Quarterly Market Update

Summary

We are sanguine about prospects for economic growth in 2022 but rather less sanguine about the outlook for inflation, which risks becoming entrenched through wage increases. The response of central banks to the inflation threat is of crucial importance and the risk of policy error is, in our opinion, the biggest risk to financial markets in 2022. Central banks are walking a tightrope.

Although government bond yields rose in 2021 inflation rates rose by considerably more so bond yields are now very negative in real terms. The outlook for bond markets in 2022 is therefore immensely challenging and our return expectations are modest. As before, and where our mandates allow, we continue to favour flexible bond funds which can cherry-pick the best opportunities as they arise.

Even after their double-digit gains in 2021, equity markets remain our most favoured asset class. We expect corporate profits to grow further in 2022 but our enthusiasm is tempered by lofty valuations which provide little protection and are also vulnerable to rising bond yields. We believe that we hold a prudent level of equity risk in the portfolios we manage and it would almost certainly require a substantial fall in stock markets for us to consider adding to exposure.

Macro Highlights

In the absence of any big surprises in the fourth quarter, it is likely that the UK economy grew by between 6% and 7% in 2021. If the final number exceeds 1973’s figure of 6.5% it will be the biggest annual expansion since 1941 (8.7%). This exceptional growth can be attributed not only to the explosive release of pent-up demand as coronavirus vaccines allowed the economy to re-open but also to the fiscal largesse of the government and the continuing monetary largesse of the Bank of England. Before we all get too carried away, however, it should be remembered that the UK economy shrank by 9.4% in 2020 and at the end of September 2021 was still 1.5% smaller in real terms than it was at the end of 2019. Whilst the economic contraction in 2020 may have been bigger and the subsequent rebound stronger, the UK’s overall economic performance since the pandemic struck has not been materially different to that seen in many other developed countries. The economies of both Germany and Japan were also 1-2% smaller in real terms at the end of September than they were at the end of 2019. Indeed, the only developed nation economy which was larger is the US which has grown by 1.4% in real terms. Given that the fiscal boost in the US in response to the pandemic has been much larger (as a % of GDP) this is not surprising.

Gloomy predictions that the end of the government’s furlough scheme in September would cause the unemployment rate to rise from 5% to nearer 7% have not been realised. Instead, the rate has continued to decline and at 4.2% (for the three months to the end of October) is at its lowest level since June 2020 and only 0.4% above its pre-pandemic record low of 3.8%. The latest unemployment rate in the US also stands at 4.2%, which compares with a peak of 14.8% in April 2020 and pre-pandemic low of 3.5%. In both countries there are record job vacancies and there is clearly very strong upward pressure on wages. This might seem at odds with unemployment rates still being above their pre-pandemic levels. In the UK, part of the explanation is a consequence of Brexit which has exposed the country’s previous dependence on foreign workers in a variety of sectors such as lorry drivers and restaurant staff. The main reason, though, is shrinking workforces. Notwithstanding the well-established demographic trend of ageing populations, millions of workers worldwide have also chosen to withdraw from the jobs market because they can afford to take early retirement funded by gains from soaring financial markets over the last few years or because they are making a lifestyle choice in the wake of the pandemic.

The growth and unemployment statistics seem almost trivial, however, when compared with the big story of 2021 which was the resurgence in inflation. At the end of December last year, the UK’s year-on-year inflation rate (as represented by the Consumer Prices Index) stood at just 0.6%. In November this year it was 5.1%, its highest level in more than 10 years. The ‘old’ Retail Prices Index, which also captures an element of house prices as it includes mortgage interest payments (and so some would argue that it is a better measure of the cost of living) reached 7.1%. With the energy ‘price cap’ set to rise substantially in the Spring, the rate of inflation is almost certainly set to climb further in the months ahead to its highest level since March 1992. Again, soaring inflation is not just a problem in the UK. In the US, the inflation rate reached 6.8% in November and in Germany, where the control of inflation is a national obsession, it has reached 5.2%. We remain confident that some of the causes of the global inflation spike, such as supply chain bottlenecks and year-on-year increases in energy and commodity costs, will ease during 2022. However, there is clearly evidence and the risks are growing that inflation becomes embedded in wages, leading to a self-perpetuating wage price spiral. It remains our best guess that inflation rates will decline from current elevated levels but remain stubbornly above the 2% figure that central bankers are targeting.

Notwithstanding the risk of dangerous new variants of COVID-19 and the squeeze on consumers through rising inflation and higher taxes, we remain fairly sanguine about the prospects for economic growth in 2022. It will not be as high as in 2021 but will be maintained by government spending and the continuing recovery from the pandemic. The big concern for 2022 is inflation, whether it becomes entrenched in wage increases and, perhaps most importantly for financial markets, what response it draws from central banks. They have clearly been wary and reluctant to withdraw the monetary stimulus which has propelled bond and stock markets for more than a decade. The US Federal Reserve blinked first, deciding in November to begin to scale back its bond purchases (quantitative easing) and in December the Bank of England raised its Bank Rate from 0.1% to 0.25%. However, interest rates and bond yields remain very negative, and unsustainably so. In our opinion, the biggest risk to financial markets in 2022 is therefore policy error by central banks. Do nothing or too little and the inflation genie, the scourge of the 1970s, may well and truly escape its bottle. However, excessive tightening of monetary policy could turn an economic slowdown into full-blown recession and also expose the very high levels of debt that now characterise the financial system. Central banks are walking a tightrope.

 

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