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2021 in review, 2022 in preview

What were the key market and economic events of 2021 and what could we expect to see in 2022? From the reopening of economies and a surge in inflation, to emerging doubts around China’s economic model, Senior Investment Manager George Lin recaps the year and provides an outlook for the next 12 months.

       Written by George Lin
Senior Investment Manager | Colonial First State
   

2021 review

Vaccines enabled global economy to reopen

The most significant drivers of the global economy are the availability and pace of vaccination and the re-opening of economies. With the approval of several vaccines in early 2021, the main developed economies started aggressive, mass scale vaccination programs. While the level of vaccinations varied across countries, the overall results are better than expected. Most developed economies have achieved a vaccination level of around 70%. These are impressive results given logistical challenges and vaccine hesitancies. However, the emergence of the more infectious Delta variant means that the threshold for herd immunity is significantly higher, leading to waves of pandemic and episodic regional lockdowns. By the end of 2021, most of the main developed economies have adopted a “living with the virus” approach which reduces the level of economic disruption. The major exception is China, which continues to adopt a strict zero tolerance policy. Given China’s importance as a manufacturing hub, this contributes to the significant dislocation in global supply chains and inflationary pressures.

Source: World in Data as at 4th Dec 2021

A strong but uneven economic recovery in 2021

The main developed economies enjoyed robust, if uneven and volatile, economic growth in 2021. Episodic outbreaks of the pandemic led to more localised lockdowns and disruptions which were temporary in nature. Among the major developed economies, the US will likely record GDP growth of around 5.6% in 2021, compared to 5.0% for Europe, 2.3% for Japan and Australia’s 3.8%. While those figures are inflated by the Coronavirus driven low GDP levels in 2020, they still represent a very sharp economic recovery. China, despite negative headlines and sharply decelerating growth in the second half of 2021, will likely grow by around 8.0% in 2021 which is still a very robust result.

Inflation emerged as a threat to easy monetary policies

A key development in 2021 is the sharp increase in inflation in a number of developed economies. The US recorded 6.1% annual inflation by November 2021, its highest level in 20 years. Inflation also rose sharply in Europe and Australia. There are several common drivers behind the surge in inflation in developed economies. Firstly, a rapid recovery in demand driven by demand for goods, as social distancing measures and fear of the pandemic depressed demand for services. Secondly, dislocation in the supply chains severely reduced the supply side response to the increased demand for goods. The best example is the sharp increase in automobile prices as manufacturers struggle to maintain production in the face of a severe shortage in microchips. Thirdly, the re-opening of service sectors led to sharp, if temporary, increases in items such as air tickets and hotel prices in some countries. Finally, a sharp increase in global energy prices was experienced from the September quarter.

Source: Factset

The surge in inflation has led to increasing scepticism of the abilities of the main central banks to continue their extraordinarily accommodative monetary policies. Since the middle of 2021, a number of central banks have already tightened monetary policies, either via reducing the size of their bond purchase programs (tapering) or by increasing cash rates. The world’s most important central bank, the Federal Reserve, announced in November that it will taper its asset purchase program by $15 billion per month and hinted that it is prepared to undertake a faster tapering. The Reserve Bank of Australia (RBA) abandoned its yield curve target of 0.10% for three year bond yields in early November, after the relevant yield rose to over 1.0% for several days before the announcement. While both the Federal Reserve and the RBA have signalled that they would not raise policy rates in 2022, financial markets hold very different views and have priced in three rate increases by the Federal Reserve and two rate increases by the RBA before the end of 2022.
 

List of Major Developed Market Central Banks Tightening Monetary Policies in 2021
Increase in Policy Rates Taper - Reduce the Size of Asset Purchase
  • The Norwegian central bank raised rates in September.
  • The Reserve Bank of New Zealand raised rates in October, and again in November.
  • The Bank of Canada on October 27 unexpectedly ended quantitative easing (QE) and announced rates would likely be hiked in mid-2022, almost a year sooner than expected.
  • The Reserve Bank of Australia reduced its bond purchase program by $1 billion per week to $4 billion per week, starting from November, and abandoned its yield curve control target.

More doubts on the Chinese economic model

Over the past 10 years, the world has grown used to China’s status as an economic powerhouse with high GDP growth. China is also an emerging financial superpower as it liberalises its financial markets. This confidence was badly shaken in 2021.

Chinese economic growth has steadily declined over the past 20 years. This trajectory is not dissimilar to that experienced by other Asian economies (Japan, Taiwan and South Korea). As a country industrialises and gets richer, the pace of economic growth tends to decline over time as some of the early gains become difficult to replicate. The concerns with China are not about shorter term, cyclical economic weakness but the longer term direction of the country.

