Market Drivers - December 2021
Risk assets ended 2021 on a strong note. December saw risk assets rise strongly despite the potentially growth crimping threats from rising Delta and Omicron infection rates. For the most part 2021 and December were influenced by stronger than expected economic activity and faster than expected rise in inflation with governments and central banks barely starting to stem very easy policy settings.
While government bond yields rose through 2021 and in December the increases were small relative to the increase in inflation. Slowly rising but still low interest rates provided key support for risk asset markets during 2021, but the threat of faster rising interest rates in 2022 will turn support for risk assets to headwind.
Inflation is proving to be higher and stickier than expected by all forecasters. Supply chain problems are taking longer to resolve and are being made worse currently by the rapid spread of the Omicron variant, increasing absenteeism in key industries already struggling to source labour. In Europe and the US supply chain problems are still worsening, rapidly increasing producer prices. Europe’s producer prices rose 23.7% y-o-y in November, up from 21.9% in October. This week on Thursday the US is expected to report that December producer prices rose around 9.8% y-o-y, up from 9.6% in November. The day before the December producer prices report the US December CPI is expected to rise to 7.0% y-o-y, the highest annual inflation reading in 40 years.
Central banks are being jolted by persistently high inflation readings but are still reacting far from fast enough to reduce the policy accommodation feeding inflation. The RBA is moving slower than its peers, partly because inflation has risen less so far than overseas, but also because of institutional stickiness in wage setting in Australia causing wages to rise comparatively slowly – although when they do rise eventually multi-year enterprise agreements mean higher wage growth becomes entrenched for longer. The RBA will also view the current huge wave of covid infections in Australia as a threat to demand adding to reasons for policy caution.
While many overseas central banks including the US Fed, European Central Bank, and the Bank of England will hike official interest rates possibly several times through 2022, the RBA will continue to try and hold out although the risk is that it may have to do more later.
Returning to what happened in December and in 2021 and taking government bond markets first, the US 10-year bond yield rose in December by 7 basis points (bps) to 1.51% and marking a 60bps lift in 2021. The 30-year treasury yield rose by 11bps in December to 1.90%, up 26bps in 2021. The lift in longer-term US bond yields seems an extraordinary under-reaction to annual US inflation lifting from 1.4% y-o-y in December 2020 to probably 7.0% in December 2021 and the Fed forced to pivot from indicating no official interest rate hikes in 2022 and 2023 at the beginning of 2021 to now at least three hikes likely in 2022 and more to come beyond.
Confirmation of the Fed’s pivot on rates in the minutes of its December policy meeting released last week caused the US bond market to suffer its worst New Year start on record. In the first week of 2022 the 10-year bond yield has risen 25bps and 30-year treasury 22bps. We see US bond yields erratically lifting higher during 2022 above 3.00% by year end.
In Australia, the 10-year bond yield fell by 2bps in December to 1.66% but was up by 70bps in 2021. It has risen 19bps to 1.85% in the first week of 2022. Australian annual CPI inflation looks set to run in 3% to 4% range through 2022 perhaps low enough to keep the RBA side-lined for much of the year but also high enough to keep the 10-year bond yield moving higher. We see the Australian 10-year bond yield pushing up towards 3% this year. We still doubt whether the RBA will be able to keep the cash rate unchanged and expect a rate hike in the second half of 2022.
As far as risk assets are concerned, rising interest rates will take a toll in 2022. 2021 was a very good year for share markets continuing to bubble along in December. Major share markets rose in December between 2.6% for Australia’s ASX 200 to 5.8% for Europe’s Eurostoxx 50. The US S&P 500 was up 4.4% to a record high. Over 2021 gains ranged from 4.9% for Japan’s Nikkei to 26.9% for the US S&P 500. Australia’s ASX 200 rose by 13.0%. Strong global growth plus rising inflation and low interest rates boosted company earnings everywhere, especially in the United States. It was also an environment that encouraged speculation in companies with high potential sales but no or low earnings.
While high growth and inflation may continue to lift company earnings during 2022 the pace of the lift will slow. Companies and households will need to contend with higher borrowing costs, a new experience for many. We see volatile share market trading and a much greater focus on companies with strong earnings potential in more challenging economic conditions.
Credit spreads mostly narrowed in December and traded substantially narrower over 2021. Rising interest rates will challenge weaker corporate credits in 2022, more particularly in the US. Australian credit may prove comparatively resilient. The household sector has built up a savings pool during 2021 and the unemployment rate is touching the lowest rate in 12 years and likely to move lower in 2022. The RBA will be slower to hike its cash rate than its peers internationally. There is no immediate impairment to Australian credit quality in prospect. Australia will not be immune if credit spreads widen internationally but deterioration should be small.
In the absence of an unforeseen factor rapidly reversing the rise in inflation and the likelihood of central bank rate hikes, 2022 will offer much smaller asset class returns to investors than 2021 and the possibility of falling returns on the most interest rate sensitive assets.