Greg Smith: Financial markets and crystal ball gazing into 2022
It’s that time again, where we reflect on the year that was, and look ahead to the coming 12 months with a degree of optimism. In financial markets land, many participants engage in the time-honoured tradition of crystal ball gazing, making big picture predictions on developments and factors that will influence markets and portfolios in the years ahead.
2021 will be remembered as anything but dull. Markets have generally coped well despite a number of headwinds, as economies have continued to rebound from the pandemic.
Vaccine rollouts, accommodative governments and central banks, buoyant consumers and a strong corporate sector have all fuelled investor optimism, amidst a year still punctuated by lockdowns. In the gift that keeps on giving, Covid has delivered another strain in the form of Omicron.
What will 2022 serve up? No one knows exactly, but below is a run down on how the ‘top ten’ may play out in terms of big themes next year.
1. Inflationary fears subside
The “I’s” (inflation and interest rates) have it, and questions remain as to whether multi-decade highs in inflation will subside, or remain persistent.
The world’s money supply has been turbo charged during the pandemic, which together with super strong demand and constrained supply, has seen the price of just about everything jump. The growing consensus seems to be that inflation is here to stay and indeed it could be ”Back to the 70’s” in this regard.
There is however another scenario, where a global reopening sees supply chain bottlenecks ease, and a tightening of monetary policy puts the inflation genie back in the bottle. Following two years of ‘better than feared’ financial outcomes during the pandemic, can this really be ruled out?
2. Don't fight the Fed (or its peers)
Markets have been unsettled by the emergence of the highly transmissible Omicron variant. Another driver has been the ‘end of an era’ and a pivot by the world’s central banks in recent weeks.
The US Federal Reserve has ‘retired’ the term ‘transitory inflation’ and is tapering asset purchases, setting the scene for three rate hikes or more next year. The Bank of England surprised with a rate increase in recent weeks, and other central banks have similarly decided to withdraw the stimulatory ‘punchbowl’ lest the inflationary hangover be even worse and longer than would otherwise be the case.
In October, the Reserve Bank of New Zealand became one of the first central banks globally to start on a tightening journey, and others are now heading this way. This can be seen as a vote of confidence in the world economy (despite the spectre of Omicron), but also an acknowledgment that inflation won’t go away on its own.
But what if inflation does cool more quickly than expected – could we then actually see the world’s central banks backtrack once again, and allow the global economy to keep growing at a strong pace (the IMF has forecast around 5 per cent for next year)?
Many are talking up the prospect of stagflation (high inflation/high unemployment) at the moment, but perhaps this view is overly pessimistic.
3. Don't underestimate the broader market's resilience
Globally, markets performed very well in 2021, led by the US where the S&P 500 is up over 20 per cent year to date, and has only recently weakened from record highs. Valuations are however elevated in many areas, and a pullback at some point next year is a question of ‘when’ rather than ‘if.’
The potential catalysts are numerous, including rising bond yields, new variants and geopolitical tensions amongst others. Many are ‘expecting the correction’ in 2022.
Markets typically do ‘climb a wall of worry’ and this is plausible again next year, with the global reopening delayed but not derailed by Omicron, which is unlikely to be the last variant the world has to face.
On the other side there will be advances in second generation vaccines (anti-viral pills could well prove a ‘game-changer’). As such any weakness during the year could well prove ephemeral once again, and potentially see the US indices ending the year at record highs – which would help support many markets globally.
4. The Great Rotation clicks up a gear or two
Technology sector leaders, which were turbo charged by the stay-at-home thematic, have helped propel markets higher this year. Share prices have surged as companies have consistently delivered on expectations, and investors have been comfortable with much higher valuations than pre-pandemic.
A prime example in the US is Apple which going back a few years was trading on a PE of around 13X – it’s now 30X, and with a market capitalisation approaching US$3 trillion ($4.4t).The iPhone maker is set to be the first company ever to achieve this feat.
Is this a case of ‘peak exuberance’ around high priced growth names, given the world is still ultimately on the reopening path (albeit interrupted recently by Omicron)? Is it time to be switching into reopeners and ‘old economy’ stocks – think banks and building companies for example – many of which are trading at modest valuations in comparison?
The prospect of higher interest rates (but maybe not as high as some expect) means that the bar of expectation for growth names and associated valuations will be all the much higher (interest rates are used to discount future cash flows). Per the Chinese Zodiac calendar, 2022 is the Year of the Tiger – could this be the year when value comes roaring back into focus?
5. The Kiwi market comes back into vogue
As we round out the year, the broader NZ market is down around 4 per cent year to date. This is the sharpest downturn since the global financial crisis, with our market having underperformed relative to the US indices in particular (and Australia which is up around 10 per cent).
The New Zealand market is one of the higher yielding globally, and this attribute has been an Achilles heel to some extent. After a rebound through to the end of September, investor appetite here has clearly weakened since the RBNZ’s decision to raise rates in October.
The question for 2022 is whether our market performs relatively better, as the rest of the world’s central banks play catch up on their tightening plans.