The trigger for investors’ re-assessment of Chinese economic growth started with the crackdown on the internet sector in mid-2020, triggered by official sanctions against the un-authorised US listing of Didi, China’s home grown rival to Uber. This quickly morphed into a high profile public campaign against the Chinese internet giants, including Alibaba and Tencent. The campaign comprises organised public vilification of the targets’ business practices, followed by harsh financial penalties and regulations which render existing business models un-operative. Private education, entertainment and media industries also came under this regulatory driven purge. Several leading business personalities, such as Jack Ma, were effectively removed from managerial positions. In many cases, prominent businessmen voluntarily donated significant proportions of their wealth to charities.

Investors’ confidence in China was already brittle when two further blows arrived in September. China Evergrande Group, a massive property developer, defaulted. The Chinese property sector has been weak since mid-2020 as the government tried to moderate the rise in house prices. China Evergrande Group’s problems have led to financial difficulties with other property developers and renewed downward price pressure. The property sector is critical, contributing as much as around 28% to Chinese GDP and is the main store of wealth for the Chinese people. Land sale is also a significant revenue contributor to local governments which are the drivers behind another growth engine – infrastructure spending.

China also experienced an energy crunch, when energy shortages led to rationing of electricity in many parts of the country, including the coastal provinces which are the country’s economic powerhouse. The causes of the energy crunch are a complex web of an overzealous push to reduce energy consumption at the provincial level, rigid control over electricity prices and an unwillingness to import Australian coal to meet the domestic supply shortfall. In short, a demonstration of the pitfalls of excessive control from the central government and ineffective policy making.

Strong returns from financial markets in 2021 – except bonds

Risky asset classes enjoyed a spectacular 2021 for the 11 months to 30 November 2021, powered by a potent combination of low interest rates, re-opening of economies and a strong earnings recovery. Developed equity markets returned 19.0% (hedged) and an even higher 24.0% (unhedged), while Australian equity markets returned 14.1%. Small capitalisation Australian shares outperformed large capitalisation and returned 14.7%. Emerging markets significantly underperformed global developed markets and returned 4.1%. The relative under performance was partly due to the poor performance of Chinese equities, as investors struggled with lower Chinese economic growth.
 

Asset Class Returns (1st Jan 2021 to 30th Nov 2021)
Asset Classes 2021 Calendar Year to Date
Australian Cash 0.0%
Australian Bonds -3.0%
Global Aggregate (Hedged) -1.3%
Global Corporate (Hedged) -1.2%
Global Sovereign Bonds (Hedged) -1.5%
Australian REIT (Hedged) 20.7%
Global REIT (Hedged) 23.2%
Global Listed Infrastructure (Hedged) 9.6%
Australian Shares 14.1%
Small Cap Australian Shares 15.3%
Global Shares (Developed Market, Unhedged) 27.1%
Global Shares (Developed Market, Hedged) 19.0%
Emerging Markets (Unhedged) 4.1%

Listed real assets delivered some of the best returns of all asset classes in 2021. AREITs returned 20.7% while global REITs returned 23.2%. The asset classes benefited from the same drivers as equity markets. In addition, some properties, particularly retail and office properties, were massively sold off in 2020 and benefited from very attractive valuation at the start of 2021.

In contrast to the spectacular returns generated by equity markets, bonds had a poor year as bond yields rose globally. Australian bonds delivered a -3.0% return, its worst return since the early 1990s. Global sovereign bonds generated -1.5%, while global corporate bonds performed better but still delivered a negative return

2022 outlook

Global economic recovery to continue

We are reasonably optimistic on the outlook for global economic growth. While central banks, in particular the Federal Reserve, and governments will reduce the level of fiscal and monetary stimuli in 2022, private sector demand should further recover to fill this gap. Global economic growth will likely be lower in 2022 but the main economies, with the exception of China, are still expected to generate above trend economic growth. A note of caution – economic growth will likely revert back to long term trend by 2024.

The current rate of inflation in the developed economies will moderate somewhat over 2022 as some of the bottlenecks in supply chains ease. However, inflation will be more persistent in this cycle, compared to the past cycle which started after the global financial crisis of 2008. Higher inflation will translate into more challenging monetary policy environment for the main developed central banks as they attempt to balance the need to control inflation with the need to maintain strong economic growth. Our base case is that the main central banks will tighten monetary policies in a measured and cautious manner. Given the persistent, if diminishing, threat of Coronavirus and the high level of public sector debt, central banks’ strong preferences are slow and steady monetary tightening.

Source: Factset

The outlook for financial markets is considerably more uncertain than 12 months ago due to the withdrawal of central banks’ liquidity. We still retain a weak preference of equity over bond but we caution investors that global equity markets are unlikely to replicate their stellar 2020 performance and will be more volatile. More cautious and risk adverse investors should consider allocations to alternatives which have low correlations with both bonds and equities.

