Laith Khalaf, head of investment analysis at AJ Bell looks at some of the key factors which will influence asset prices in 2022.
The Omicron variant has raised the prospect of a stagflationary start to the new year. COVID vaccines and treatments will take some of the edge off any social disruption we may face, and while many businesses have learned to trade through the stops and starts of the pandemic, a return of substantial winter restrictions here and abroad would be a blow for the global economy. Though there has clearly been a damaging effect on share prices in the travel, retail and hospitality sectors, as a whole the market seems to be largely shrugging off the Omicron threat for now. That may be because there is still little alternative for investors seeking a real return. The stock market looks like the best game in town when it comes to delivering long term returns in excess of inflation.
In 2022 markets are likely to have to face down a new threat though – rising interest rates. In theory tighter monetary policy means a resilient global economy, which should be supportive of corporate earnings. However higher interest rates will gradually increase the debt payments requirements paid by companies, which will put downward pressure on profit margins. Increasing bond yields could also pin back equity valuations, which would undermine stock market returns. This is a particular concern given high valuations in the US, which now accounts for two thirds of global stock market capitalisation, much of this concentrated in a small number of big tech names. If the US technology sector sneezes, then the rest of the world stock market is going to catch a very nasty cold.
Even if monetary policy tightens in 2022, it will still be hugely accommodative, so greater danger to stock markets lies in a significant resurgence of the pandemic, out of control inflation, or a flare up in geopolitical tensions, all of which look like distinct possibilities. So far Omicron has dented rather than wrecked confidence, but it is a reminder that biological developments don’t neatly yield to the traditional tools of market analysis. As ever investors need to tune out the short term noise and keep an eye firmly on the long term, putting money into the market regularly where possible, in order to smooth out volatility.
While the precise timing of further interest rate rises and the unwinding of QE still hangs in the balance, the longer term direction of travel looks pretty clear. Central banks will want to take a slow and low approach, but tighter monetary policy is on the way, barring a significant resurgence of the pandemic which sees global economic growth, and inflation, pegged back. That could come as a shock to the bond market, which has become accustomed to ultra-loose monetary policy and explains why fixed interest markets have proved so twitchy in the last year. A tightening cycle would be a paradigm shift that would undermine some of the assets that have performed best in the last decade or so.
In 2010 the bond guru Bill Gross said that the UK gilt market was sitting on a ‘bed of nitroglycerine’. He was wide of the mark, but he may just have been a little early in his forecast, to the tune of a decade or so. At the time of his comments, the 10 year gilt yield was sitting at a much more normal 4%, before the scars of the financial crisis really made their longevity known, before Brexit prompted another shock interest rate cut, and of course before the pandemic resulted, inconceivably, in even looser monetary policy. Today the yield on government debt is significantly lower than a decade ago, which means the explosive power of tighter monetary policy, and any ensuing sell-off in the gilt market, could be even more damaging for government bond investors.