DigitalCFO Asia | 4 February 2022
Monex Europe have outlined what they believe are the key thematic drivers for global markets in 2022.
Predicting events and their likely market impact over the next 12-months is always a difficult task, but the constantly shifting Covid-19 backdrop and the varying ability of policymakers to respond to its consequences has made this task all the more difficult over the past year. With trade ideas set to have a short shelf life in this environment, Monex Europe have opted to instead outline what they believe are the key thematic drivers for global markets in 2022, ranking them on their importance accordingly.
1. Variant Risk
Omicron has provided a stark reminder that the arrival of new variants still pose a risk to the global economy and financial market pricing. Given the prevalence and adaptability of the underlying virus, along with its impact on global growth and inflation conditions should it lead to a rise in new cases, variant risk stands out as the most obvious driver of financial markets in 2022.
To date, the arrival of each variant has been accompanied by more limited financial market volatility, as the underlying global economy is now better adapted to the tightening of mobility measures. However, this theme may not be extended into 2022, should vaccine efficacy be impacted by the arrival of new mutations – especially at a time where there is little scope to offset the economic damage with fiscal and monetary measures.
Under such a scenario, a traditional risk-off repricing, which has been observed in past variant cycles so far, is to be expected. The magnitude of such a repricing is likely to sit between that registered during the Alpha and Omicron phases, but will largely depend on how significant the health repercussions are. As everyone looks out to 2022 as a whole, the arrival of subsequent variants stands out as a likely major driver of price action, especially if it forces policymakers to tighten mobility restrictions again.
2. Persistence of Inflation & Central Bank Normalisation
The persistence of inflation and the central bank normalization race – with the word “transitory” now retired by Fed Chair Powell, the persistence of inflation, the progression of inflation expectations, and the role of monetary policy in containing any price spiral will be a dominant theme in 2022.
The arrival of the Omicron variant has only emboldened concerns around more persistent inflation and the potential for inflation expectations to become unanchored. Unlike during previous waves, surges in new cases are having a more limited impact on spending and jobs due to the less severe response from authorities. Instead, the rise in cases threatens to prolong issues around the already-stressed supply chains. As a result , most G10 central banks have adjusted their near-term inflation profile while also raising their expectations of peak inflation. In some cases, this has resulted in policymakers bringing
forward their estimates of policy normalisation.
While high inflation is a risk for 2022 in isolation, more entrenched inflation expectations are also a risk that central banks will have to pay acute attention to over 2022H1. Wage-price spirals and rising inflation expectations will only embolden hawkish central bankers, thus fueling price action in bond markets.
3. Post-pandemic Labor Marketing Scarring
Estimates of the pandemic’s impact on the labor market have dramatically changed over the course of the past 24 months. In 2021, as lockdown measures were lifted across the developed world and supply chain frictions remained, labor shortages were acute in the US, UK and eurozone. The changes in the nature of labor market scarring are visible in how projections from major central banks have changed throughout the pandemic. The unemployment rates were continuously revised downwards throughout 2020 and 2021 as it became clear the nature of this crisis and the supportive government schemes in major economies led to a different type of labor market scarring than initially expected.
Looking ahead to 2022, dynamics in the labor market will be closely monitored by both markets and policymakers. With the economic recovery maturing and the effects of the pandemic fading, the true impact on the labor market is likely to become more visible in 2022. This, along with inflation, will hold the key for policy normalization.
4. Terminal Rates
As central banks begin to normalize policy, a lot of focus will be on front-end rates. However, towards the end of the year, once the repricing in front-end rates slows, focus will quickly shift to intermediate yields and the projections of terminal rates. This will determine the steepness of most yield curves. Given the expectation that underlying economic assumptions are set to change once the post-pandemic landscape looks more navigable, markets are yet to buy into the central banks’ current longer-term projections.
Not only do markets doubt that 10-year bond yields will reach the heights that some central banks are calling for, but they don’t expect real rates to enter positive territory any time soon either. Whether this is due to supply/demand imbalances in longer-date bonds or strong inflation persistence is
largely beyond the point. The main takeaway from what forward rates are suggesting is that further bear flattening in bond curves next year is set to be a dominant factor until markets realign their expectations of terminal rates.
