2022 year ahead

What ‘normal’ will look like post-pandemic is not easy to predict, as inflation, rising interest rates and quantitative easing tapering lead to greater uncertainty in the year to come. Edward Russell-Walling reports.

The world, its economy and life in general will start to normalise in 2022, though headwinds may slow down a final return to ‘normal’. As this year’s recovery continues, financial markets will stay in reasonable shape while commodities play a different tune. Sustainable finance will simply keep on growing.

Certainly, 2021 has been better than most dared to expect at the start of the year, with an emphatic return to growth – from a low base – and persistently buoyant capital markets.

Last year now appears to have been the Covid-19 pandemic’s economic nadir, with negative growth in every G20 member bar two. They were China and Turkey, where gross domestic product (GDP) grew by 2.3% and 1.8%, respectively, according to the Organisation for Economic Co-operation and Development (OECD).

Collectively, the G20 economies shrank by 3.1% in 2020. This year, the OECD expects them to expand by 6.1%, with no negative performers. That should moderate to 4.8% in 2022, once again with growth across the board. Scarring will be limited in the advanced economies, many of which are already seeing GDP back at or above pre-pandemic levels.

The strength of the 2021 recovery has varied. At the weak end are Saudi Arabia (estimated 2.3%), Japan (2.5%), Russia (2.7%) and Germany (2.9%). Those enjoying a stronger rebound should include India (9.7%), China (8.5%), Turkey (8.4%), Argentina (7.6%) and the UK (6.7%).

On a broader basis, the OECD expects global GDP to grow by 5.7% this year and 4.5% in 2022. The International Monetary Fund is more optimistic – but only just – pencilling in global growth of 5.9% in 2021 and 4.9% in the year ahead.

Some, though not all, of the factors that have bolstered this year’s growth will persist in 2022. Chief among these is the fact that Covid-19, while it may not have gone away, poses less of a threat.

Vaccination is now widespread in the developed world, though low rates in developing countries remain worrying. Waves of infection come and go, along with relentlessly new variants of the virus, but mortality rates are down and further lockdowns seem less likely. “We are learning to live with Covid,” is the common refrain.

The more cautious forecasters continue to identify Covid as the largest single risk to their baseline scenarios, but it is no longer central to most outlooks. Some economists think China is a more pertinent risk. “If there is a material slowdown in China, Germany is very exposed, for example, because it exports a lot there,” says George Buckley, Nomura’s chief UK and euro area economist.

Supportive fiscal and monetary policies, on the other hand, will be modified as economic conditions normalise. To what extent remains one of the biggest question marks for next year.

Inflation fears

Underlying this ambiguity is the return of inflation. As if to belabour the point, US year-on-year consumer price inflation in October was the highest in more than 30 years, at 6.2%. There and elsewhere rising prices were aggravated by spiking energy costs and demand pressures stoked by supply chain bottlenecks. A number of emerging market central banks have already responded to inflation by raising interest rates, significantly, in some cases.

In developed nations, central banks are wary of repeating past mistakes and are mostly biding their time. When and by how much they hike depends partly on whether they see inflation as transitory or sticky. So far, transitory is winning.

“Supply bottlenecks have been getting worse until now,” observes Klaus Baader, global head of economics at Société Générale (SocGen). “Inflation is not necessarily permanent, but a lot of price increases are very visible. It is important to contain inflationary expectations because they tend to feed into wage demands.”

The Federal Reserve has already started tapering its quantitative easing purchases, sufficiently modestly to avoid a repeat of the market’s 2013 taper tantrum. It is not, however, expected by many to raise rates until 2023. The Bank of England ducked an anticipated hike in November, though it may raise this month. The European Central Bank (ECB) and the Bank of Japan are expected to stand pat for the foreseeable future.

Given the relative hawkishness of the Fed, most expect the US dollar to strengthen against other major currencies over the course of 2022 – even after adjusting for inflation. “As long as there are excess savings across the Atlantic, the dollar will be stronger,” says Kit Juckes, chief global foreign exchange (FX) strategist at SocGen.

Not everyone is convinced that inflation is entirely temporary, however. Deutsche Bank global strategists used the word “stagflation” to draw attention to their November summary of forecasts. Though they stopped short of actually predicting stagflation – the toxic combination of stagnant growth and persistent inflation – they lowered their near-term growth forecasts while raising those for inflation. They predicted earlier tightening from central banks, with the Fed moving in December 2022.

Neil Shearing, group chief economist at Capital Economics, thinks that GDP growth in the major economies will be weaker than most expect – particularly in the US and China – and that inflation will fall more slowly.

Emerging markets have not found inflation quite so easy to shrug off. “Because they have not been able to give as much support to their economies, they have been more vulnerable to the effects of supply chain bottlenecks and rising food and energy prices,” says Reza Moghadam, Morgan Stanley’s chief economic adviser. “So, their inflation has shot up and their central banks have had to act faster.”

Market rally

What happens to rates is important to asset prices, which some see as stretched and vulnerable to an upward shift in expectations. So far, capital markets have had a good crisis. They (mostly) defied gravity last year and have not disappointed in 2021. The question is how long they can maintain the momentum.

