Global equity markets have gradually shrugged off some of the uncertainties created by the discovery of the new Omicron variant a few weeks ago. Markets are once again approaching their highs for the year. The renewed strength has been supported by reports that the Omicron variant may be more transmissible but cause less severe illness, and that vaccines may still offer people some degree of protection. This has reassured investors that the risk posed to the global economy may be small.
Below, we offer some thoughts on the year ahead, which we believe has the potential to deliver another good, albeit less spectacular, year of gains for investors.
Our underlying view for 2022 is that it will be a year marked by some moderation in trends. Rising levels of vaccinations and natural immunity, combined with less morbidity from continuing circulation of COVID-19 variants, should gradually lead to a more normal environment. We expect some reversion in some of the most influential factors that typically drive equity returns: inflation, growth and central bank support.
Inflation has been on the rise throughout 2021. In some countries, it sits at levels not seen in decades. Since inflation is calculated as a year-over-year price change, recent readings have been based on price levels in effect when the impact of the pandemic was most severe. As we move through 2022, price levels will be compared to levels from 2021, and thus inflation readings should begin to recede for this reason alone. In addition, some of the supply chain pressures that have plagued many industries are expected to ease. At the same time, the exceptional demand for goods should eventually recede and shift back toward demand for services, as conditions normalize and the hospitality industry experiences a long-awaited revival. Overall, we expect that these factors will lead to a moderation of inflation in affected pockets of the economy. Nevertheless, inflation may remain higher than we have been accustomed to, underpinned by wage pressures formed as a result of labour shortages and the elevated level of job openings.
We expect economic growth to moderate in the year ahead. GDP growth in many major economies will be in the mid-single digits this year, which is exceptional for the developed world and meaningfully higher than the low single digits seen prior to the pandemic. Corporate earnings growth around the world has also been abnormally high. Much of this strength has been the result of the rebound following last year’s declines, but earnings growth next year still has the potential to be above average. Economies have yet to fully reopen in a synchronized way, production has been limited due to supply chain issues, inventories remain historically low and need to be rebuilt, and households have high savings and may be eager to spend. All of these factors suggest that earnings growth has the potential to remain robust.
Central banks have started to unwind some of the exceptional amounts of stimulus provided to economies over the past two years. Over the next week, the Bank of England and U.S. Federal Reserve are expected to provide policy decisions. Regardless of the outcome of these decisions, the future direction is clear: less stimulus and the possibility of tighter monetary policy in the year ahead. While this may create some bouts of volatility as investors digest the implications, we believe it will take time and several interest rate increases before credit conditions become more restrictive and present a headwind to economic growth. These conditions are more likely to arise in 2023 or 2024 rather than next year.
Overall, we expect the backdrop in 2022 to be characterized by healthy economic and earnings growth, modestly lower inflation and an interest rate environment that will remain favourable for consumers and businesses. These conditions will be supportive for equity markets. As always, there will be risks, both known and unknown, that investors will have to grapple with. In addition, stock market valuations are higher than historic averages, particularly in the U.S. These valuations do not, however, imply that there is an imminent risk to equities. Investors should, however, manage their expectations, prepare for more moderate returns over the foreseeable future and ensure that they have well-diversified portfolios that are not overly exposed to any one particular asset class or sector.
As the year winds down to a close, we would like to wish you and your loved ones a safe and happy holiday season. We look forward to returning in 2022, and plan to continue sharing our thoughts and perspectives in what should be another interesting year for investors.
Should you have any questions or would like additional information, please feel free to reach out.
Drew Pallett LL.B., CFP Vice-President & Director, Investment Advisor and Portfolio Manager
RBC Dominion Securities