As markets spend most of 2022 repricing front-end rates in the G10 space and EM central banks start to run out of room in their fight against inflation, the focus will quickly shift in bond markets to terminal rates and the back-end of the curve as the risk of inversion draws closer.
5. Balance Sheet Reduction & The Impact of Sovereign Bonds
The pandemic saw more central banks adopt QE in order to stabilize sovereign bond markets during the onset of the pandemic and over the course of increased bond issuance. The magnitude of purchases in 2020 and 2021 far outweighed that of the financial crisis. Given the higher level of purchases, greater
emphasis is likely to be placed on the level of bond reinvestments and the active selling of assets over the coming years. While the Bank of England has already laid out plans for the sequencing of its normalisation process, other central banks continue to debate over the right time to reduce their balance sheets.
This was highlighted in the Fed’s December meeting minutes, with some participants favouring quantitative tightening in order to offset the bear flattening from rate hikes, and others favouring a two-year window between rate lift-off and balance sheet reduction like that of 2017. As for the Federal Reserve, the 2017 wind-down of assets received harsh criticism from market participants as they complained that money market liquidity was becoming unusually tight under the asset reduction and caused harmful volatility.
While even more cash is likely to be drained out of the banking system under the unwind this time around, the latest Fed minutes showed that money market liquidity is ample enough, while the Fed’s Overnight Reverse Repurchase Agreement Facility could also offset the impact. Moving forward, the focus will be on the sequencing of policy normalization and the role of quantitative tightening as this could induce further bond market volatility as liquidity conditions change while also having an impact on rate projections.
6. Political Risk
Numerous elections are scheduled for 2022 and range in levels of market impact. After a smooth electoral year in 2021, French and Hungarian elections in Europe, along with US mid-terms and Brazilian election in the Americas, are likely to see policy outlooks shift more dramatically than in Germany and Canada last year.
After smooth elections in Canada and Germany this year, the political calendar will pick up pace in 2022. From a market perspective, the most notable elections include the French presidential election in April, the Brazilian general election on October 2nd, and the US midterms on November 8th, but before then, the focus will be on more minor elections in Europe. Italy’s presidential election on January 4th starts proceedings with incumbent president Sergio Mattarella set to stand down despite being eligible for
reelection. Then, the focus will shift to Portugal’s legislative election on January 30th, when Prime Minister Antonio Costa is hoping to maintain power and improve his position in the snap election after his minority government was defeated in a key budget vote.
The impact of both is likely to be limited in relation to the French presidential election on European markets. The most impactful election outside of France within the European Union in 2022 is likely to be the parliamentary election held in Hungary in April. While no specific date is set, markets will be keeping a close eye on political dynamics in Hungary leading into April’s election as incumbent Prime Minister Viktor Orban faces off against United Opposition leader Peter Marki-Zay.
The repercussions of the election result are likely to be widespread as a shift in power could see Hungary realign more with the EU, thus enabling a smoother passage for policy, while also soothing geopolitical tensions in the area.
The final risk factor for markets in 2022 from a political standpoint is the US midterm elections. While the Senate midterms initially favored an increase in the Democrat majority due to more Republican seats being up for grabs, history tells us that incumbent parties tend to lose ground at midterms more often than not. The repercussions of losing either the House or the Senate, or both, are likely to be large for markets as it limits the Democrat’s ability to pass further fiscal support measures for the Build Back Better initiative. In this sense, November could mark the turning point for US fiscal policy.
7. Geopolitical Risk
The Russia-Ukraine crisis, US-Iran nuclear talks and China-Taiwan military exercises all stand out as known geopolitical risks heading into 2022.
Russia – Ukraine:
Tensions between Russia and Ukraine may escalate further throughout the coming year, but a large-scale invasion is unlikely as this would not be in line with Vladimir Putin’s preference for plausible deniability and subterfuge. Instead, Putin could aim to destabilise Ukraine, intimidate Nato, and force more concessions in talks to end the fighting in the Donbas without actually invading Ukraine. For this reason, any spill-overs to broader risk sentiment may be more muted, but an escalation in tensions is likely to play out in regional currency markets with RUB leading losses due to capital controls being imposed by Western allies.