Debt capital markets (DCM) enjoyed a record year in 2020, as corporates reached for liquidity whatever the cost and sovereigns borrowed lavishly to fund their Covid support. Global issuance breached the $10tn mark for the first time.

This year, corporates have not needed to fund to the same extent, so euro corporate issuance, for example, is down by some 20%. That masks significant differences between investment grade and high yield issuance, however, with the former down by 30% and the latter up by more than 50%, according to Felix Orsini, global head of DCM at SocGen.

“The first half of last year was not conducive for high yield,” notes Mr Orsini. “But this year rates and spreads have been super low, so more issuers have been taking advantage of market conditions.” Investors, who are getting negligible yield from investment grade bonds, have been stepping up accordingly.

Emerging market bonds have done well for the same reasons, with central and eastern Europe, the Middle East and Africa issues, in particular, up by more than 70%. Both asset classes could have a bumpier year in 2022, with the possibility of heightened volatility and execution risk.

Mainstream bond markets have been supported by central bank purchases, in Europe most recently by the Pandemic Emergency Purchase Programme (PEPP). ECB president Christine Lagarde has indicated that PEPP will end in March 2022. “The Asset Purchase Programme (APP), started in 2015, is still going,” points out Jordan Rochester, G10 FX strategist at Nomura. "Will they allow the APP to increase, to offset the end of PEPP?”

Mr Orsini thinks the ECB will be accommodating. “Personally, I think it wants stability in the market and will act gradually, so I don’t expect [purchasing] volumes to go abruptly down,” he says.

Securities issuance

The only fixed-income asset class not to grow during the pandemic was financial institutions group (FIG). FIG issuance in Europe, including covered bonds, fell by 20% in 2020 as banks turned to more attractive targeted longer-term refinancing operations funding from the ECB. In western Europe, it has grown by 12% this year, helped by the issue of capital securities.

“We should see a similar picture next year, with the elevation of additional Tier 1 (AT1) issuance,” says William Weaver, Citi’s head of DCM, Europe, the Middle East and Africa (EMEA). Significant volumes of AT1 issued five years ago will be coming up for redemption in 2022, he adds.

This year has seen a compression of relative pricing between subordinated and senior debt. In the event of any decompression in 2022, issuers will look to front-end load the riskiest – i.e. subordinated – securities first, Mr Weaver believes.

The star performers in the fixed-income markets, at least in euros, have been environmental, social and governance (ESG) bonds. This market has been accelerating exponentially. “The first €1tn in issuance took 12 years,” says Jarek Olszowka, Nomura’s head of sustainable finance EMEA. “We have now done the second trillion of green, social, sustainability and sustainability-linked bonds in just the past 12 months.”

ESG bonds now account for more than 20% of western Europe’s investment grade issuance and 30% of new sovereign, supranational and agency issues. “That will increase,” Mr Orsini says.

One positive is that sustainability-linked bonds are now eligible for the ECB’s purchase programmes. The introduction in 2022 of the EU’s daunting Taxonomy Regulation, which defines sustainable economic activity, may slow the acceleration of this market, at least to begin with.

ECM weakness?

Despite sailing serenely through the geopolitical dramas of recent years, bond markets remain vulnerable to any suggestion of aggressive rate hikes. What else?

Citi’s Mr Weaver notes that the only event really to shake global markets in the last six years was the 2015 China market crash. The resulting volatility lasted into the following year. “China’s influence on global growth is so big a factor that a China slowdown is something to watch,” he says.

Equity capital markets (ECM) would be every bit as vulnerable, and probably more so, to a China shock or hawkish central bank policy. They too have powered ahead since lockdown. Last year saw global equity issuance top $1tn for the first time and this year will exceed that, with $1.2tn for the year-to-date.

Citi’s global co-head of ECM James Fleming thinks that, while considerable capital formation and growth is expected to continue in 2022, equity issuance could be down by 10% to 15%. While a feature of recent market wobbles has been a rotation from growth stocks into value stocks, Mr Fleming thinks there will continue to be a “huge” focus on growth industries in the year ahead.

The world is starved of growth and a lot of great companies need capital. The market will support these early-stage companies.

James Fleming, Citi

“The world is starved of growth and a lot of great companies need capital,” he says. “The market will support these early-stage companies.” Favoured sectors are likely to include technology, fintech, energy transition and renewables.

This has been a record year for both initial public offerings (IPOs) and mergers and acquisitions (M&A). Europe showed that it can successfully bring to market technology and biotech IPOs, with listings such as Oxford Nanopore (London), Auto1 (Frankfurt) and InPost (Amsterdam).

“This year tech really grew up in Europe, showing it could be a realistic alternative venue to listing in the US,” says Luis Vaz Pinto, global head of ECM at SocGen.

Mr Vaz Pinto notes that exhausted IPO investors have become more selective and are applying filters in terms of size. “Smaller deals take the same time to evaluate but have less impact on their portfolios,” he explains, adding that there is now a delayed pipeline of smaller IPOs hoping to come to market in 2022.

