2021 in review, 2022 in preview

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.

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.

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.

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.

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.