The onset of the Omicron variant looked set to mark the biggest challenge of the global pandemic. At the same time, worries about rising inflation and supply shortages persist, amid high expectations that central banks will increase interest rates. We look at the likely outcomes this year, and what they mean for corporate earnings and financial markets.
We begin the year with Omicron continuing to run rampant in some of the world’s big economies, albeit amid signs that infection rates are falling in certain countries. The obvious questions to ask are: will Omicron turn out to be as bad as some feared; will it put a spanner in the works of a global economic recovery; and could it destabilise markets?
It appears that financial markets believe we will shake off the Omicron variant. If we look at the evolution of consensus forecasts for economic growth this year over the last few months, it shows us some interesting things.
Growth and inflation
Last year, the expectation was that the UK would grow very strongly this year, with good growth in the US and EU as well. And, although the outlook has dimmed a little, there hasn’t really been a significant change to forecasts since the arrival of Omicron, which has really affected northern Europe the most.
Likewise, if we look at forecasts for what will happen to inflation during the year, we can see that the expectation is for a very significant increase in the UK, a reasonable rise in the US and, actually, for a period of remarkable stability in Europe.
Chart 1: 2022 inflation forecasts
Source: BMO Global Asset Management and Bloomberg as at 6-Jan-2022
This is interesting. Inflation was subdued in the EU pre-Covid, but has made its presence felt since. January is a big month for prices in the region and, between January and April, there are a lot of wage negotiations. Although it’s settled now, inflationary worries could resurface in the EU over the next few months.
So, what do we know now about how the pandemic is unfolding? We should note that restrictions imposed because of the virus, particularly in western Europe, have risen, but their force and impact are way less severe than at this time last year.
In terms of Omicron specifically, we know that it is much more transmissible, but much less severe, and has been disproportionally hitting younger age groups. Importantly, the forthcoming introduction of anti-viral pills will offer significantly higher protection for the vulnerable. In short, the world is much better protected against the virus and its variants, whose impact should continue to diminish during the months ahead.
Another pressure on economic activity has been supply shortages. According to the purchasing managers’ indices (PMIs), manufacturing in Asia excluding China has had a big bounce, moving back into positive territory. Similarly, the production of semiconductors in Korea has jumped. The shortage of semiconductors has been a big problem for the automotive sector, but as it continues to clear there should be a healthy increase in production to come.
Turning to some of the other forces at work, on the plus side, US consumers have huge spending power, because of what we’ve called the ‘Covid piggy bank’, or the savings they’ve built up during lockdowns and as a result of government stimulus. There are pressures – the end of child tax credits, for example – but consumer spending should remain firm.
American companies are also increasing their capital expenditure, which is good news for demand, profitability and productivity. This is happening because companies have plenty of cash, their margins are high and there is a labour shortage. This is a positive both for the economy and the stock market.
Supply shortages are also easing in the US, in part because of the semiconductor effect mentioned earlier, but also because the surges in demand that take place on Black Friday and at Christmas have passed.
Prices have also been rising in the US, notably of used cars, which have doubled in the past year or so. Car rental prices have come down but remain high. Both of these have been driven by the shortage in supply of new vehicles.
Even as that bottleneck eases, however, there may still be pressure on the labour market where, despite employment remaining well below pre-covid levels, there is still a big labour shortage. This in turn is feeding into wage inflation. The rising cost of renting accommodation in the US is also a major factor contributing to inflationary pressure.
Bring all of these effects together, and we expect that overall inflation will continue to rise over the next few months. Even when it eases, it will continue to be well above the Federal Reserve’s 2% target.
That means the Fed is going to have to take an even tougher stance than it already has and accelerate its planned rate rises to bring the situation under control. Real interest rates, adjusted for inflation, have risen and will continue to rise, something that is likely to favour value stocks over growth companies.
Eurozone consumers also have significant spending power, with a similar Covid piggy bank, albeit a smaller one. While fiscal policy in the US and the UK has been tightened, it’s actually been eased in Europe. So, in part as a result the big stimulus measures that have been introduced, Europe could have a good year in growth terms in 2022.
The eurozone PMIs for both manufacturing and services have been edging lower, but remain firmly in positive territory and expansion mode. In fact, it is possible that services will rebound quite strongly in Europe.
There are lots of negative pressures in the UK, including rising taxes, interest rate hikes and an inflationary squeeze on real incomes, not to mention prevailing worries about Covid.
There are, however, some important positives. UK consumers also have spending power, bigger than Europe and similar in size to the US. Even though energy prices are rising, real wages are falling and there are further rate rises on the cards, households still have plenty of money to spend if they’re feeling confident.
Chart 2: 2022 GDP forecasts
Source: BMO Global Asset Management and Bloomberg as at 6-Jan-2022
Looking at the PMIs, the figures for manufacturing, construction and services have all come down modestly, but we think they will recover, partly as a result of the lifting of Covid restrictions. The housing market also remains remarkably strong.
In the last few months, financial markets have sharply increased their expectations for the level of interest rates in a year’s time in the US, EU and UK. In the US, for example, the market has moved abruptly, from forecasting that rates will remain unchanged for a year to predicting that they will rise by 1%. We think that good growth and the upward pressures on inflation mean that there will be significantly more tightening than that on the part of the Fed.
The UK is less clear as a picture because of the wider factors, but we do expect that there will be some rate rises. Interestingly, interest rates in Europe are expected to remain negative for the next year. Here, we’ll have to see what happens in the months ahead in terms of prices and inflation.
The success rates with falls in Covid cases have been remarkable in emerging markets, particularly in South Africa, where Omicron originated, despite low vaccination rates and weaker healthcare systems.
In terms of economic surprises, both positive and negative, emerging markets have been highly volatile. But China, whose problems in the property market, for example, are well known, has moved back into positive territory. In fact, we believe that expectations for China are so low that there is the prospect of a recovery in its fortunes, albeit a temporary one.
The negative factors in the emerging markets include rising interest rates and PMIs that are lower than in the developed economies.
While we remain negative on emerging markets, we believe the case is building that they are poised for a bounce, in spite of the impact of rising US rates. We wouldn’t expect a big recovery, but we are not as negative as we’ve been in recent months.
Finally, let’s look at corporate earnings, which are driven by the economy. If we look at analysts’ earnings forecasts, which traditionally start bullishly, last year there was a massive upgrade in expectations for the year ahead.
Chart 3: Earnings growth forecasts
Source: BMO Global Asset Management, Datastream, IBES, as at 7-Jan-2022
This year, analysts have already nudged down their forecasts. At the same time, companies have been telling them to revise their estimates downwards. It’s a complex picture but, arguably, analysts have become sufficiently gloomy about the prospects that this year’s earnings might turn out to be reasonably strong. The next set of reported numbers will cover the fourth quarter of 2021, and we think that they will be positive.
Drawing all of these various moving parts together, it seems clear that medical science is enabling the world to ‘live with Covid’. Major central banks are continuing to tighten fiscal policy, but the underlying financial conditions remain highly supportive. Companies have plenty of cash and are not struggling with debts, and the financial firepower of consumers also remains strong.
So, if corporate earnings are going to outperform, we think that equities will continue to rally and, as last year, will again generate better returns than bonds. We can’t expect equities to perform as well as they did last year because they have already rallied strongly and interest rates are rising, traditionally not good news for shares. Overall returns are likely to be low, but the best returns should come from risk assets, namely equities.
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