HAPPY New Year! Welcome to a fresh beginning and one that is filled with hope and expectations.
With the global gross domestic product (GDP) growth of 4.9% this year, as predicted by the International Monetary Fund in October last year, the global economy and markets are ushering in the new year with caution as economic growth expectations are again being disrupted by the Omicron variant which has now become the dominant form for the spread of Covid-19.
Despite more than 9.1 billion doses of vaccines administered worldwide, the Covid-19 pandemic seems to be behaving like a guest who never wants to leave and has been overstaying its unwelcome presence.
Scientists and governments have been battling hard to tackle the pandemic and despite the booster shots and the third dose, while reducing the severity of cases, the number of cases and deaths are persistently and stubbornly high.
With the total number of cases reaching 287 million worldwide and almost 5.5 million deaths globally, the Covid-19 pandemic is indeed a catastrophic event that will leave its mark on the economy and lives for years to come.
The record high daily cases of almost 1.83 million cases globally on Thursday, with more than half originating from the United States, France, and the United Kingdom alone, shows the seriousness of the threat of the variant to the global economic growth trajectory for 2022.
In a two-part series, this column will highlight key factors that will impact the economy and markets with this week’s column focusing on three main global factors, and next week the column will discuss in greater detail five key elements that will dictate the local economy and financial market.
Inflation worries
The year 2021 saw inflation showing its ugly head and governments globally are now battling hard to contain it with measures to tackle the spiralling rise in aggregate prices.
From supply disruptions to pent-up demand, which has gained significant pace over the past year, a runway inflation pressure will just kill off the economic momentum if not contained well, and worse, a period of stagflation will instead prevail – a period of high inflation, slow growth, and rising unemployment.
From what was seen as transitory in the beginning, inflation is now persistently high with the November reading in the US core Personal Consumption Expenditure at 4.7%, well above the United States Federal Reserve’s (Fed) comfort zone of 2%.
While the Fed has fast-paced its tapering move by doubling on the pace of reduction of its bond purchase programme, the Fed is still nowhere near lifting the benchmark interest rate, which remains at the floor of between 0.0-0.25%.
Nevertheless, the Fed has indicated, based on the projected dot plots, that it will raise interest rates three times this year, followed by three more times next year, an expectation that is matched by Fed Fund Futures probability, with the first hike scheduled in March 2022.
The dollar, which was one of the best-performing currencies in 2021, is set to continue its fine run this year.
With the projected hike in US interest rates, emerging market currencies too will be under pressure again this year unless the hike in interest rates is equally matched.
With the expected rate hikes comes market expectations as to how asset classes will behave.
Naturally, the fixed income market will be up against the wall as rising rates would suggest that yields will rise, which indirectly means bond prices will be weaker.
However, for investors with fresh cash inflows, rising yield gives them an opportunity to purchase fixed income papers at a much more attractive and higher yield, giving them higher returns on investments.
For equity markets, which have a global market capitalisation value of US$120 trillion (RM504 trillion), other than banking stocks and companies with high net cash positions, higher interest rates will drag earnings and stock valuations.
Companies with net debt positions will be exposed to higher borrowing costs, which will eat into companies’ profitability and hence a lower valuation. Companies too will be bracing themselves from a potential great rotation between fixed income and equities as higher rates will reduce the fair market values of companies resulting in investors switching to a higher-yielding asset. As it is markets are coming into 2022 at peak levels, with the S&P500 trading at a forward 12-month price to earnings ratio (PER) of about 21.5 times, any further upside of the benchmark index has to be supported by earnings growth that matches the forward PER.
Central bank’s balance sheet
It is projected that the Fed’s balance sheet will likely hit a high of about US$9 trillion (RM37.5 trillion) before the Fed freezes its bond purchase programme from its current size of US$8.8 trillion (RM36.7 trillion). For the European Central Bank, its balance sheet is presently at US$9.6 trillion (RM40 trillion) while two other central banks, the Bank of Japan and People’s Bank of China are at US$6.4 trillion (RM26.7 trillion) and US$6.2 trillion (RM25.9 trillion), respectively. Collectively, the size of the four central banks alone is at US$31 trillion (RM129.3 trillion). This is some 50% more than what it was before the pandemic and clearly, the money supply created over the past two years has lifted asset prices as we see today.
The question is with the Fed projected to stop its quantitative easing programme, are we going to see the Fed shrinking the size of its balance sheet and move towards quantitative tightening? What would it do to markets if the Fed decides to do so?
As we have seen from the start of the Global Financial Crisis of 2008, central banks around the world have been keeping markets alive and kicking with continuous and unprecedented support with all sorts of bond purchase programmes. For now, most market watchers do not see the likelihood of these bloated balance sheets of central banks to be reducing anytime soon. In fact, some economists or market strategists see that the central banks will most likely maintain the size of these balance sheets before even thinking of shrinking. Hence, maturing bond papers will likely be supported via fresh new issuance to keep the liquidity within the financial market intact.
Geopolitical factors
The two global superpowers remain at odds with each other even after almost a year since President Joe Biden took office. While domestic considerations for both of the presidents is a priority, it is their failure to bridge the information gap and technological advancement, especially in relation to China’s rising and increasingly dominant position, that is seen as a threat to the US and not complimentary to the world’s largest economy.
The competitive nature between the US and China, not only within the highly competitive tech sector but in other areas too, is becoming flashpoints of contentions between the two superpowers. This can be seen from the recent legislative move by the US Senate with the introduction of the Industrial Policy Bill, which will support American companies in building up their capacity as well as technological know-how.
Even the markets are not spared as the US Securities Exchange Commission is requiring Chinese-based companies listed in the US to provide more market disclosures. The move by DiDi Global to initiate delisting of its shares on the New York Stock Exchange just six months after gaining market recognition there suggests that the market’s perception of Chinese listed companies is taking its toll due to the standoff between the two superpowers.
The recent move by the US to impose a ban on Chinese produce out of the Xinjiang region due to human rights issues, in particular, the treatment of Muslim Uighurs, has also seen China retaliating by imposing sanctions on US officials.
In addition to China-US geopolitical concerns, other potential conflicts could rise in 2022 and this includes Russia’s build-up of its military near its border with Ukraine, climate change issues as well as the uneven rollout of the Covid-19 vaccines too may have an impact on geopolitical tensions.
As it is, we are seeing increasing demand for those unvaccinated to be given equal rights and clashes across the globe have been observed.
In summary, the year 2022 is a challenging one for markets, mainly driven by the expectation of higher inflationary pressure as well as the path towards interest rate normalisation. While geopolitical risk exists, how these factors play out during the year will dictate the market’s direction and investors’ sentiment as the battle against covid-19 enters into its third year.
Pankaj C Kumar is a long-time investment analyst. The views expressed here are the writer’s own.