China – Taiwan:
The recent escalation in military exercises by China near Taiwan has begged the question as to whether a large-scale invasion is on the agenda for 2022. Similar to Russia – Ukraine, an actual attack would risk severe economic repercussions for China as this would undoubtedly be followed by harsh sanctions from the US – China’s main trading partner. With China being highly dependent on the US both for exports and imports, it is unlikely China will take such a high risk, especially as their domestic growth profile matures. Additionally, logistics make a full-on invasion more difficult.
Should tensions between the two nations escalate more quickly, then this is more likely to filter through to overall risk sentiment in markets compared to the Russia-Ukraine situation as the global economic
recovery is dependent on China’s output. The risk-off reaction will lead into US dollar inflows, likely more so than the US-China trade war of 2018, given more would be at stake than just trade restrictions.
In the case of sanctions, these are likely to be related to imports/exports as there is arguably less scope for sanctions on China’s capital market access relative to Russia, given the world’s dependence on China’s growth and the large Chinese holdings of US assets. Although financial sanctions are unlikely, the impact on global risk may still be large should China – Taiwan tensions escalate given recent inflows into Chinese assets that could reverse aggressively as risk sentiment sours.
Iran – USA:
Negotiations around the easing of sanctions and a revival of the nuclear deal are likely to extend well into 2022. Tensions between the US and Iran have been heightened recently amid the negotiations as Iran asked for more concessions in the latest proposals which the US does not agree with. The first formal talks on how to restore the 2015 nuclear deal were suspended in December, with Europe warning that Iran had walked back all previous diplomatic progress and fast-forwarded its nuclear programme.
Talks were suspended for a few weeks but resumed in January and are now said to be making modest progress. The talks could create large uncertainties for the 2022 crude oil outlook as negotiators reconvene time after time, although the negotiations failed to show enough of a breakthrough for markets to meaningfully respond. Should a revival of the deal be accompanied with an easing of sanctions, then this would spark volatility not only in commodities, but other linked assets such as petro-linked currencies.
Unlike in the aftermath of the global financial crisis, increased capex spending in 2022 is set to be a dominant theme as loose financial conditions, diversification of supply chains, and tight labour markets all support increased investment.
Unlike the aftermath of the global financial crisis where global investment took two years to return to the pre-recession peak, the post-pandemic environment is set to be dominated by capex. Throughout the pandemic, firms have been battling with supply chain disruptions leading to higher input prices, depleted inventories, and suppressed margins. However, with the demand outlook set to be supported by robust household balance sheets rising wages as labor market slack diminishes, businesses are expected to not only diversify their production methods, but increase output too. Layering on top of that the transition towards green energy, the tech boom, and still favorable financing conditions in developed markets, the macroeconomic environment next year looks set to be defined not only by inflation but also by capex.
Both soft and hard data in the US suggest Capex is set to pick-up post-pandemic as companies adapt to supply issues and robust demand conditions. The impact this is set to have on financial markets outside of equities is likely to be a bit more nuanced. Firstly, increased capex tends to go hand in hand with productivity gains. If this is the case, rising wages may not be reflected in rising inflation from a cost-push
perspective. Secondly, cross-border investment flows are likely to increase, which will likely lead to greater liquidity in corporate debt and FX markets.
9. Fiscal Consolidation
With Covid risks fading and the global economic recovery in full swing, fiscal authorities are likely to start prioritizing fiscal consolidation in order to minimize the pile of sovereign debt amounted after March 2020. Following unprecedented fiscal expenditure in 2020 and 2021, next year looks set to be defined by fiscal consolidation as the global recovery matures and Covid risk diminishes.
Signs of such policies and increased opposition to further spending are already visible in G10 economies. In December, President Biden’s $1.75trn Build Back Better legislation went up in flames after losing the support of Senator Joe Manchin, while in the UK, the Autumn budget saw plans for national insurance contributions and dividend taxes to rise by 1.25%, in order to raise £12bn per year as of April 2022. While the level of consolidation is unlikely to be dramatic this early on in the recovery, the fiscal cliff still poses a threat to the global economic recovery, as the withdrawal of stimulus is likely to come at a time when monetary conditions are also tightened.
