|Equity markets are heading for their third consecutive above-average calendar year, and as discussed in Views before, at work here are three main drivers:|
- Covid-19/vaccination progress
- Fiscal policy (for the most part government support and quantitative easing)
- Monetary policy (ultra-low interest rates, relaxed lending controls and money printing).
Over the last month, we have seen new developments on all three fronts.
Firstly, on the virus front…
The year began with COVID as the biggest threat to the economy, and it looks like it may end in the same way. Not surprisingly, the virus is still causing real economic consequences.
Globally the number of cases has been rising again, particularly in Europe and parts of the United States. And, of course, more recently, we have the new Omicron strain.
The good news in Australia is that the number of cases has come down from their highs, both in Victoria and New South Wales, but they are still lingering at reasonably elevated levels. What’s critical is the hospitalisation rate, and that shows that vaccines continue to work. In Australia, 78 per cent of the total population (including infants and children) have had their first dose. And 73 per cent are fully vaccinated. That’s above the developed nation average, and it’s still rising.
The pandemic is far from over, but 2022 should see us move from the pandemic to the endemic stage of the virus. Vaccines are so far highly effective in preventing serious illness but are less effective in preventing infection and transmission. Health professionals are predicting if the hospitalisation rates can stay low then hospital systems around the world should be able to manage as re-openings continue.
We still don’t know much about the Omicron strain. However, doctors in South Africa say it does not cause particularly severe disease (the World Health Organisation has urged caution given the limited data available).
The pessimistic scenario is that it’s more transmissible and turns out to be more virulent than Delta, necessitating a rollout of new vaccines, which will delay the recovery. The optimistic scenario is that it’s less virulent, more transmissible and becomes the dominant strain. For those interested in understanding how this works, click here.
On the monetary front, the key factor is the outlook for inflation.
Initially, central bankers dismissed inflation as ‘transient’, but over the last month, one by one have admitted that they may need to accelerate their rate hike plans. Even US Fed Chair Jay Powell acknowledged that it might be time to retire the term, announcing (on the last day of November) that the risk of higher inflation has increased.
Markets had already factored in earlier rate hikes, so the collective stirring to date hasn’t rattled markets too much.
In our view, pandemic related pressures in supply chains are still in part transient and will subside as economies fully reopen and people’s spending habits shift away from goods and back to services. However, this could be offset by pressure in wages (as we have seen in the US) and energy prices (volatile oil prices was a major theme for November). Even with growth in economic activity slowing, we agree with experts that we won’t see core inflation in the US peaking until the end of next year.
Australian inflation will also become more of an issue in 2022. Economists forecast that underlying inflation will get to about 2.6 per cent by the middle of next year, which is in the centre of the RBA target range. It’s likely to remain there, and hence why it is also likely that the RBA will raise rates towards the end of next year.
From a fiscal perspective, the positive developments over the past month lie with the progress of Biden’s $1.2 Trillion stimulus package and, on his broader, $3.5 Trillion ‘Build Back Better’ programs focussing on welfare and climate change.
The recent confluence of these drivers (uncertainties by any other name), along with liquidity constraints that often affect financial markets at year-end, will most likely be a recipe for volatility heading into 2022. The challenges facing central banks globally are complex, but they can also create opportunities for active investors that can nimbly respond to divergences in policy and asset prices.