We think nominal bond yields will rise further in 2022 as inflation in the main developed markets stay at the upper end of the central banks’ target ranges. However, real bond yields will likely remain negative since central banks are reluctant to aggressively tighten policy. US bond yields look particularly vulnerable given the Federal Reserve has started to reduce the pace of its asset purchase program. Financial markets currently expect three increases in the US cash rate before the end of 2022. We think this may be too aggressive but two rate increases by the Federal Reserve are likely.

There are several reasons for our cautious optimism on equities, despite their expensive valuations compared to historical norms. Firstly, earnings momentum for equity remains strong and will likely stay positive in the near term. Admittedly, earnings momentum will probably weaken as 2022 progresses, given the gains from the re-opening of economies dissipates. Secondly, equities will likely remain attractive relative to bonds as long as the rise in bond yields is modest. We leans toward the view that a correction in global equity markets is more likely a mid-term correction. Investors who seek higher returns and with a high risk appetite may consider “buying in the dip” if such a correction eventuates.

Factset as at 30 November 2021
Factset as at 30 November 2021

We discuss below the main risks to our reasonably constructive base case for 2022.

 

COVID-19 remains a tail risk

As the world approached the end of 2021, the main developed economies faced another wave of the pandemic. European countries were already experiencing a surge in new cases, with Austria announcing a 14 day national lockdown, even before the identification of the Omicron strand in South Africa. At this stage, Omicron is a serious concern but not a disaster. Evidence suggests that Omicron is likely more contagious than other variants (including Delta) but, given South Africa’s low vaccination rate of around 20%, the effectiveness of approved vaccines against Omicron cannot yet be determined, and its hospitalisation and mortality rates are also unknown.

The developed world is unlikely to revert to the early 2020 model of systematic, global lockdown. The availability of vaccines and the ability to tailor mRNA based vaccines are significant mitigating factors. However, Omicron may accentuate the different policy approaches to the pandemic by different countries. The United States, with a federal political structure which gives state governments significant control over health policies, and the strongest medical research capabilities, have an extremely high hurdle for nationwide, large scale lockdowns. On the other hand, the European countries seem to have less tolerance for high infection rates and are more willing to impose lockdowns. China will likely “double down” on its strict zero tolerance policy until the availability of domestic mRNA vaccines. Those differences suggests that if Omicron turns out to be more contagious and more deadly, the negative impact in European economic growth may be more significant than in the US.

A Chinese Economic Hard Landing is a Real Possibility

Chinese economic developments surprised the markets on the negative side over the last six months. Our base view is that a soft landing of the Chinese economy is still the most likely outcome in 2022. The reason is simple – the Chinese Communist Party (CCP) will hold its 20th Party Congress by the end of 2022. The event will mark the de facto coronation of President Xi as leader for life. Given this context, the CCP will use its many policy and administrative levers to ensure a stable economic and social environment.

However, this does not mean that it will be smooth sailing for the Chinese economy. The inevitable bankruptcy of China Evergrande Group will likely exacerbate the weakness in the critical property market. Consumer spending and corporate investment may turn out to be weaker than expected due to uncertainties generated by the Common Prosperity program. China’s insistence on a zero tolerance policy towards Coronavirus is another potential headwind. Finally, there is also the prospect of a policy mistake in an increasingly authoritarian society.

A weaker than expected Chinese economy will negatively impact the global economy. Given China’s dominance in demand for commodities, in particular industrial commodities such as iron ore, it will be a significant negative demand shock for those commodities and commodity exporters such as Australia. If the driver of a Chinese slowdown is Coronavirus driven, higher manufactured good inflation for the rest of the world is a potential outcome, given China’s role as a global manufacturing hub.

Inflation and central banks

The greatest risk to financial markets is significantly higher than expected inflation in the main economies leading to faster and more severe monetary policy tightening in 2022. The Federal Reserve is the central bank to watch, given the US Dollar’s status as the global reserve currency as well as the challenges faced by the US economy. The US economy is experiencing a lack of supply, centred on its labour force as the pandemic caused a sharp decline in the labour participation rate. Our base case scenario is those pressures will ease in 2022 as a combination of higher wages, re-opening of schools and higher vaccination lures more Americans to re-enter the labour force. However, there is a possibility that this process will be more drawn out than expected. Given the current high rate of US inflation, any negative external supply shock such as higher energy prices, driven by supply side disruption, or persistent bottlenecks in supply chains, may lead to a vicious cycle with expectations for higher inflation becoming more entrenched among both workers, employers and investors. Under such a scenario, the Federal Reserve will be forced to play “catch up” with financial markets.

While bonds are clearly vulnerable to an inflation shock, other asset classes are not necessarily immune. In particular, long duration assets such as property and infrastructure assets may be vulnerable. The downside for individual assets will be highly dependent on the ability of an asset to generate revenue increase to match inflation. Some growth stocks, with hefty valuation driven by strong expected earnings growth in the distant future, also look vulnerable.

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