Hello, good morning and welcome, 2022!
I felt like the Grinch, Scrooge and Noel Edmonds all rolled in to one big ball of Christmas humbug postponing our team Christmas shindig, but as the entertainment triumvirate recede from our screens for another year, New Year wish lists will be hoping for a more settled 2022 and a pathway back to a better sense of normal.
Transitioning from Transitory
Rising prices whether it be in petrol, energy or second-hand cars have been key drivers of the inflation that has been making headlines. The big question is whether inflation is here to stay over the long term or whether it is a by-product of the frictions suffered as economies rebounded strongly from Covid lockdowns and demand surged. A consensus has yet to emerge as to whether inflation is becoming more persistent due to lax central bank policy or from continued supply disruptions.
Energy has been a large contributor to the inflation we are currently seeing as witnessed when you visit the petrol station or turn your heating on, but the pulse of this inflationary pressure is forecast to cease being as significant the further we move from the collapsing oil prices of April 2020 and work through the spike in wholesale gas prices through this winter.
We are still not convinced that inflation, this time driven by rising wages, is going to be a longer-term inflationary problem. Wage inflation hasn’t accelerated up the corporate ranks and whilst many employers with staff typically focused in the low wage end of the economy have seen rises, there isn’t a broad wage revaluation in the face of an increased bargaining power of labour. The de-unionisation of the labour workforce from late 1970’s through the 1990’s significantly reduced collective bargaining power, particularly in the private sector and we’re not anticipating a return of the bogeyman levels of inflation seen in the 1970’s when unions held sway. But, what are we seeing and what are companies thinking? Are there cases where an employer is seeking to attract staff and increasing wages by 10% to tempt applicants? Almost certainly yes. Are there mass, sector-wide above inflation wage rounds taking place? We’re less convinced.
There are contrary signs to acknowledge here though that could point to building wage pressures. In the United States there are now more job openings waiting to be filled than at any time since the US Bureau of Labour Statistics started the survey, up to 11 million at the last count, implying companies are not tempting workers back and workers can ‘shop’ around for higher paid jobs. For now, wage growth, where it is being found, is centred in lower-wage jobs and among younger workers who, a decade or so since the financial crisis brought an increasing divide between the ‘haves’ and the ‘have-nots’ will rightly feel this is better late than never.
For now though, the headlines are all highlighting inflation heading in the wrong direction – Euro area inflation accelerated to 4.9% in November, UK consumer prices inflation is 4.6% (over double the Bank of England target rate) and the November print for US CPI came in at an eye-watering rate of 6.8%. These are all big numbers and pose big questions for central bank policy remaining so loose.
For our part, we continue to believe that whilst inflation is certainly more persistent than we would have considered this time last year, this initial high pulse of inflation will subside as the energy price rises stabilise, we’re likely to be entering a period of higher (but not high) than targeted inflation. This should not be read with alarm! Where the years after the global financial crisis were characterised by central banks being unable to hit their inflation mandates and employing policies to get inflation to lift off; the coming years are likely to see central banks more focused on trying to keep a lid on inflation, rather than trying to generate it. This will create a ‘mindset’ shift in central banks. The primary tool at central banker’s disposal has for years been rate cuts; going forward it is likely to be rate rises but all within the framework of interest rates staying low versus their historic norm…
Central Banks. Tightening, but not frightening…
The early part of 2022 is likely to see markets grapple with two main challenges. First, the ongoing public health emergency with Omicron and Covid-19 and second, a less supportive central bank environment.
We are witnessing the concern raised from the news about a new Covid variant, Omicron, that has emerged out of southern Africa and the rattling effect that had on global equity markets. This highlights how asset markets are still susceptible to the evolving virus situation and will continue to be through the course of this winter. The main concern for markets is less health-related and more that new variants have the capacity to throw us back to a lockdown-style economy and the damage that does to economic growth and our capacity to remain active consumers.
Central banks have been reacting to inflation numbers that we have not seen for decades and are sharpening their focus on tightening policy.
There remains a gap between where we are and where long-term rates will settle. Markets are anticipating central banks being unable to reach the level of rates that they themselves are forecasting. As of mid-December, the markets are pricing in long-term interest rates in the States topping out around 1.5% by 2030, whereas the Fed itself is anticipating long-term central bank policy will see rates at 2.5%. Whilst predicting that far ahead is fraught with difficulty, what is important is the shape of the move in rates. In late summer, the anticipated path was for rates to rise through the course of next year slowly and gradually to the middle of the decade up to that 1.5% level. Now there is a much sharper rise in rates through the course of 2022 and 2023 to get to that same 1.5% level. Through 2021 bond yields moved a reasonable distance higher and there is more to come, but we remain, and will do for many years, in a low-interest rate environment.
