1. Health and geopolitics cause concern for financial markets
In addition to current valuations, financial markets are being driven by a combination of factors, comprising: health, geopolitics, economic data and policy. Of these, the majority of the time it is the latter two, economic data and policy, that dominate, but the impact of health and geopolitical factors can be impactful, and both have the ability to trigger extreme outcomes for financial markets. This has been particularly so in the last couple of weeks as fears about the Omicron variant have come to the fore.
The lesson since the pandemic began is that the economic impact of Covid has varied across countries, and as we have seen in the UK, there is both: (a) a direct impact, resulting from government restrictions and lockdowns; and (b) an indirect effect, as firms and people have taken their own action. The same is likely to be evident now.
The uncertainty surrounding the latest variant has already had a negative impact globally and in the UK. But countries like the UK with a large rollout of vaccinations and boosters are expected to have a high level of protection against the latest variant.
Omicron appears to be more transmissible, but less lethal, however the high rate of its transmission could affect many people in a short space of time and is triggering many countries to impose new restrictions. Thus, there will be an impact on economic growth, but this is expected to be transitory, negatively affecting some sectors like hospitality and travel.
The emergence of this latest variant in South Africa reinforces the importance of the production and rollout of vaccinations globally, with lower income countries where vaccination rates are low appearing most vulnerable. It does not prevent future scares from other variants, although this can be viewed as economies having to live with Covid
In addition, geopolitical worries lurk, with three in particular warranting current attention: Ukraine, the South China Seas (with a specific focus on Taiwan), and rising fears linked to Iran.
2. Global growth is recovering but worries persist about the sustainability of growth
Global equity markets have discounted much good news and have been vulnerable recently to uncertainty surrounding the new variant and renewed concerns about the sustainability of strong growth. The recovery in the world economy reflects the rebound from the lows in the pandemic, plus the economic boost from reflationary policies.
Despite this, there is renewed focus on a likely future economic slowdown, as inflationary pressures feed through in coming months, thus squeezing spending power across many economies. Also, growth is likely to slow during 2022 as the post-pandemic rebound loses momentum and as some western economies may face tighter monetary or fiscal tightening.
The recent release of the Organisation for Economic Co-operation and Development (OECD) December Economic Outlook provides a snapshot of current policy thinking. The world economy, according to the OECD, grew by an annual average of 3.3% between 2013-19. It then contracted 3.4% in 2020, is expected to rise 5.6% this year, 4.5% next and 3.2% in 2023.
For the US, the OECD predicts that after contracting 3.4% last year it is set to grow 5.6% this year, 3.7% next and 2.4% in 2023, the latter being the same as its average growth rate between 2013-19. The latter reflects current economic thinking that post-pandemic growth rates in most countries will return to those in pre-pandemic times. This does not auger well for western Europe, including the UK, pointing to sluggish rates of growth.
3. Inflation is rising and should peak in the first half of 2022
Inflation has risen globally post-pandemic, as a strong rebound in demand alongside supply-bottlenecks have triggered rising costs. Initially, central banks viewed this as “transitory”, but during congressional testimony recently, US Federal Reserve Chairman Powell said, “it’s probably a good time to retire that word”. As inflationary pressures persist, central banks will come under greater pressure to change both their language and their policies, tightening sooner and faster than previously planned.
When measured on an annual basis, inflation is likely to peak in the first half of 2022. However, there is still considerable uncertainty as to where inflation rates may settle once it subsides, in part influenced by second round effects such as wage growth, as well as by policy actions that central banks may take.
4. Oil prices have weakened in recent weeks
Although oil demand fell sharply because of the pandemic, production adjusted, too. Thus, this current quarter is expected to be the sixth successive quarter when oil demand has exceeded supply. But by the first quarter of next year, demand and supply are expected to be in balance, as production recovers and stocks are reduced, and while demand continues to rise its rate of increase is expected to slow during 2022 compared with this year.
November’s Oil Market Report from the International Energy Agency (IEA) summed up developments: “Global oil demand is strengthening due to robust gasoline consumption and increasing international travel as more countries re-open their borders. However, new Covid waves in Europe, weaker industrial activity and higher oil prices will temper gains.”
