What were the key market and economic events of 2021 and what could we expect to see in 2022?
From the reopening of economies and a surge in inflation, to emerging doubts around China’s economic model, Senior Investment Manager, George Lin recaps the year and provides an outlook for the next 12 months.
Vaccines enabled global economy to reopen
A strong but uneven economic recovery in 2021
Inflation emerged as a threat to easy monetary policies
List of major developed market central banks tightening monetary policies in 2021
More doubts on the Chinese economic model
Over the past 10 years, the world has grown used to China’s status as an economic powerhouse with high GDP growth. China is also an emerging financial superpower as it liberalises its financial markets. This confidence was badly shaken in 2021.
Chinese economic growth has steadily declined over the past 20 years. This trajectory is not dissimilar to that experienced by other Asian economies (Japan, Taiwan and South Korea). As a country industrialises and gets richer, the pace of economic growth tends to decline over time as some of the early gains become difficult to replicate. The concerns with China are not about shorter term, cyclical economic weakness but the longer term direction of the country.
The trigger for investors’ re-assessment of Chinese economic growth started with the crackdown on the internet sector in mid-2020, triggered by official sanctions against the un-authorised US listing of Didi, China’s home grown rival to Uber. This quickly morphed into a high profile public campaign against the Chinese internet giants, including Alibaba and Tencent. The campaign comprises organised public vilification of the targets’ business practices, followed by harsh financial penalties and regulations which render existing business models un-operative. Private education, entertainment and media industries also came under this regulatory driven purge. Several leading business personalities, such as Jack Ma, were effectively removed from managerial positions. In many cases, prominent businessmen voluntarily donated significant proportions of their wealth to charities.
Investors’ confidence in China was already brittle when two further blows arrived in September. China Evergrande Group, a massive property developer, defaulted. The Chinese property sector has been weak since mid-2020 as the government tried to moderate the rise in house prices. China Evergrande Group’s problems have led to financial difficulties with other property developers and renewed downward price pressure. The property sector is critical, contributing as much as around 28% to Chinese GDP and is the main store of wealth for the Chinese people. Land sale is also a significant revenue contributor to local governments which are the drivers behind another growth engine – infrastructure spending.
China also experienced an energy crunch, when energy shortages led to rationing of electricity in many parts of the country, including the coastal provinces which are the country’s economic powerhouse. The causes of the energy crunch are a complex web of an overzealous push to reduce energy consumption at the provincial level, rigid control over electricity prices and an unwillingness to import Australian coal to meet the domestic supply shortfall. In short, a demonstration of the pitfalls of excessive control from the central government and ineffective policy making.
Strong returns from financial markets in 2021 – except bonds
Asset class returns (1st Jan 2021 to 30th Nov 2021)
Notes: Bloomberg AusBond Bank Bill Index, Bloomberg AusBond Composite 0+ Yr Index, FTSE World Broad Investment Grade Index AUD hedged, FTSE World Broad Investment Grade Index ex FTSE World Government Bond Index AUD hedged, FTSE World Government Bond Index AUD hedged, S&P / ASX 300 – A-REIT Accumulation Index, FTSE EPRA/NAREIT Developed Rental Net Index AUD hedged, FTSE Developed Core Infrastructure 50/50 Index (AUD hedged), S&P / ASX 200 Accumulation Index, S&P/ASX Small Ordinaries Accumulation Index, MSCI World Net Index (AUD), MSCI World Net Index AUD Hedged, MSCI Emerging Markets Net Index (AUD)
Listed real assets delivered some of the best returns of all asset classes in 2021. AREITs returned 20.7% while global REITs returned 23.2%. The asset classes benefited from the same drivers as equity markets. In addition, some properties, particularly retail and office properties, were massively sold off in 2020 and benefited from very attractive valuation at the start of 2021.
In contrast to the spectacular returns generated by equity markets, bonds had a poor year as bond yields rose globally. Australian bonds delivered a -3.0% return, its worst return since the early 1990s. Global sovereign bonds generated -1.5%, while global corporate bonds performed better but still delivered a negative return.
Global economic recovery to continue
We are reasonably optimistic on the outlook for global economic growth. While central banks, in particular the Federal Reserve, and governments will reduce the level of fiscal and monetary stimuli in 2022, private sector demand should further recover to fill this gap. Global economic growth will likely be lower in 2022 but the main economies, with the exception of China, are still expected to generate above trend economic growth. A note of caution – economic growth will likely revert back to long term trend by 2024.
The current rate of inflation in the developed economies will moderate somewhat over 2022 as some of the bottlenecks in supply chains ease. However, inflation will be more persistent in this cycle, compared to the past cycle which started after the global financial crisis of 2008. Higher inflation will translate into more challenging monetary policy environment for the main developed central banks as they attempt to balance the need to control inflation with the need to maintain strong economic growth. Our base case is that the main central banks will tighten monetary policies in a measured and cautious manner. Given the persistent, if diminishing, threat of Coronavirus and the high level of public sector debt, central banks’ strong preferences are slow and steady monetary tightening.
