Despite the rapid spread of the Omicron variant, equity markets recovered strongly following the late November setback and - as each COVID wave has less economic impact - investors appear to accept that disruption to activity is the new normal. There were useful gains across most major markets with the US and Eurozone up 4%, although Asia and emerging markets closed marginally lower. Bond yields rose over the month on higher inflation and the prospect of monetary policy normalising in 2022. Conventional and index-linked indices both recorded small losses.
2021 was a strong year for risk assets with a number of markets closing at or near all-time highs. Global equities returned over 20% and the US almost 30%. While the UK (+19%) lagged, the most significant outliers were Asia and emerging markets where a 7% appreciation in the dollar proved challenging. Sterling closed 1% lower at $1.35. Central banks continued their monetary and fiscal support measures enabling economic activity to rebound towards the underlying growth trend. However, there was a marked contrast between goods and services and increased demand for goods, combined with supply chain disruptions, resulted in a sharp rise in inflation towards the year-end. While vaccine availability helped limit COVID mortality, new strains and recurrent waves of infection accompanied by movement restrictions impacted services - particularly hospitality and travel.
Global GDP rose 5.7% after the previous year’s 3.5% fall
Advanced economies grew 5.2% and emerging economies 6.4% boosted by growth of almost 8% in China, albeit this had slowed by Q4. Low-income developing countries lagged significantly reflecting a lack of access to vaccines and limited policy support. The US (+6%) was a major global contributor with output above pre-pandemic levels. Although the UK (+6.8%) exceeded the US, the economy was recovering from a near 10% downturn in 2020 and output was still lower than pre-pandemic. This was also the case in Europe and Japan where GDP rose 5% and 2.4% respectively. The growth rate in Germany was a relative laggard within the Eurozone partly reflecting the economy’s less severe downturn in 2020.
Two unexpected pandemic outcomes were the extent and duration of the global supply chain disruption and the reluctance of employees in the developed world - predominately those in contact sensitive sectors - to return to work. These contributed to a sharp uptick in inflationary pressures late in the year and increasing concern that the impact would be less transitory than anticipated. Higher energy and transport costs accounted for much of the CPI increase. Oil production cuts agreed in mid-2020 meant less supply to meet the rapid rebound in demand and resulted in Brent closing up 50% at $79. Natural gas prices also rose sharply triggered initially by a change in China’s policy on coal usage. This coincided with depleted reserves in Europe as Russia cut flows to Germany prompting an energy crisis which saw a near ten-fold increase in EU gas prices. By the year-end, inflation had surged to nearly 7% in the US, 5% in the UK and Eurozone but only 0.6% in Japan. With companies reporting skilled labour shortages, average earnings in the US and UK increased around 5% year on year to November and unemployment fell towards 4%.
A main driver of the global recovery was accommodative monetary policy as central banks kept interest rates close to zero (negative in the Eurozone) and expanded their balance sheets to facilitate asset purchases. This helped suppress longer-dated bond yields and the cost of capital to business. Deeply negative real (inflation adjusted) rates in effect forced investors to channel capital into risk assets to seek returns. At the margin, this also provided speculators with near “free” money for mergers and acquisitions as well as a record number of initial public offerings. On the assumption that inflation would be transitory, central banks maintained their accommodative policy for most of the year before pivoting to a hawkish stance in Q4 as CPI continued to rise. The Bank of England was one of the first to raise rates by 15bp to 0.25% in late December and asset purchase tapering will start in earnest in Q1 2022. After rising sharply in Q1 as economic activity accelerated, bond yields followed a roller coaster trajectory correlated more to lockdown restrictions than CPI. By year-end, US 10 year yields were 50bp higher at 1.5% while UK gilt yields rose 70bp to 1%. 10 year Bund yields were negative throughout 2021 ending at -0.15%. Index-linked performed well as breakeven rates rose to near record highs.
After falling 11% in 2020, global corporate earnings rose just over 50% and significantly exceeded expectations at the start of the year. At the headline level, UK companies recorded the largest EPS increase of over 80% following an above average 35% fall in 2020. This also highlighted the extent to which energy and commodity companies distort the UK market. Excluding these, the improvement was around 40% or in line with most major regions. Earnings from companies sensitive to the economic cycle saw the highest rebound - notably industrials (+90%), consumer discretionary (+70%) and financials (+50%). By contrast, after a flat prior year consumer staples rose just 11%. Information technology, which was the only sector to emerge unscathed in 2020, reported another strong year with EPS growth of just over 30%. However, valuations and future prospects meant that share price performance did not always match earnings and leadership was narrowly based in some indices. The notable example was the US where the top five contributors - mainly IT companies - accounted for one third of the overall market gain.
The rate of global economic growth in 2022 is expected to moderate towards 4% which will still be above the longterm trend. While another surge in COVID infections may dent sentiment at the start of the year, policy error could be a more serious threat to GDP growth. Having pivoted from their transitory approach, central banks are now focused on withdrawing monetary stimulus and normalising interest rates to prevent inflation spreading from asset prices to the real economy. The potential risk is that overzealous corrective action coincides with a natural peak in supply chain inflationary pressures in H1. At this stage, we are assuming that economic activity and earnings will support equities and other risk assets but investors should expect more modest gains and increased volatility. The consensus estimate of 7% global corporate earnings growth is modest by historical standards with energy, industrials and consumer discretionary likely to see the highest growth. Materials may be the only major sector to report a decline. A forward valuation of 18x for global equities appears extended compared to the 13x long-term average although there are still regions, sectors and companies offering value.