The spread of the latest variant since that report was written may temper those gains further, but the underlying trend is still one of rising oil demand, forecast by the IEA to be up 5.5 million barrels per day (mbpd) in 2021 and 3.4 mbpd in 2022. Against this backdrop, oil prices are now being widely forecast to stabilise at around or slightly below current levels.
This will see gasoline prices ease. The US Energy Information Administration, for instance, reports that US gasoline prices reached $3.39 per barrel in November, the highest since 2014, but are expected to fall to $3.13 in December, $3.01 in January and average $2.88 next year.
5. China is in a growth recession, prompting policy easing
The policy focus in China has shifted because of the slowdown in the economy. At the beginning of this week, monetary policy was eased via a cut in the reserve requirement ratio by 0.5% for major banks to 8.4% (it remains at 5% for smaller banks); it was previously cut in the summer.
Further reductions are now expected, alongside some fiscal easing. This reflects a change in focus. Previously the policy focus had been on deleveraging through a prudent monetary policy and targeted measures aimed at curbing speculation in the property sector and limiting further build-up of local government debt.
Now, the policy focus in China is to be on stability, including supporting the commercial housing market to allow people to buy and expanding domestic demand. Monetary policy is still described as being “prudent” with “reasonable ample liquidity” while fiscal policy is to remain proactive.
This followed a recent meeting of the 25-person Politburo, just ahead of the annual Central Economic Work Conference this week, at which economic priorities for the year ahead are identified. This year, China’s growth target was set at above 6%. While this Conference may decide upon next year’s target, it is not expected to be formally announced until next spring, at the annual Two Sessions political gathering in Beijing.
Normally, the Two Sessions are the major political event of the year in China but next year this will be superseded by the 20th Party Congress, with its first plenary session and the quinquennial change in personnel. A new President, though, will not be one of them. Ahead of next autumn, the policy focus in China will be aimed at ensuring the economy does not slow further, and rebounds through 2022.
6. Exit strategies still needed from cheap money and high government debt
During this pandemic, total global public debt has reached an all-time high. Many countries have not outlined or enacted policies to exit from their high national debt. It would be premature to conclude that the focus is on stronger economic growth in order to reduce the debt overhang, but that may well be the consequence.
Often the policy approach is driven by domestic politics and the desire to avoid tough fiscal action. The UK is an exception, raising taxes. Another exception is the US, where the focus has been to relax fiscal policy, although President Biden’s huge fiscal boost has yet to be approved by Congress.
7. Monetary policy was eased globally when the pandemic hit, now it is driven by domestic factors
In recent weeks, the US Federal Reserve (the Fed) has signalled it may exit from its asset purchase programme at a faster pace. This reflects the pressure from rising inflation. The Fed is also keeping a close eye on the jobs market to determine its exit strategy. November’s US jobs data sent a mixed message.
While non-farm payrolls rose by 210,000 in November after a rise of 546,000 in October, the unemployment rate fell from 4.6% to 4.2%. US employment is now 3.9 million below its pre-pandemic peak of February 2020.
In contrast to the Fed, the messaging from the Bank of England remains confused and the new variant has triggered speculation that the Bank will opt not to tighten at its December meeting. Meanwhile, the European Central Bank’s bias is to retain its current accommodative policy. In China, policy is being relaxed.
A big question is what constitutes normalisation of monetary policy? In the wake of the 2008 global financial crisis, monetary policy became the shock absorber for the world economy. So much so that on the eve of this pandemic, policy rates were already low in many countries. This partly reflected subdued inflation and that so-called “neutral” interest rates were lower than in the past.
Policy has eased further during the pandemic. Now, the attention of financial markets is on exit strategies for monetary policy. The timing and scale of exit strategies from low rates and asset purchases will vary from country to country. This is probably the biggest challenge for financial markets in coming months. Ultra-loose monetary policies pose a threat to monetary stability in the form of higher inflation and to financial stability as markets are not pricing properly for risk and are vulnerable to any unexpected or aggressive monetary policy tightening.
Please note, the value of your investments can go down as well as up.
