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Laith Khalaf, head of investment analysis at AJ Bell looks at some of the key factors which could 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 could be 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 could 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, considering 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.
As Bill Gross amply demonstrated, it’s unwise to try to predict the future, but it is prudent to consider the balance of probabilities. Right now, aside from the pandemic, inflation appears to be the big risk in the global economy. Even if it proves to be transitory, a bout of inflation is still extremely negative for the fixed income streams provided by bonds. If inflation persists, it’s even worse. Particularly if that is accompanied by central banks closing their massive bond purchasing programmes. There is of course a chance that the global economic recovery will stutter, that inflation will fall away, and central banks will ease back on tightening policy. The Omicron variant has shown this isn’t just a theoretical hypothesis. In that scenario, bonds would rally again. But even then, it’s a stay of execution rather than a pardon. Unless we believe that monetary policy will never normalise, and that QE is here forever, there must come a day of reckoning for the bond market. It might be a gradual deflation rather than an explosive rupture, but it does look like a question of when, not if. Long dated government bonds would be most in the firing line so bond investors could seek to protect themselves by looking to shorter dated bonds, higher yielding markets, and strategic funds that employ a flexible approach.
Interest rates will almost certainly rise again in 2022, but this will be a pyrrhic victory for cash savers, because inflation will rise faster. As a result, money in the bank will be losing its buying power even faster. Inflation is forecast to hit 6% in spring, but is then expected to moderate over the next three years. For much of that time, CPI will still be above the 2% target though. Cash therefore still looks like an uncomfortable place to be for the foreseeable. It’s still an option for short term savings that might be needed at the drop of the hat, but as a longer term store of value, the return of inflation has left cash looking even more woeful. Savers should consider aiming to have three to six months’ worth of expenses set aside in cash for an emergency, but should consider investing anything above that which they are willing to leave untouched for five to ten years or more. Investing any cash gradually should help to level out entry points into the market, and make for a smoother journey.
Residential property - It’s hard to get a proper read on the UK housing market, given the huge distortions created by low interest rates, long term government subsidies, short term government booster shots, and the pandemic. One thing seems certain- the next year won’t be anywhere near as good for house prices as the last twelve months, which were turbo charged by the stamp duty holiday, changing working patterns and ultra low mortgage rates. While growth will moderate, it might not disappear altogether though, given the imbalance between housing supply and demand in the UK. Higher interest rates will be a slight headwind for the property market, but many households have bought a big bit of protection by fixing, and by the time they have to remortgage, higher wages will probably have taken up a lot of the slack. In recent years around 95% of new mortgages have been on fixed rates, up from about 60% ten years ago, according to UK Finance. Anyone hoping for a house price crash to finally jump on the ladder may be sorely disappointed.
Commercial property - the sector may have recovered from the depths of the pandemic, but there’s still a great deal of uncertainty over its prospects as we head into 2022. Widescale hybrid working is still in its infancy, and it remains to be seen to what extent office space is desirable for UK plc. Where it is in demand, big corporations will likely place a premium on sustainably built spaces that enable them to lower their carbon footprint. Low unemployment and economic growth should help to underpin office and retail space, and the continued growth of ecommerce after the quantum leap of the pandemic should mean more demand for logistical hubs. Inflation and the potential for interest rate rises will take some of the shine off commercial property yields, which could prompt some investors to move elsewhere, particularly if there is a material rise in bond yields. For open-ended fund investors the FCA’s long-awaited policy on notice periods still hangs over the sector like the sword of Damocles. If the regulator does impose long notice periods on open-ended commercial property funds, that’s likely to at least dent demand, and in the worst case scenario could lead to a synchronised exodus, dealing suspensions, and fund closures.
The resurgence of inflation has put some pep in the step of goldbugs, though the precious metal has really failed to shine since the early days of the pandemic, when it topped $2,000 an ounce. Part of the problem may be that interest rates are also expected to rise, and as gold pays no income, it looks less attractive by comparison with interest bearing assets like bonds and cash. That dynamic can be expected to deepen in 2022, if central banks tighten policy as expected. The lack of any cash flows also makes the precious metal difficult to value and volatile – there’s a reason Bitcoin is called digital gold. Gold is known as a safe haven, but between 2011 and 2015 investors had to stomach a 40% fall, so it’s not an asset for the feint-hearted. It acts differently to other assets so should be considered as part of a diversified portfolio.
Rolling a dice on a spinning roulette wheel is probably as good a tool as any for predicting the course of the crypto markets over the course of 2022. There are however five key things to watch out for in this nascent market which can be expected to exert some influence on prices; business adoption, new investment products, regulatory activity, environmental progress and central bank competition.
If crypto starts to be used as a means of exchange between businesses and consumers, then that strengthens the bull case. Such adoption needs to take place in a meaningful way though, rather than as a marketing gimmick, whereby companies accept payment in crypto and then immediately convert it into traditional currencies. Likewise, new investment products could open up further liquidity for cryptocurrencies and help to establish them as a new asset class for investment managers, which would be a positive step for crypto. In both these cases, the volatility of crypto is a major sticking point which makes it hard to see much progress being made, when companies have bills to pay in dollars, euros and pounds, and likewise big funds need to report back to their investors in traditional currencies.
Regulatory activity is there to protect the consumer from anything that could be used to launder money, scam consumers, and could ultimately lead to heavy losses amongst investors. Crackdowns in India and China could be repeated elsewhere, and more broadly regulators and governments are going to turn their beady eyes on crypto, as it becomes more enmeshed in the traditional financial ecosystem. Central banks, including in the UK, are also looking at launching their own digital currencies, which would be negative for crytpo as these could usurp some of the perceived benefits of Bitcoin et al, such as speed of payments and transaction costs, particularly across borders.
Finally the environmental piece of the puzzle could swing either way, with the Tesla CEO, Elon Musk, being the somewhat unpredictable bellwether on this particular issue. Tesla made some bold plans to facilitate crypto payments for cars at the beginning of 2021, but rowed back over concerns about the environmental impact of crypto mining. Musk said Tesla would resume its plans once mining transitions to more sustainable energy, and already this is starting to happen. Watch this space, or more specifically, Elon Musk’s twitter feed.
These articles are for information purposes only and are not a personal recommendation or advice.