10. Fiscal Stability Risk
As monetary conditions tighten, financial stability risks become more prominent. China’s housing market deleveraging is the most obvious financial stability risk, but rising asset prices globally are at risk of a severe moderation as the risk free rate begins to rise.
Concerns around global financial stability fluctuated throughout 2021, but most apparent risks have yet to be resolved in their entirety heading into 2022. The largest financial stability risk comes in the form of China’s real estate crisis and the implications that could have not only to domestic growth, but the global financial system as a whole, given the aggressive FDI inflows into China over the course of the past twelve months. While authorities have drawn a line in the sand when it comes to bailing out real estate
developers, such as Evergrande, they have shown willingness to limit the spillover effects in the credit market by easing monetary policy at the margin.
With the deleveraging of China’s real estate market held together by very fine margins, China’s
housing market could be the biggest story of 2022 or a damp squib. Whilst China’s property market isn’t the sole source of financial stability risk, it does pose the largest threat to the global financial system. On a more localised scale, concerns remain elevated in New Zealand and Canada over the rise in house prices since the onset of the pandemic, with macroprudential measures implemented over the past year in order to limit the risk of high leverage ratios.
With 2022 bringing tighter monetary policy in Canada and New Zealand, concerns will remain over the rise in variable rate mortgages and default risk, especially if interest rates rise too quickly. On a larger scale, the sustainability of global debt levels is another stability concern, especially as pandemic policies are wound down. While most central banks aren’t close to actively withdrawing their presence in sovereign debt markets, the sustainability of high debt-to-GDP ratios remains a concern. Finally, shifting risk appetite must be noted as another key source of vulnerability, as the global economy transitions out of a low interest rate environment. As rates begin to rise globally, financial market volatility may pick up once again as lofty asset prices are reconsidered now financing conditions shift. This may be amplified by
altering prospects for growth, inflation and interest rates from the current consensus.
11. Europe’s Energy Reliance
Europe’s green transition towards renewable energy sources has economic vulnerabilities that were highlighted in 2021. With the transition set to be inflationary, especially as inventories and storage capacity remain areas of concern, rising spot prices for traditional energy sources are likely to remain an area of focus for markets.
Surging energy prices were a topic discussed in every single newspaper in the last quarter, as demand remained strong amid colder temperatures and economic reopening while supply issues arose from low inventories, topped with lower wind energy creation amid the green transition and delayed repair work due to the pandemic. The majority of these issues are set to subside in spring, but some of the broader themes will continue to dominate news headlines over the next year.
UK inventories have been down since the closure of the nation’s largest gas storage site in 2017, which means the UK now relies upon imports from other European countries. Gas supplies to these countries has also been limited more recently, as Russian gas flows to Europe through a major transit route to Germany were capped regularly over the last months, worsening the European energy crunch. With
energy tariffs set to be adjusted in the UK in April and rising energy costs in Europe set to fuel inflation pressures further in Q1, the focus of higher energy costs is unlikely to abate heading into Q1. Throughout the year, focus may remain on gas supply given the political connotations it has due to the EU’s reliance on Russia for supply.
12. The Disruption Caused By Crypto
While there may be no formal study on the impact of cryptocurrencies on the traditional currency space, most traders will attest to the fact that the uptake in crypto more generally has been a disruption FX markets. With analysis into centralized digital coins like central bank digital coins set to continue, expect to hear a lot more about the uptake in crypto over the course of the next 12 months.
The past 24 months in financial markets can’t be discussed without referring to the growth in retail trading and the continued advancement of cryptocurrencies – whether as a speculative vehicle or a store of value. The advancement in central bank digital coins has also raised questions about what the future of financial services payments will look like; whether corporates and individuals can hold accounts at the central bank or whether the coins will be available to the real economy via the traditional banking system. While it is not expected that crypto based assets will be substantially more disruptive to the traditional financial system in 2022, many can expect to see continued developments in their availability and institutional adoption.
All in all, these are the 12 key themes of 2022 that Monex Europe believes will affect the finance industry. Though many of them may be looked at as negative effects to the financial landscape, they are also driving the countries to work towards change as they will need to come up with strategies and implement policies to overcome these challenges. With that said, 2022 may become the best financial year when the cards are played right.