The Covid comeback endures and matures – our 2022 Outlook

After the global economy roared back to life in 2021, markets were quick to predict problems ahead in 2022, from stagnant growth to runaway inflation. Instead, we see a new phase of the cycle dawning. While demand has peaked, and growth is slowly reverting to trend, we nevertheless foresee the global economy registering a solid mid-cycle expansion in 2022, with growth and inflation both remaining firm.

Indeed, far from stagflation fears, the global economy is set to grow at one of its fastest paces in over 40 years. We forecast 4.6% 2022 growth in the US, 4.5% in the euro area and 5.0% in China. Demand continues to be strong; surveys that track the pace of business activity have shown no let up, while high frequency data confirms this picture. Companies recorded record Q3 profits and margins, and have plenty of room to invest and support employment in the years ahead. Indeed, we expect labour markets to continue their gradual healing, and the unemployment rate to continue to fall to multi-decade lows in the western world.

Meanwhile, excess savings built up during the pandemic remain partially unspent, and consumption remains strong. In the emerging world, more demand should be unleashed as the vaccination rollout gathers pace. In the developed world, services could take over from goods as a consumption driver, as Covid infections recede and confidence in travel, leisure and eating out returns.

Another reason for our positive view is fiscal policy: with less consolidation ahead than feared. Draft budgets submitted to the European Commission by national governments suggest policies will be neutral in 2022, and funds provided from the EU’s Recovery and Resilience Facility will result in a mildly expansionary fiscal stance across the bloc. The EU’s fiscal rules remain suspended, and could be restored in 2023, probably amid reforms and only gradual consolidation. In the US, a multi-trillion investment package looks set to become law in the months ahead. Although ambitions have been scaled back, this should add 1% of GDP in the first years of disbursement, starting in 2023.

One of the biggest questions for the global economy in 2022 hangs over inflation and monetary policy. After months of above-target inflation across the developed world, markets have begun to question the narrative that price pressures driven by supply bottlenecks and depleted inventories are temporary. Many emerging market central banks have hiked rates in 2021, and markets believe their developed market counterparts, including the Federal Reserve (Fed) and the European Central Bank (ECB) will be compelled to do so in 2022.

We remain more positive on the outlook. We believe most supply-side inflation will recede in the coming months and quarters. Measures of supply chain bottlenecks such as delivery times show conditions may no longer be deteriorating. show conditions may be improving. European gas and Chinese coal futures are falling. Core US consumer price inflation appears to be peaking. Shipping rates may be on a similar path. A resolution to supply issues, a normalisation in demand (fewer goods and more services) and labour market healing – together with the removal of extra unemployment assistance – should mean inflation starts to ease in 2022. We believe it will fall to 2.6% in the US, 1.4% in the euro area and 2.4% in China.

Of course, supply-side inflation will in time be replaced by more persistent pressures from wages and housing: demand-led pressures that merit a policy response. We believe these will start to build in late 2022, as we enter the mid to late-stages of the cycle. We are hopeful that, at first, productivity gains will help contain unit labour costs. Longer-term, we note that in addition to well-anchored inflation expectations in the developed world, the factors that drove disinflation over the past 20 years or so – including ageing demographics, competition, globalisation, technology, innovation and high debt levels – remain in place.

Meanwhile, the Fed has repeatedly stressed that the bar for raising rates is much higher than that for tapering asset purchases. In the last 18 months, both it and the ECB have made changes to their inflation-targeting regime that can imply leaving inflation below – or above – target for longer. Both have been criticised for prematurely raising rates in the past. We believe the first European and US rate hikes will come in 2023, with more cumulative rate rises than consensus forecasts predict, and the US rate cycle peaking at 2.75% in the latter half of the decade.

Another big question mark for 2022 is the situation in China, where authorities are trying to engineer a property sector slowdown, a shift away coal in the energy mix, and a regulatory crack down on sectors from technology to online education. While large, these adjustments are already underway, and we do not believe 2022 will be a year of big shocks in China. True, reaching the country’s 5-6% official growth target will be a challenge, but we believe it can likely be met through monetary easing and additional fiscal spending. Stimulating the economy to maintain social stability is standard practice before the five-yearly Party Congress, a key political event that will take place in late 2022.

Naturally, we continue to monitor risks to our scenario. These include new disruptions caused by Covid-19, rising inflation and a monetary policy misstep, geopolitical tensions, and excess leverage in China. For now, we see none of the major risks we monitor materialising. But late-cycle conditions should start to emerge by end-2022, and with policy normalization underway, the margin of safety will slowly erode. Markets will likely price these changes in advance. Yet we believe that barring a new wave of vaccine-resistant Covid infections, the prospect of a pronounced global economic slowdown in 2022 is remote.

A tale of lost inventories

Over the last thirty years, many companies have moved towards a ‘just-in-time’ inventory method, only holding a limited stock of goods as a buffer against demand fluctuations or time lags in supply.

Increasing globalisation boosted this trend. Western firms became increasingly reliant on importing intermediate goods and services, and a global manufacturing hub sprang up in China and south east Asia. The general trend in companies’ ratios of inventories to sales fell.

With capital thus freed up, firm were more able to reinvest in the business or repurchase shares. In many cases, this boosted growth, and drove up share prices. Operating with lower inventories worked well in the opening decades of the century. Global supply chains became increasingly efficient.

Then came Covid-19, bringing production and global trade to an abrupt halt. Faced with complete uncertainty over future demand, firms wound down their already depleted inventories. Building them back up – from gas supplies and timber, to microchips and Christmas toys – cannot be done overnight.

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