Macro Outlook in a nutshell:
1. Strong growth in the US, eurozone and Japan; China to lag behind slightly.
2. Economic reopening will trigger higher growth.
3. Higher inflation is persisting for longer than expected, but it should still be temporary.
4. Interest rates will climb gradually in 2022.
5. Equities remain attractive, gold is preferable to bonds, while infrastructure and land provide protection against inflation.
Stagflation becomes the new buzzword
The recent slowdown in the pace of growth in the US, eurozone and China, coupled with rising inflation, has led to stagflation quickly becoming the new buzzword. Stagflation is an exceptional event given that stagnation does not usually go hand-in-hand with high inflation, but rather with the opposite: low inflation. The most famous example of stagflation occurred in the 1970s, when rising oil prices led to a wage-price spiral that central banks reacted too late to. We certainly do not anticipate stagflation this time around. This is because we do not believe stagnation is likely, and also because the global economy is structurally less inflationary than it was in the 1970s.
Economies reopening after coronavirus
We are reasonably optimistic about economic growth prospects in 2022. Our forecast is for above-trend growth in the US, eurozone and Japan, although we expect China to struggle to achieve its target of 5.5% growth next year.
The recovery phase has been boosted by some highly expansionary monetary and fiscal policies and also by the reopening of economies following lockdowns. These stimuli will reduce in 2022, and more so in the US than in Europe. Yet the economies of both regions have acquired independent momentum in which growth has led to increased demand for labour, higher incomes and higher consumer spending. Households accrued substantial savings during the pandemic, and the gradual reduction of these savings will boost consumer spending. Economic growth, earnings growth, low interest rates, low stock levels and tightness in production chains are also helping to create a positive climate for corporate investment.
China is grappling with severe problems in its real estate sector. We expect the Chinese government to successfully avoid a financial crisis but, given that the real estate sector accounts for a significant proportion of the economy, it will still have a negative impact on growth.
Once the pandemic is under control, consumers are likely to spend more on services, such as those linked to tourism and hospitality, in 2022. This will lead to a drop in demand for consumer goods. While this is a positive in that it will help alleviate ongoing production chain problems, it will be bad news for China and other exporters of consumer goods. Of the major industrialised countries, Germany is the most sensitive to an economic slowdown in China.
Graph 1: BBP VS, Eurozone and China
Source: Kempen Capital Management, November 2021
High inflation to persist for longer, but remain transitory
Despite the coronavirus-induced recession , headline inflation has risen sharply, hitting 5.4% in the US in September and 4.1% in the eurozone in October. Some of the increases in prices this year could have been predicted in advance. The outbreak of the coronavirus pandemic early in 2020 and the subsequent sharp economic downturn led to prices falling. As inflation measures price increases over a period of a year, lower prices last year result in higher inflation a year on when prices get back to normal. Such effects are by definition temporary, so inflation should initially be temporary as well. Yet these base effects have now passed and inflation remains high.
Energy prices are playing an important role in the persistent inflation that we are seeing. The price of oil has doubled in the space of a year, while European gas prices have increased sevenfold. Even though energy prices only account for a small proportion of the consumer price index, such large increases have a significant impact on inflation readings. But this impact is likely to be temporary. Energy prices can only keep inflation high if they continue to climb. However, oil- and gas-producing countries have enough capacity to expand production, so we believe prices are unlikely to do so. What’s more, higher energy prices erode consumers’ spending power, which in turn acts as a brake on inflation. This is why central banks will not be quick to act to curb energy-driven inflation. Further energy price rises similar to those we have seen recently seem unlikely, although OPEC members and energy companies are reluctant to increase production rapidly. While prices could remain high this winter as a result, the upwards pressure they are applying on inflation readings should decline somewhat.
If we adjust for volatile food and energy prices, inflation looks especially high in the US, at 4.0% in September. It is clearly lower in the eurozone, at 2.1% in October, but this is still double its average rate in recent years. This is due to shortages of components in production chains as well as economic reopening. For example, a shortage of microchips has caused considerable disruption to production in the automotive industry, pushing up the prices of second-hand car prices in the US considerably . Hotel and flight prices also shot up as soon as people could travel again. But again, these reopening effects should be temporary.
Central banks will act if inflation forecasts get out of hand or if wages start to rise. Inflation forecasts have already risen steeply, but central banks have not yet expressed concern about them. Employment is still far from having recovered in most countries, even though there are signs of tightness in labour markets, especially in the US. This is because far fewer people are entering the job market. We believe this will improve over the course of 2022, but wages are already starting to rise in the US. It therefore makes sense for the US Fed to taper its bond-buying programme between the end of 2021 and next summer. This will create scope for interest rates to be raised, perhaps as early as before the end of 2022. We believe there is only a very small chance of the ECB raising interest rates in 2022. However, it will buy fewer bonds when its emergency purchase programme ends in the spring, and its regular bond-buying programme will only partially compensate for this. The Bank of England is likely to be the first major central bank to raise interest rates.
Higher capital market yields
Above-trend growth, inflation risks and central banks that are cautiously moving towards less extreme stimulatory policies should result in higher yields in the capital markets in 2022. That’s because yields are still extremely low both in historical terms and relative to the prevailing levels of growth and inflation. However, we only expect yields to rise gradually. Inflation might be high at the moment, but we do not believe that it will remain high over the long term. What’s more, there is still a large amount of capital seeking safe-haven investments, and 2022 is likely to see a decline in sovereign bond issuance as government deficits shrink. However, government bond returns will probably remain low. The same applies to investment-grade credit, the spreads of which could widen marginally if yields rise. Bond investors looking for positive returns will need to turn to riskier areas such as high-yield credit or emerging-market debt.
It will be hard for equities to match this year’s (up to the end of October) price gains of about 20% in the US and Europe. Earnings growth continues to represent a tailwind for the asset class, but a decline is already visible in the number of upwards adjustments to earnings. In the past, equities have usually risen even if earnings revisions turned negative, but there is a higher risk of a correction if this happens now because equity valuations are relatively high and monetary policy is becoming less expansionary. In our view, the equity markets are likely to become more volatile next year, but there are still factors that are likely to prove supportive of equities. These include low expected returns for fixed income and equities’ higher dividend yields in relative terms. Equities generally hold up well in times of higher interest rates and inflation, which tend to go hand-in-hand with economic growth.
Should investors seek protection against inflation?
We believe seeking to do so is sensible, but not easy. The level of inflation priced into inflation-linked bonds is already high, which means there is little return to be earned from investing in them. Listed infrastructure offers some protection against inflation, but as an equity investment it has a high correlation with the broad stock markets.
We view gold as an alternative diversification option to government bonds. Gold is of course much more volatile and sensitive to real interest rates than sovereign bonds, but it has recently failed to profit from lower real interest rates. We believe government bonds have an asymmetric risk profile: there is a considerably higher risk of higher bond yields – and therefore lower bond prices – than vice versa. Within illiquid asset classes, we believe infrastructure and land should provide a sound hedge against inflation.
Macro and Micro Kempen Outlook event