the year when Covid-19 starts to transition from being a public health crisis to an endemic disease that can be managed without economic shutdowns.”

Policymakers increasingly recognise that lockdowns, quarantines and closed borders are not a long-term solution, not least because they are running out of money to support them. Peron adds that rising vaccination numbers and promising new medicines could make it easier for countries to “live with Covid” in 2022.

Kyrklund adds: “Levels of immunity are considerably higher, even in the face of mutations, governments react more quickly and the processes of how to develop new vaccines are increasingly efficient. Market participants have also developed a framework to consider the virus. We have moved on significantly from the extreme uncertainty of early 2020.”

Nevertheless, she believes Omicron will slow economic growth in the early part of the year and may stall the market’s rotation into more cyclical parts of the economy.

As it stands, the IMF forecasts growth of 4.9% for the global economy in 2022. In terms of trends, advanced economies are being revised slightly lower, largely due to supply disruptions. Lower income developing countries are also struggling due to worsening pandemic dynamics.

There are stronger near-term prospects among some commodity-exporting emerging market and developing economies. Vaccine access and the extent to which governments have provided early policy support continue to be important differentiators between countries.

Asset classes that should thrive

In an environment that should be pro-growth with some inflation, equities are still the obvious choice, even if some parts of the market – notably the US technology sector – look expensive.

JP Morgan Research chief US equity strategist Dubravko Lakos-Bujas agrees global stock markets can continue to make progress in 2022.

“We expect the S&P 500 to reach 5,050 on continued robust earnings growth as labour market recovery continues, consumers remain flush with cash, supply chain issues ease and inventory cycle accelerates off historic lows.

“Most of the equity upside should be realised between now and the first half of 2022. Equities have already priced in a more aggressive Fed, while high-beta stocks have significantly de-rated, lowering the bar for equities to outperform.”

Liontrust deputy head of multi-asset James Klempster says that if five is as good as it gets for a backdrop for equities, 2022 is looking like a four. He says equities outside the US remain attractively priced, so this is where the Liontrust team is allocating its risk budget. In particular, he sees more upside in the “very cheap” UK market.

JP Morgan Research remains bullish on the European equity market into 2022, as central bank policy remains accommodative. Japanese stocks are expected to have moderate upside in 2022 and the group also sees a strong performance from emerging market equities, forecasting a return of 18% in 2022. This is controversial. A number of economists see tailwinds for emerging markets against the backdrop of a rising dollar and higher US interest rates.

Amid this generally positive environment for equities, there remains a question over whether investors should direct themselves to more cyclical parts of the market or stick with the highgrowth companies that have served them well in recent years. Having started out with a value rally, 2021 saw growth bounce back for much of the year.

Klempster says: “Value stocks are still very cheap compared to history. The spread between the top and bottom is as stretched as it has ever been. ‘Value’ is never loved, but it is extremely out of fashion today. The trouble is that many of the value sectors are problematic.”

The Liontrust multi-asset team is aiming to keep a balance across its portfolios, given the relative uncertainties. There are also signs that markets are looking harder at the characteristics of underlying companies, which may mean these labels aren’t as helpful in determining the direction of markets in the year ahead.

It is difficult to make a good case for bonds. Central banks are withdrawing support at a time when low yields offer little room for manoeuvre. High inflation is pushing real yields even lower.

There may be selective opportunities for those with good credit analysis, or in areas such as emerging market debt, but it is likely to be a tough year in fixed income.

Blackrock, for example, is “strategically underweight nominal government bonds given their diminished ability to act as portfolio ballasts”. The group retains a weighting to inflation-linked bonds for interest rate exposure and as a portfolio diversifier.

Unpredictable elements

The rogue element in 2022 may be politics. France goes to the polls in April, with president Emmanuel Macron struggling to defend his position against a right-wing challenge from Valérie Pécresse. Jair Bolsonaro’s hold on the presidency in Brazil looks increasingly shaky, which may see him ejected in the October general election.

On current polling, president Biden may face a humiliating defeat in the US midterms in November. The Democrats may lose one or both houses of Congress. A resurgent Donald Trump – should it happen – may send jitters through the geopolitical order.

The Chinese Communist party begins its five-yearly National Congress, which may bring a raft of new initiatives.

All these events have the power to disrupt global markets.

It is a year in which balance and individual asset selection are likely to prove important. Investors cannot hope to stay ahead of the myriad macroeconomic forces buffeting markets – but they can find the right assets and ensure portfolios are not geared to a single outcome. It may turn out well, but there will be pitfalls.

This article appeared in the January edition of Portfolio Adviser magazine