Recovery has legs. What are the new year’s challenges?

We went into 2021 with confidence about the economic recovery and financial returns, as was highlighted by Generali Investments’ 2021 Outlook: Repair and despair. Global growth beat optimistic expectations, and so did equity markets. The key question, as we enter 2022, is whether the surge in inflation that has come with the policy-induced recovery, will prove sticky or not. Partly, probably. And more so that the recovery has legs, with consumer spending and capex (capital expenditures, i.e. money used by an organization to purchase, improve, or sustain physical assets) likely to keep the cycle going for longer.

The global recovery is in fact set to extend in 2022, but at a slowing pace, as discussed in Generali Investments’ analysis for its 2022 Outlook: Bye Bye Beta. With many economies having recovered pre-pandemic ground, governments and central banks will cautiously withdraw their support. Consumption, cushioned by high savings, will remain the backbone of the recovery and capex is set to pick up especially in the US, helped by favourable financial conditions. Supply bottlenecks will gradually ease, with a shift of consumption towards reopening services (tourism, hospitality) helping to prolong the recovery.

Yet the outlook is complicated by risks from a policy mistake causing financial havoc, a disorderly energy transition seeing a surge in selected commodity prices, and a new Covid variant escaping vaccine protection. In particular, persistent inflation overshoots risk de-anchoring inflation expectations (especially so in the US), entailing the risk of a stronger response by monetary policy, while high price pressure would dent real disposable income.

Such dynamics are also confirmed by the latest studies from the International Monetary Fund (IMF) and the World Bank, showing that global economic forecasts for 2022 are less optimistic than last year’s projections would have led us to believe.

In the most recent update of the IMF’s World Economic Outlook, published on January 25^th, it is noted that the global economy starts 2022 “in a weaker-than-expected” position, with global growth set to slow from 5.9% in 2021 to 4.4% in 2022; the latter estimate is half a percentage point lower than that of its October report. The IMF’s forecasts have been affected not only by new Covid-19 variants, notably Omicron, but also unexpectedly steep increases in inflation rates, particularly in the United States and many emerging markets and developing economies.

The two leading global economies, the United States and China, will see lower growth rates in 2022 than those predicted in 2021: 4.4% in the USA (-1.2% compared to October’s predictions) and 4.8% in China (-0.8% compared to October’s predictions). The IMF has also downgraded its 2022 growth estimate for the Eurozone to 3.9%, 0.4 percentage points down from the October report.

The outlook released by the World Bank also predicts slower economic growth in 2022, following the strong rebound of 2021. In its Global Economic Prospects report, the World Bank forecasts that global growth will decelerate from 5.5% in 2021 to 4.1% in 2022. This slowdown will hit advanced as well as emerging and developing economies: in advanced economies, growth is predicted to soften from 5% in 2021 to 3.8% in 2022, a pace that, although moderate, will be sufficient to restore output and investment to their pre-pandemic trend in these economies; however, in emerging and developing economies growth is expected to slow from 6.3% in 2021 to 4.6% in 2022.

Once again, one of the factors greatly affecting the economic situation of the current year is a worrying rise in inflation. Its effects are clear: the cost of heating in much of Europe has doubled and food is less affordable in places such as sub-Saharan Africa and Brazil, leading to lower consumption especially in industrialised countries.

In December 2021, the US recorded a 7 percent price growth, compared to 0.1% in May 2020 and a contraction in consumption of 0.6%. Investors are starting to worry about the Federal Reserve’s aggressive stance. Some are concerned an aggressive interest-rate-hiking cycle, combined with a reduction in stocks held, could cause too sharp an economic slowdown or even a new recession.
Such recent shift has also put significant pressure on Europe, where rising costs of energy have already heavily impacted real wages, leading to a squeeze on margins, which is weighing – and will continue to weigh – on private consumption. In December, inflation in the Eurozone stood at 5% compared to 2020 and, according to the European Central Bank (ECB), it should remain at around 3.2% in 2022, above the 2% target.

Nonetheless, while the ECB can do little to influence the Fed, it has been strenuously trying to convince markets that it is not going to blindly follow the example of the US, where both core and wage inflation are higher. Christine Lagarde, ECB president, has downplayed the chances of a “measurable tightening” of monetary policy to tackle this year’s record eurozone inflation, explaining that any shift would be gradual, although recent inflation trends make interest rates more likely to rise already in 2022.

In conclusion, as the global recovery continues in 2022, albeit at a slower pace, and even though a hawkish Fed is not the only risk, the key question for the economy and global markets is how they will adjust to an accelerated monetary policy normalisation, in the context of persistent inflation, evolving pandemic scenario, risks of bottlenecks in the global supply chain, and worries about European energy supplies amid Ukraine tensions. Resilience is generally to be expected, but with two significant differences in the new year compared with 2021: much lower financial returns and higher volatility.