The outlook for financial markets is considerably more uncertain than 12 months ago due to the withdrawal of central banks’ liquidity. We still retain a weak preference of equity over bond but we caution investors that global equity markets are unlikely to replicate their stellar 2020 performance and will be more volatile. More cautious and risk adverse investors should consider allocations to alternatives which have low correlations with both bonds and equities.
We think nominal bond yields will rise further in 2022 as inflation in the main developed markets stay at the upper end of the central banks’ target ranges. However, real bond yields will likely remain negative since central banks are reluctant to aggressively tighten policy. US bond yields look particularly vulnerable given the Federal Reserve has started to reduce the pace of its asset purchase program. Financial markets currently expect three increases in the US cash rate before the end of 2022. We think this may be too aggressive but two rate increases by the Federal Reserve are likely.
There are several reasons for our cautious optimism on equities, despite their expensive valuations compared to historical norms. Firstly, earnings momentum for equity remains strong and will likely stay positive in the near term. Admittedly, earnings momentum will probably weaken as 2022 progresses, given the gains from the re-opening of economies dissipates. Secondly, equities will likely remain attractive relative to bonds as long as the rise in bond yields is modest. We leans toward the view that a correction in global equity markets is more likely a mid-term correction. Investors who seek higher returns and with a high risk appetite may consider “buying in the dip” if such a correction eventuates.
We discuss below the main risks to our reasonably constructive base case for 2022.
Covid-19 remains a tail risk
As the world approached the end of 2021, the main developed economies faced another wave of the pandemic. European countries were already experiencing a surge in new cases, with Austria announcing a 14 day national lockdown, even before the identification of the Omicron strand in South Africa. At this stage, Omicron is a serious concern but not a disaster. Evidence suggests that Omicron is likely more contagious than other variants (including Delta) but, given South Africa’s low vaccination rate of around 20%, the effectiveness of approved vaccines against Omicron cannot yet be determined, and its hospitalisation and mortality rates are also unknown.
The developed world is unlikely to revert to the early 2020 model of systematic, global lockdown. The availability of vaccines and the ability to tailor mRNA based vaccines are significant mitigating factors. However, Omicron may accentuate the different policy approaches to the pandemic by different countries. The United States, with a federal political structure which gives state governments significant control over health policies, and the strongest medical research capabilities, have an extremely high hurdle for nationwide, large scale lockdowns. On the other hand, the European countries seem to have less tolerance for high infection rates and are more willing to impose lockdowns. China will likely “double down” on its strict zero tolerance policy until the availability of domestic mRNA vaccines. Those differences suggests that if Omicron turns out to be more contagious and more deadly, the negative impact in European economic growth may be more significant than in the US.
A Chinese economic hard landing is a real possibility
Chinese economic developments surprised the markets on the negative side over the last six months. Our base view is that a soft landing of the Chinese economy is still the most likely outcome in 2022. The reason is simple – the Chinese Communist Party (CCP) will hold its 20th Party Congress by the end of 2022. The event will mark the de facto coronation of President Xi as leader for life. Given this context, the CCP will use its many policy and administrative levers to ensure a stable economic and social environment.
However, this does not mean that it will be smooth sailing for the Chinese economy. The inevitable bankruptcy of China Evergrande Group will likely exacerbate the weakness in the critical property market. Consumer spending and corporate investment may turn out to be weaker than expected due to uncertainties generated by the Common Prosperity program. China’s insistence on a zero tolerance policy towards Coronavirus is another potential headwind. Finally, there is also the prospect of a policy mistake in an increasingly authoritarian society.
A weaker than expected Chinese economy will negatively impact the global economy. Given China’s dominance in demand for commodities, in particular industrial commodities such as iron ore, it will be a significant negative demand shock for those commodities and commodity exporters such as Australia. If the driver of a Chinese slowdown is Coronavirus driven, higher manufactured good inflation for the rest of the world is a potential outcome, given China’s role as a global manufacturing hub.
Inflation and central banks
The greatest risk to financial markets is significantly higher than expected inflation in the main economies leading to faster and more severe monetary policy tightening in 2022. The Federal Reserve is the central bank to watch, given the US Dollar’s status as the global reserve currency as well as the challenges faced by the US economy. The US economy is experiencing a lack of supply, centred on its labour force as the pandemic caused a sharp decline in the labour participation rate. Our base case scenario is those pressures will ease in 2022 as a combination of higher wages, re-opening of schools and higher vaccination lures more Americans to re-enter the labour force. However, there is a possibility that this process will be more drawn out than expected. Given the current high rate of US inflation, any negative external supply shock such as higher energy prices, driven by supply side disruption, or persistent bottlenecks in supply chains, may lead to a vicious cycle with expectations for higher inflation becoming more entrenched among both workers, employers and investors. Under such a scenario, the Federal Reserve will be forced to play “catch up” with financial markets.
While bonds are clearly vulnerable to an inflation shock, other asset classes are not necessarily immune. In particular, long duration assets such as property and infrastructure assets may be vulnerable. The downside for individual assets will be highly dependent on the ability of an asset to generate revenue increase to match inflation. Some growth stocks, with hefty valuation driven by strong expected earnings growth in the distant future, also look vulnerable.