2022. The year of the squeeze?
One of the questions that needs to be answered through 2022 is how the consumer acts, and reacts, to the pressure of rising prices. Rising wages on the one hand are good, but if they are declining in real terms because annual pay rounds do not keep pace with an elevated level of inflation then real purchasing power declines. In addition to stagnating wage packets, during 2022 UK consumers are facing further peril from continued interest rate rises as well as higher tax burdens from forthcoming National Insurance increases that come in to force from April. These will be eating into the pockets of people’s disposable incomes with the cost of living now expected to be £1,700 higher in 2022, according to the Centre for Economics and Business Research (or £1,200 from The Resolution Foundation depending on your choice of reading).
There is one important area where UK households have been quietly and effectively protecting themselves from rising rates and that is by fixing the rate on their mortgage. Historically, UK households have been particularly sensitive to rising rates given the predominance of mortgages being variable rate mortgages. Since 2016, however, when just over 45% of all the mortgage stock in the UK was on a variable rate mortgage, this balance has dramatically swung with almost 80% of all mortgage stock now on fixed rate deals, with 40% of all mortgages secured on fixed rates of greater than 5 years or more. With thanks to the Market Insights team at JP Morgan Asset Management for this nugget of data.
There is also some comfort to be drawn from the strong recovery in asset prices since the lows marked in Q1 last year. In the US, household net worth has hit new highs rising from $111 trillion in Q1 2020 to $145 trillion by Q3 2021 and the strength of this ‘consumer’ balance sheet does provide a buffer against this coming squeeze. So too does the level of household savings which remains elevated, particularly so in the UK & the US but even ‘our friends in Europe’ have elevated nest eggs intact.
Growth & Inflation Numbers
We said last time that we are moving in to the ‘tricky second album’ phase of the economic recovery and we have no reason to change our view. The initial economic rebound from last year’s shutdown was swift and the stimulus and support packages injected into households and companies was timely enough to leave the economy in enough good health to see through the damage of lockdown.
Growth forecasts highlight a slowing global economy but still an economy that is growing at a faster pace than we have been used to in the pre-pandemic years. Inflation numbers for 2022 are generally all creeping upward.
As ever, with many thanks to our friends at Schroders for these latest consensus forecasts.
Over the coming months, markets will face the twin headwinds of winter and the continued rise of Covid cases as well as less supportive central bank backdrop. Both have the capacity to unsettle markets.
In fixed income, we remain very wary of long-dated bonds given the likelihood of rising yields in the coming quarters, which would result in declining prices. There is equity-like risk in some parts of the fixed income world and this needs to be navigated with care. Corporate credit markets still have some strong fundamentals to warrant holding in portfolios. Low default rates, high demand and strong corporate earnings all make for an attractive backdrop, but the significant contraction in both yields and credit spreads have driven valuations to very high levels.
There are two things we need to be wary of though. First, is where bond yields settle in terms of their peak yield for the cycle and, second, how we get there. The first half of 2022 could prove challenging if bond yields move sharply higher in short order, but central banks remain very cautious in their moves and tightening is likely to be well-flagged and gradual. Bond yields drifting higher in the early part of the year should be able to be digested acceptably. We continue to position portfolios so that, where held, fixed income holdings are sheltered in strategic bond funds and short-dated fixed income funds to limit the effects of rising yields. They won’t be immune from the headwinds of rising rates, but they are currently harboured rather than out on the open seas.
In equities, valuations in the US look relatively expensive but in this low rate environment investors remain prepared to pay handsomely to access the more dynamic US corporate environment and its continued earnings strength. Elsewhere valuations look less expensive; we retain our UK equity weightings and would argue that they have still not had the chance to bounce back from the discount that accumulated since the 2016 referendum. For years, the UK equity market has been easy to ignore if you are an overseas investor, but there are signs investors are noticing the value on offer, particularly with private equity investors increasingly taking interest. The structure of the UK market with its heavy financials, energy and materials weightings and the positive correlation these sectors have with rising Treasury yields as well as a healthy dividend yield warrants continued patience for the value to be unlocked. As any follower of the travails of the English Test team this winter, it is the hope that kills you.
Conclusion – Don’t stop me now.
The first half of 2022 is looking challenging for several reasons as there are many obstacles to be navigated, namely an inflationary pulse, a less-accommodative central bank backdrop and, of course, Covid. This is likely to deliver spikes of volatility along the way.
Whilst there is plenty to focus on in the near term, when investing it rarely pays to have your strategy dictated to by what happens in the next few months or quarters. Looking to the long term there remain good reasons why we should continue believing equity markets can move forward from here. The consumer is still in good health despite this inflationary pulse and pent-up consumer demand in the service economy is yet to fully recover from its 2020 lows; corporate health remains strong and defaults extremely low; government stimulus and infrastructure spending plans are multi-year affairs and there will need to be sustained investment in low-carbon solutions to drive the energy transition. These are all positives that should not be overlooked. We need to prepare for 2022 to be a more volatile market environment with potentially more muted returns than 2021, but we do not fear we are entering late-cycle territory, more a period of pause and reflect.
We thank you for continuing to place your trust in us in managing your portfolio. Finally, from all of us in the investment team, Emma, Finlay, Becky, Kim and me, we wish you a very happy New Year and hope 2022 brings health, happiness and joy to all your homes.