Volatility return is the safest bet for 2022
Global equity markets had another fabulous year in 2021 with investors gaining double digit growth on their invested capital helped by continued fiscal stimulus, loose monetary policies, high levels of savings during the pandemic, a robust economic recovery, and most importantly solid corporate earnings.
The MSCI World Index ended the year 20.1% higher compared to 14.1% gains in 2020 and enjoyed their third best performance in 10 years. US equities were the major contributor to the solid performance as the S&P 500 rallied 26.9% led by energy stocks, real estate, and megacap tech firms like Alphabet, Apple, and Microsoft.
The outlier in 2021 was the Hang Seng Index which dropped 14.1%, as China took harsh regulatory measures against the education and tech sectors, forcing investors away from these stocks. However, many may become attracted again to these beaten down sectors given how cheap their valuations are now compared to other markets.
2022 will hopefully be the year of normalisation, in which the pandemic comes to an end, and people return to normal lives. Most investment banks remain bullish on equities but expect returns to be single digit or low double digit in percentage terms. The three major risks to the bullish forecasts are new, deadlier coronavirus variants, rampant inflation and monetary policy tightening more than expected, and further crackdowns in China.
Covid-19 cases have been on the rise recently, but the latest variant, “Omicron”, is not the same disease we experienced in the past. Death rates remain low despite the very high transmissibility. If that’s the trend going forward, we may be approaching the end of the pandemic, but it is probably too early to judge. Confidence can still be shaken if new variants evolve and lead to renewed supply chain disruptions and a further rise in the cost of goods. Investors will still need to closely monitor how the pandemic plays out in the upcoming few months.
Tightening monetary policy is another headwind investors should be aware of. It is the pace of tightening which is the wild card and a lot will depend on inflation. US Fed policymakers expect interest rates to rise three times in 2022 after the bond purchase program ends in March. Those interest rates hikes will keep rates below 1% in 2022 which is relatively low to historic averages, but it’s happening at a time where a lot of debt has been incurred and there is a large amount of leverage in the system.
The spread between the US two- and 10-year Treasury notes is already below 80 basis points, having flattened more than 50% since March, suggesting that a recession may not be far away. If inflation fails to fall back and the Fed speeds up the tightening cycle, we’re likely to see the curve invert and hence lead to some sort of panic selling in equities. That’s why it will be very important to monitor inflation trends over the next several months.
In such a changing environment, it is corporate profits and consumer spending that needs to pick up the slack for equities to continue heading north. However, with many assets looking overvalued compared to historic measures and several potential risks in the air, expect volatility to pick up significantly as we go through the year.