Economic Insights for January & February 2022

The following are some economic insights for January and February 2022.  There was a surge in COVID-19 cases in Europe and the US.  Coupled with the new Omicron variant, classified by the WHO as a variant of concern, this has brought uncertainty.  Markets hate uncertainty.  This muddies the path for economies to return to pre-COVID conditions.  However, the impact of the omicron variant on economic activity has not peaked yet.  Cases are still rising globally.  Given higher vaccination rates and more effective measures on the less deadly variant, markets have largely recovered and sidelined the initial impact of the variant. 

Should Covid either start to subside or continue to persist in varying conditions of prevalence, it will have significant implications on growth, inflation, labour, monetary policy and performance among bonds, equities and other asset classes.  A baseline path for many economies will be a blend of these two scenarios, which means a stuttering start-stop of propagating Covid waves that will delay recovery in many markets.  We are looking at an elongated curve.  The fact that many countries are easing restrictions at an accelerated rate is not helping, especially in places that have not managed the pandemic well. 

A world in which Covid either starts to subside or continues to persist will have significant implications for economies, markets and asset classes.  Inflationary pressure in developed markets has forced the Federal Reserve into anchoring inflation expectations, which has led to a hawkish tilt faster than the market has anticipated.  Inflation has continued to rise amid lingering supply chain bottlenecks and strong demand for manufactured goods.  The global economic recovery since the middle of last year has been driven by a surge in demand for goods.  The global logistics industry was unprepared for this, which created bottlenecks and delays in key infrastructure points such as ports and border crossings.  This is the cause of the inflation, and it will ease as production catches up. 

Rebalancing economic recovery between goods and services is a prerequisite to easing these supply-chain bottlenecks in 2022.  However, this depends on the evolution of the pandemic, and we have no definitive scenario.  The continued high inflation is becoming a matter of concern to a growing number of central banks, leading to a tightening of their monetary policy or an impending tightening.  With stronger inflation expected for the next few months, that volatility in both rates and equities will return in the near term.  In Asia, China stands out with its relatively moderate inflation plus an easing monetary policy bias.  However, sentiment toward Chinese equities has yet to turn bullish amid the structural and regulatory changes.  Chinese corporations are over-leveraged. 

The Monetary policy debate within central banks is dominated by a combination of high inflation and tight labour markets.  Monetary policy normalisation accelerated at the end of 2021 with several key central banks announcing interest rate hikes or a substantial reduction of their asset purchase programmes.  The Federal Reserve has started tapering its quantitative easing programme.  Expectations based on market prices point to an acceleration of this normalisation in 2022.  This will likely lead to a federal fund rate hike, possibly in June 2022.  It would be better if it came earlier, before inflation becomes hyperinflation in some markets.  Indeed, hawkish tones were coming out from the Federal Reserve’s January meeting, which left markets with uncertainties about the timing and the magnitude of policy tightening down the road.  In particular, market participants are now evaluating the risks of quantitative tightening immediately after the completion of tapering in March. 

Asset allocation decisions remain one of the largest drivers when determining the range of portfolio outcomes.  Being in the market and invested in equities has proven to be the optimal strategy since the dramatic market correction during the onset of Covid in March 2020.  As we transition into 2022, we continue to hold the view that risk assets such as equities will continue to shine against government and corporate bonds, as well as low-interest-bearing cash investments.  This correction due to inflation is temporary, and we expect a rebound in the market. 

Asset allocation decision remains one of the largest drivers when determining the range of portfolio outcomes. For 2022, on the back of still above-trend growth, we continue to hold the view that risk assets such as equities will continue to shine against government and corporate bonds as well as low-interest-bearing cash investments. However, given inflation, employment and central bank policies, we expect market volatility to stay elevated in the near term. 

The above-trend growth among major developed economies is expected to continue in at least the first half of 2022, which supports the earnings growth momentum.  Major fund managers are expected to overweight risk assets by tilting more in favour of US and Developed Market equities.  Conversely, they are likely to be less bullish on Emerging Market equities due to accelerated tightening from the Federal Reserve, China’s regulatory recalibration and economic slowdown, and the potential for stronger dollar outflows.  The recent equity market correction in January significantly improved the odds for a decent equity market outperformance in the next 6 to 12 months.  However, since high volatility will likely persist, adding further equity to a portfolio should be done cautiously. 

There is a strong free cash flow generated by firms, and low corporate downgrades and defaults.  This means credit spreads should continue to remain tight.  However, in an expected rising rates environment, the price performance of some of these bonds might suffer since we do not expect a material tightening of credit spread from the current level.  This means there is a preference for Asian credit over US credit, given the credit spread premium from Asian counterparts.  This is especially so against the backdrop of diverging monetary policy by key central banks in the West versus in the East, such as the People’s Bank of China.  The Federal Reserve’s new pivot to focus on fighting inflation is welcome.  This expectation means short rates will move sharply, causing the yield curve to flatten.  Over the next few months, we expect higher rates volatility and weaker price performance.  Over the medium horizon, expect higher rate volatility and weaker price performance.