M&A has been driven by confident CEOs seeing an opportunity to buy growth, with finance readily available. “If economies are strong, M&A will continue to provide rights issue opportunities for investors,” Mr Vaz Pinto predicts.

An equity rotation out of the US and into Europe has been theoretically on the cards for some time now, but no one believes 2022 will be the year. “The US market continues to be vibrant,” he says.

Joyce Chang, chair of global research at JPMorgan, agrees. “This will be another year of US exceptionalism in the equity market,” she says. “A stimulus package is still in place, and US household balance sheets are strong, with savings rates higher than pre-Covid. Corporate balance sheets are showing lower debt than for decades.”

That said, Ms Chang says that the house view is to be overweight European equities next year. “We see more upside in Europe, with a strong earnings rebound,” she says. “And stocks are still trading cheap.”

Growing revenues

This has been a good year for bank equities which have outperformed the market by margins of up to 50%. The Covid-19 crisis has vindicated the last decade’s work on their balance sheets and capital ratios, and investment banking profits have been ample.

Next year will be more “normalised” for banks, according to Magdalena Stoklosa, European head of bank research at Morgan Stanley. From a revenue and credit cycle perspective, earnings in 2022 in aggregate are projected to be 15% higher than in 2019 before the pandemic, she says.

“The corporate world thinks we are probably at the bottom of the interest rate cycle,” Ms Stoklosa observes. “And there is so much liquidity about. Private equity is also sitting on a lot of dry powder. Given the search for scale in a still-globalised world, I think investment banking revenues will normalise at about 20% higher than in 2019, as transaction volumes in M&A and debt and equity issuance are likely to stay elevated.”

Given the search for scale in a still-globalised world, I think investment banking revenues will normalise at about 20% higher than in 2019, as transaction volumes in M&A and debt and equity issuance are likely to stay elevated

Magdalena Stoklosa, Morgan Stanley

Another positive for investment banking is the ballooning of sustainable bonds in Europe, which is accelerating the process of bank disintermediation. Europe leads globally in terms of climate transition regulation.

“But when the US finalises its own climate transition policies, that will have the biggest impact in sustainable deal numbers,” Ms Stoklosa says. She adds that an upturn in US ESG deals will happen “soon”.

European banks should benefit if negative rates prompt retail depositors to transfer into mutual funds. “Every 5% of excess retail deposits switched into mutual funds raises banks’ fees by 4%-6% per annum,” she calculates.

At the same time, fintechs will continue to nibble away at banks’ vast market shares. “They are getting picked off in the most interesting places, like asset management, current accounts and mortgages,” Ms Stoklosa notes. “[Buy now,] pay later companies are eating some of their lunch. The customer experience gap is so huge and the customer demographic is getting younger.”

Commodity seesaw

Commodities have had a curious Covid, exemplified by the oil price going negative before recovering to over $80 per barrel. Next year they are likely to be “front and centre”, with meaningful effects on FX and inflation, according to Michael Haigh, head of commodities research at SocGen.

Base metals will have their own mini super-cycle as they are used more heavily in green industries, Mr Haigh predicts. He distinguishes between this and earlier commodity booms – starting with the Industrial Revolution – which were driven by innovation and growth. “This is driven by government policy, but it won’t be commodity-wide,” he says.

Copper will be a big winner, while lead and coal will be losers. Platinum and palladium, still needed in electric engines, will do well, as will silver, used in solar panels.

Energy prices are rising now that coal has been struck from the energy menu. Both metals and energy have suffered from lack of investment in recent years, and all this feeds into the inflation mix.

“We can’t make up our minds whether inflation will be transitory or permanent,” Mr Haigh says. If permanent, however, gold benefits. SocGen sees gold peaking at $1950 per ounce in the first quarter of 2022 before ending the year at $1700 as inflation retreats. Oil will level off at $75 per barrel by the fourth quarter, the bank says.

Credit conditions

The view from the risk specialists is always instructive, and ratings agency Moody’s foresees a fairly resilient recovery over the next couple of years.

“Credit conditions will stabilise as we go into 2022,” says Elena Duggar, chair of Moody’s macroeconomics board and chief credit officer for the Americas. “But debt levels are at an all-time high for governments and corporates, so liquidity risks come to the fore.”

Not everyone is in the same boat, however. In advanced economies debt servicing costs are going down even as debt goes up, but emerging markets are in a different position, Ms Duggar points out.

“Over the past five years, their debt servicing costs have been starting to rise,” she says. “Their metrics are deteriorating, and emerging markets are more vulnerable where funding conditions tighten, especially if the recovery lags.”

Having peaked at the end of 2020, corporate default rates are now falling. Defaults among speculative grade corporates hit a high of 6.8% in late 2020, but are expected to stabilise at 1.5% to 1.7% in the first half of next year. “They could rise again to 2% by September 2022, because monetary policy will be less accommodative,” Ms Duggar says.

She notes that banks entered the Covid-19 pandemic situation in better condition than they entered the financial crisis, and have weathered it quite well. The agency expects non-performing loans to pick up “a bit” as government supports are withdrawn, and there will be an impact on capital ratios. Overall, however, banks will emerge looking relatively healthy, Ms Duggar believes.

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