2021 brought the recovery many had hoped for. Businesses reopened, commuters returned to their desks, and the bravest of us even went on holiday. But no one could describe it as ‘getting back to normal’ amid rocketing energy prices, high debt levels, and past-the-peak growth.
These conditions increase the risk of a policy mistake in the next 12 months as central banks and governments try to navigate various ‘Catch-22’ (or Catch-2022) narratives - reminiscent of the conundrums faced by the air crew in Joseph Heller’s 1961 novel - without losing the trust of markets.
One dilemma is how to tighten monetary policy and rein in inflation without killing off the recovery. Another is how to cope with higher energy prices as the world transitions to a low-carbon economy. Fine-tuning policy settings to unravel these conflicting dynamics will not be easy.
Persistent inflation
Despite central bank rhetoric about inflation pressures being transitory, some price rises look set to persist due to supply chain blockages and de-globalisation, and, longer term, due to the cost of getting to net zero. Letting inflation spiral out of control would only make it a bigger issue later on, but clamping down aggressively could hamper growth when it is already stalling. On balance, we expect interest rates to remain lower for longer despite higher prices and central banks’ desire to taper asset purchases relatively swiftly. Ultra-low rates are needed to keep the system afloat given debt levels are higher today than during World War Two.
China’s focus on the real economy
China, meanwhile, appears determined to move to an economic model geared to the real economy, rolling back debt and addressing inequalities, rather than reacting to any downside in financial assets. This should be helpful for markets in the long run, increasing moral hazard and enabling investors to price assets more accurately.
Nonetheless, the country’s policy stance could weigh on global growth in 2022, and consensus expectations may be revised lower.
Climate impact on asset allocation
The need to think about the impact of climate factors on asset allocation increased in 2021 and will accelerate in 2022. Fossil fuel importers wish to improve energy security while investors are hunting for climate solutions and new technologies in preparation for a more radical repositioning of the economy. National government recognition of climate change is high, and climate policies are proliferating, even if global cooperation cannot be guaranteed.
This will not make the challenges of changing consumption patterns any easier, however, and we expect plenty of bumps on the road to net zero, some of which have yet to be priced in. Given the potential for an increase in correlations between publicly-traded securities in 2022, we think private markets could continue to offer alternative growth profiles for long-term investors, especially in the greening of brown assets. Select Asian bonds and equities should act as diversifiers, while (value orientated) sections of the developed equity markets and real estate may provide hedges against moderate inflation.
US dollar dynamics
The environment around the US dollar is changing as the country relies more on friendly strangers to buy its debt. The currency may benefit from a more defensive stance in 2022 if volatility rises. But if China and Japan accelerate an unwinding of their exposures and/or move up the yield curve, worried by debt ceiling debates, the US fiscal deficit, and high levels of money supply, then at some point the Fed may have to offer higher yields to attract domestic buyers.
At the same time, fiscal support will reduce in 2022 which could leave incomes stretched and push up unemployment, especially if energy prices remain high. Central banks may find they suddenly have no option but to pull back on the liquidity tightening commentary. If they don’t pull back, the ‘catch’ could come into play. Markets may start to believe that inflation could stick around for much longer, leading to a further re-pricing of risk as the year develops.
