Political events such as the re-election campaign of French President Emmanuel Macron will loom larger this year than inflation, write Larry Hatheway and Alex Friedman.
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About the authors: Larry Hatheway and Alex Friedman are the co-founders of Jackson Hole Economics, and the former chief economist and chief investment officer, respectively, of UBS.
As the New Year commences, it is opportune to consider what may be the key drivers of market performance in 2022. And those that may not matter much.
We see six main candidates. Here they are, divided into two parts: three underappreciated factors that are likely to have outsized impacts on markets this year and beyond, and three overestimated factors that will probably matter less than the consensus now thinks.
Factors that will matter
Slowing corporate earnings. Global equity markets have roughly doubled from their 2020 lows. While many casual observers readily assign that outcome to easy money and excessive exuberance, stellar earnings growth has been a major driver of market performance. But earnings momentum is now slowing, both on account of less favorable comparisons (so-called base effects) and as higher costs impinge on profit margins. With valuations above long-term averages across most markets and sectors, earnings deceleration combined with less favorable monetary policy stances will prove more challenging for equity returns. The days of rising markets accompanied by low volatility are coming to an end. Market performance this year is likely to be bumpy. A proper equity market correction is also likely in 2022.
Chinese growth. Isolated abroad and handicapped by debt overhangs, above all in its domestic property sector, China is likely to surprise most observers by growing faster this year than the consensus expects. Consensus forecasts peg 2022 Chinese GDP growth at just below 5%. We suggest that by year end China’s GDP growth will comfortably top that figure.
Two reasons underpin our view. First, retooling the global economy away from long, vulnerable supply chains will prove to be more difficult than many assume. Indeed, that is a major factor explaining the persistent bottlenecks that plague today’s world economy. Accordingly, short-term supply responses are more likely to take advantage of existing modes of production and distribution than those that one day may—or may not—replace them. China remains the world’s industrial superpower, accounting for over a quarter of global goods production. Reports of its death are premature.
Second, beset by Covid disruption, trade distortions, and property market hangovers, China is apt to ease monetary and fiscal policy, and invest greater sums in infrastructure, a well-worn form of economic stimulus. Highlights may include big announcements to improve water storage, transportation, and efficiency, as well as in alternative energy. President Xi Jinping recognizes that, as powerful as his sword may be, domestic order and tranquility are best assured by rising living standards.
French elections. On April 10 and 24 (should a run-off be necessary), the French people will go to the polls to elect their president. Legislative elections will probably follow. The French elections matter, following those in Germany last year. Europe is adjusting to major changes: Brexit, the realization that the U.S. is no longer the reliable ally it once was, and Russian aggression in the East. Angela Merkel is gone as German chancellor and Mario Draghi, Italy’s prime minister, now represents Europe’s best-known and most capable leader. If the center holds in France, as we expect it will, the stage will be set for Europe to move, albeit slowly, to address its key security challenges, namely, Russia and climate change. Nothing happens quickly in Europe without a crisis, but the recognition that Germany, France, and Italy will enjoy centrist majorities and that their voters have rejected radical extremes will serve the old continent, its capital markets, and its currency well.
Factors that won’t matter (as much as the consensus believes):
Inflation. A year ago, we wrote that inflation was likely to be more important for economies, monetary policies, and financial markets than most observers then believed. Today, we are willing to argue that inflation fears are now overrated. That might seem odd, given that major central banks—the Federal Reserve, the European Central Bank, and the Bank of England—have recently capitulated, jettisoning notions of “transitory price pressures” and vowing to end quantitative easing and even hike rates.
Yet we believe that a combination of elements, including receding base effects, more-flexible supply responses, peaking developed-country growth, and—perhaps most important—stable inflation expectations will combine to slow price pressures during 2022, reassigning inflation to yesterday’s story. Accordingly, central banks will gradually recalibrate their monetary policies over the next 12 months in a fashion that will be well-communicated and therefore predictable. Given that markets already discount an end to quantitative easing and several Fed rate hikes by end-2022, the odds of jarring monetary policy surprises in 2022 are not as high as many would have us believe.
Fiscal policy. Following consecutive years (2020 and 2021) of massive—indeed, unprecedented—fiscal easing in advanced economies, it seems obvious that the absence of the same would weigh heavily on global growth in 2022. Compounding matters are legitimate concerns that Democrats will not be able to muster a majority for a significant Build Back Better legislative agenda in the U.S. Congress.
Yet economics is not arithmetic. Gross domestic product is more than simple addition. Lags and still impactful fiscal multipliers lessen the size of cliff-like fiscal surprises in the next 12 months. U.S. and global household savings rates are now declining, implying that private-sector demand already is and will continue to replace the impetus of fiscal stimulus. Finally, few countries are prepared this year to make large discretionary cuts in government outlays, much less hike taxes.
Assuming the pandemic does not resurface in new and dangerous ways—and Omicron suggests that, if anything, infections are becoming less risky—job and wage growth, coupled by peaking price inflation, will provide a lift to real purchasing power, enabling rising consumption to offset some fiscal drag in 2022. And politics, for better or worse, will ensure that aggressive fiscal tightening is postponed to a later date.
Bond yields. Nominal government bond yields in developed countries remain well below economically sustainable levels. Negative real interest rates are not normal. They ought to gravitate toward trend rates of growth, between 1% and 2.5% depending on the economy in question. But 2022 is unlikely to be the year that bond yields snap back toward sanity.
It is difficult to argue, for example, that the end of quantitative purchases by central banks will jar bond investors. If that were the case, the clear commitments to end such policies already made by the Fed or the ECB Bank at the end of last year would have produced a rush for the exits. High inflation is also unlikely to be the catalyst for a bond market capitulation. Inflation is already elevated, having risen late last year without making a dent in bond pricing and is now poised to recede during 2022. Finally, budget deficits, new bond issuance and the rollover of existing debt burdens are known-knowns, implying they are unlikely to rattle debt markets.
Yes, bond yields ought to move higher in 2022, but the pace is likely to be gradual. Moderate global growth, receding inflation, the end of fiscal expansion and tepid monetary policy tightening is apt to produce somewhat higher yields, but also a flatter yield curve. Indeed, curve flattening is more likely to drive market performance in 2022 that higher yields, particularly for styles and sectors sensitive to the shape of the yield curve.