The RBNZ meets again in February, and currently is expected to raise rates at least five times next year. This is with the Kiwi economy showing reasonable resilience during the pandemic (the September quarter contraction at 3.7 per cent was better than the feared 4 per cent), and with unemployment below 4 per cent.
But could our central bank also be forced to loosen the tightening reins?
This is possible, particularly as the already phased border reopening is pushed out further. Other relevant risks are the potential for the housing market to cool more than expected (see below) and the possibility of interest rate sensitive consumers starting to recalibrate their spending.
An about turn by the RBNZ is a development that not many see coming, and could be something to watch out for next year. Ironically this could also support our own dividend heavy stock market.
6. The housing market avoids a crash but weakens much more than expected
Everyone knows that New Zealand’s housing market has been on a tear this year, with data from REINZ suggesting that house prices are up nearly 50 per cent on where they were pre-pandemic.
FOMO has reigned supreme – with money just about ‘free’ it has been a great time to buy a house (or several). Prices have kept on rising, and homeowners are all feeling very good about themselves. Real estate agents have been happy as well – around $2 billion in commissions have been paid across the industry this year!
The school of thought generally (and per many economists) is that house prices will not rise as fast next year, and will start to flatten out. The thought of material price weakness is simply not palatable it seems, with there being no obvious precedent for this (house prices don’t go down!), other than the GFC. Contrary to what Split Enz sang to us, history sometimes does repeat.
Only one third of Kiwi homes are mortgage free, with the remainder holding around $320b of debt, and over 70 per cent have less than a year until the maturity of their current loans.
Nearly 40 per cent of total Kiwi household disposable income is required to service the average mortgage. It is hard to imagine this not flowing through to the property market (auction clearance rates have already fallen dramatically in some regions in recent weeks) as rates tick higher.
Time will tell whether a doubling in some people’s interest rates is handled simply by cutting back on cappuccinos or whether there is a measured head for the exits by property sellers.
7. Workers become more pay-packet conscious
The rising cost of living (and an increasing degree of self-reflection) during the pandemic has refocused the attention of many workers globally on their pay packets. This dynamic could play out locally next year, with rising levels of industrial action as we have seen across the Tasman.
“The Great Resignation” has very much become a thing this year, with one survey from Microsoft showing that 40 per cent of the global workforce were planning to leave their jobs in the next 12 months.
Possibly we may see this evolve here into ‘The Great Shoulder Tap” as corporate transtasman rivalry ratchets higher, with Australia poaching Kiwi innovators and skilled workers.
In any event, wages look set to push higher next year, with consequent implications for corporate bottom lines.
8. The runway is cleared for a third supermarket operator
Rising inflation this year has been highly visible in the weekly supermarket shop (along with the trip to the petrol station). But are our groceries still higher than they need to be? New Zealand is ranked sixth highest in the OECD for spend per capita on groceries (vs 19th in terms of median wages).
The country’s two main operators are making supernormal profits and will contend that the system works ‘just fine.’ The ComCom’s final report goes to the Government in March, and with rising mortgage payments, it is hard not to imagine a ground swell of Kiwis crying out to be treated more ‘kindly’ at the till.
A break-up of the current cosy duopoly could well be on the cards, and the consequent readjustment of prices (as happened in Australian with the introduction of Aldi a decade ago) would be well-received by consumers.
9. Tensions ratchet higher on the geopolitical front
Geopolitical tensions ebbed and flowed during 2021, as Donald Trump’s exit from the White House was seen as ushering in an era of greater diplomacy. This has not exactly proven to be the case, with trade balances in focus. Questions over where Covid all started has also seen China impose protectionist tariffs of its own.
Geopolitical tensions are unlikely to recede in 2022, as nations look to rebuild their finances post the Covid-induced monetary splurge. Military movements will be closely monitored watched across the globe, particularly any in resource-rich regions.
10. A dose of reality sets in for some of 2021's biggest themes
Other subplots during this year included rampant levels of activity in terms of mergers & acquisitions, and IPO’s (there have been more listings globally in 2021 than there were than in any year of the dot-com boom).
Will buyers become increasingly choosy next year?
Corporates will also be cognisant of the impact of rising interest rates given debt loads. Investors meanwhile may also be mindful that the IPO market wasn’t exactly a recipe for riches in 2021 – over half of the world’s biggest IPOs are under water on their listing price.
Volatile crypto-currencies continue to capture many people’s imagination, but will 2022 be the year officials follow through on calls for tighter regulation or digital alternatives of their own?
Elsewhere, Environmental, Social, and Governance (ESG) has been another huge theme this year. With a focus on ‘net zero’ by 2050, governments will likely need to show even greater unity with respect to the practicalities of transitioning away from fossil fuels. For investors, sustainability and ethical awareness have increased greatly in recent years.
The concept of well-being has been turbo charged during the pandemic, and these considerations could well ratchet up a few levels yet in 2022.
– Greg Smith is the Head of Retail at Devon Funds.
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