Three reasons for market optimism in 2022 despite economic risks

  • The global pandemic, rising inflation and hawkish stances by central banks linger in the air, but economic conditions and market sentiment can easily diverge
  • Investors learning to live with the virus, limited effects from the Fed’s tonal shift and policy easing from China should hearten investors in the new year

There is no shortage of risks and vulnerabilities for global investors to fret about as the second year of the Covid-19 pandemic draws to a close.

The sudden emergence and rapid spread of the Omicron variant has shaken confidence in the outlook for the global economy as governments reimpose restrictions and virologists warn about the severity and consequences of the highly infectious strain. Doubts over the efficacy of current vaccines against Omicron are adding to the uncertainty.

To make matters worse, the resurgence of the virus is fuelling concerns about the sharp rise in inflation. A more prolonged pandemic would cause further disruption to supply chains and exacerbate labour shortages, driving prices higher. Renewed lockdowns, on the other hand, threaten to undermine the recovery.

The third major risk, and the one investors are most worried about, is the hawkish shift from some of the leading central banks. The US Federal Reserve’s decision last week to speed up the tapering of its asset purchases and signal as many as three interest rate increases for 2022 has increased the threat of excessive policy tightening, a particular menace to emerging markets.

All these risks are amplified by the fact that global stock markets are priced for perfection. The value of global equities has doubled to US$120 trillion since March 2020, according to Bloomberg data. The forward price-to-earnings ratio – a popular valuation tool – of the benchmark S&P 500 index is not far below its level at the height of the dotcom bubble in the late 1990s.

However, if one thing has been abundantly clear since the virus struck, it is that economic conditions and market sentiment can diverge dramatically. Getting the big macroeconomic calls right has been much easier than predicting how markets will react to the most important economic and policy developments.

Who could have foreseen that the S&P 500 would surpass its end of 2019 level as soon as late July 2020, when the United States was suffering a second wave of infections, months before the breakthrough in the race to find an effective vaccine and when the world economy was experiencing its worst recession since the Great Depression?

By the same token, if investors looked into their crystal balls at the start of 2021 and saw that US inflation would soar to nearly 7 per cent by the end of the year, would any of them have been taken seriously if they had predicted that the 10-year US Treasury yield would stand at a mere 1.4 per cent by Christmas?

The disconnect between economic fundamentals and investor sentiment is nothing new. Yet, the unprecedented shock of the pandemic and the increasing influence that central banks exert over markets have made it doubly difficult for investors to correctly anticipate the performance of asset prices.

This should at least make bearish investors think as much about what could go right in markets next year, particularly since investment strategists are acutely divided over the direction of asset prices, especially equities.

First, it is unlikely that Omicron will become a key determinant of sentiment. The pandemic ceased to be a major concern for investors some time ago, partly because of the arrival of vaccines but also because markets quickly learned to live with the virus soon after it erupted. Massive amounts of monetary and fiscal stimulus made the learning process much easier.

Second, it is not clear whether the hawkish tilt from the Fed will severely damage sentiment. Having been behind the curve on inflation, the US central bank is now ahead of it. This is why bond yields have barely budged since last week’s hawkish shift.

Investors are already less concerned about inflation in the US – where price pressures are strongest – and believe the Fed will struggle to raise rates as sharply at its forecasts indicate. If they are correct, there is considerable scope for the Fed to strike a less hawkish tone, helping underpin sentiment. A dovish surprise in 2022 is a distinct possibility.

Third, fears about China’s economy, which have increased sharply in certain parts of the market, are unlikely to be the trigger for a global sell-off. While the downturn in the country’s all-important property market is set to intensify in the coming months because of the severity of the liquidity crunch, markets scent a shift towards looser policy.

Never mind that the measures have so far been modest and that Beijing remains committed to its goal of reducing corporate indebtedness and social inequality, the change in tone has heightened expectations of further easing. By dangling the prospect of looser policy in front of investors, Beijing might prevent stocks and corporate bonds from suffering sharper declines.

Global asset prices could still take a nosedive next year, possibly for reasons that have nothing to do with the most prominent risks. However, investors should know by now that being right on the economy can go hand in hand with getting the markets wrong.

Author: Nicholas Spiro, SCMP

You might also like