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Lowering inflation and a bright future for the markets – our view on 2022
Lombard Odier Private Bank
Societies and economies have been living and suffering the consequences of the Covid-19 pandemic for some time now. As we approach the two-year milestone, we see vaccination programmes progressing, healthcare infrastructure remaining intact and strict lockdowns in Europe appear to be a thing of the past. On the policy front, we have seen the implementation of massive government spending and central bank support. The US Federal Reserve (Fed) has cut rates to zero, doubled the size of its balance sheet and carried out an ambitious quantitative easing programme. So, what are the consequences?
Many economies have avoided a deep depression and experienced a strong V-shaped recovery, with many developed countries back on their long-term growth trajectories. Equity markets finished last year in positive territory but as we start 2022, what kind of economic activity can we expect?
Acclimatising to our new economic reality
There is, without doubt, a heightened nervousness in markets. They are more volatile but we believe this is due to the fact we’re entering a new phase of the cycle. One could say the first phase was all about crisis management and support. This new phase will be all about normalisation and a reduction in support. We expect central banks to remove some of the most accommodative parts of their policies, thus we can expect there to be questions, uncertainties and volatility. Markets will just have to adjust to this new reality. So what is the path of the economic recovery? What are our expectations when it comes to inflation? And where do we see the possible evolution of central banks’ monetary policies?
Read also: Pandemic to endemic; living with infection, inflation and higher rates
The growth outlook for 2022
2021 was a ‘resurrection’ year for economies, with world growth topping 6%. Despite the fact that we continue to battle a relatively severe wave of new Covid-19 cases, we observe that the fundamental difference between this wave and previous ones is the divergence between the very high number of cases and the number of fatalities. The latter remain, for the most part, well contained and relatively low. As we enter into this fifth wave of mass infection, we can look back on previous ones in order to understand their economic impact. The conclusion? As these waves go on, their economic impact lessens. Furthermore, as they end, we see a catch-up effect. We are therefore faced with an economic environment that’s less linear and choppier but which remains solid despite the volatility. What about 2022’s prospects? We expect a favourable environment when it comes to economic activity – with the world economy growing between 3.5 - 4.0%. This may not compare to the 6% we saw in 2021 but it’s not far from pre-Covid levels.
Read also: Rising rates don’t yet turn the tide for investors
The equity question
The recent unpredictability of markets has unsettled investors. The Cboe Volatility Index (VIX), which measures volatility on the S&P500, has risen sharply this year. Stock markets have seen the worst start to the year since the great financial crisis, with the S&P500 falling 5.2% in January, the Stoxx Europe 600 falling 3.8%, and emerging market indices also losing ground. At Lombard Odier, our investment process is anchored in fundamentals. This year, we are not predicting the same level of performance that we had in 2021, but we remain positive on equity markets and believe they will potentially see high single-digit gains. Of course, not all stocks are created equal. In the current rising rate environment, we favour value and cyclical over growth stocks. The former tend to have stronger short-term earnings and cash-flows; the latter tend to have earnings tilted towards the longer-term, and with rising rates, these become more heavily discounted. In terms of regions, we favour areas with catch-up potential, including Europe and the UK.
Inflated inflation…
The inflation story isn’t the same everywhere. One important point is that in 2022 we don’t expect anywhere near the levels of inflation we experienced in 2021. Why? Mainly the fact that all the factors that tend to generate inflation came together at the same place and at the same time in 2021 – and particularly in the UK and USA.
These price pressures were a result of two important factors: supply chain disruptions and varying government stimulus. On the supply side, there remain some bottlenecks, including when it comes to microprocessors, but more manufacturing plants in Asia are now operating at full capacity. Shipping costs also increased towards the end of last year but we expect these to gradually flatten in 2022. Energy prices skyrocketed due to both supply and demand challenges. When it comes to monetary policy, stimulus varied across different economies. In the UK, the fiscal stimulus amounted to close to 20% of the country’s GDP and in the US it was around 25% of GDP. Other parts of the world had significantly less, including China. Inflation spiked in countries where there was a lot of income support, but further down the road, we should begin to see more normal, cyclical inflation emerging.
During the economic shock of the pandemic, central banks engineered extreme measures that now need to be removed as we enter a new phase of the cycle. So the process begins of normalising monetary policy. We believe that central banks, including the Fed, will go from being ultra-accommodative to simply accommodative in 2022. As time wears on, they’ll tighten policy further and move from being accommodative to neutral and then from neutral to restrictive, but this will take time. For now, rates remain historically low, and central banks remain supportive.
Read also: Global Investment Strategy Q1 2022: Taming inflation
Keeping an energy crisis at bay?
Governments, investors and consumers are generally in agreement that we must drastically reduce our reliance on fossil fuels as they greatly contribute to global carbon emissions. However, sun, wind and other renewable energy sources are not yet meeting demand. The energy crisis seen in Europe at the end of 2021 was exacerbated by China’s attempted shift to natural gas as a cleaner alternative to coal. The shift to renewables globally has much further to go and requires huge investment. Today, gas prices have eased somewhat, helped by a gradual unwinding of pandemic-related supply issues, and a mild winter in Europe to date. However, geopolitical tensions in the Ukraine, and attacks in the United Arab Emirates, are keeping oil prices elevated.
The management of the climate transition will have an impact on the future of inflation. Governments need to not only invest in infrastructure to support the energy transition but also to efficiently implement the right regulations. Businesses have a part to play in evolving or changing their business models, consumers should continue to adopt more sustainable habits and investors must finance the transition to a more sustainable economic model.
*Unless otherwise stated, all figures are from government or national statistics agencies and market data is taken from Bloomberg; forecasts are Lombard Odier's own.
Important information
This document is issued by Bank Lombard Odier & Co Ltd or an entity of the Group (hereinafter “Lombard Odier”). It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a document. This document was not prepared by the Financial Research Department of Lombard Odier.
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