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Equities held their ground in December despite being faced with two factors that could have led to sharp falls: The resurgence of Covid infections and US monetary policy becoming less dovish.
Concerns grew over the risks to global growth from the worsening pandemic, particularly with the Omicron variant leading to renewed lockdowns, quarantines and international travel restrictions.
While the data on the severity of the strain is still patchy and many unknowns remain, investors appeared optimistic that the latest outbreak would not cramp the global economy recovery.
China adopts a more supportive economic policy
With the Chinese Central Economic Work Conference labelling ‘stable growth’ a priority for 2022, signs have emerged in the country of a more assertive economic policy to support investment and confidence.
Together with the People’s Bank of China’s (PBoC) easing of monetary policy in mid-December, the shift in Beijing’s stance appears to have reassured investors at a time when the country imposed strict lockdowns in cities hit by the virus, leading to a slowdown in consumer spending.
Growth and virus concerns meant Chinese equities were a major driver of emerging market underperformance in 2021.
Central banks’ narrative is changing
While bond markets weakened on the prospect of lower central bank asset purchases and higher key interest rates (already seen in the UK and expected this year in the US), equities managed to post gains. The Bank of England’s rate rise was not surprising. Equally, signals from the US Federal Reserve that it, too, would move to tighten policy had been anticipated.
However, observers had not been expecting a precise roadmap from the ECB on the reduction of its asset purchases from March 2022. The central bank indicated that after the end of its pandemic emergency purchase programme (PEPP), its ‘normal’ asset purchase programme (APP), currently at EUR 20 billion a month, would be increased to EUR 40 billion in Q2 2022 and EUR 30 billion in Q3 before returning to EUR 20 billion a month in Q4.
In 2021, average monthly purchases under the PEPP had been EUR 80 billion, so the amounts in 2022 will be significantly lower. The figures announced by the ECB matched the most pessimistic economist forecasts.
Against this backdrop, given the large amount of bond issuance expected in the first few months of the year, ‘peripheral’ eurozone bond markets underperformed as long-term yields rose. Compared to the end of November, the yield on the Italian 10-year BTP rose by 21bp, while the spread over the German 10-year Bund widened to 135bp, the highest level in more than a year.
Equities held their ground
Global equities posted a monthly rise of 3.9% (MSCI AC World index in US dollar terms), taking the annual gain to 16.8%. Emerging markets, which are more exposed to the fallout of rising US rates, underperformed. The MSCI Emerging Markets index gained only 1.6% in December. Over the year, it lost 4.6%.
Within developed markets, eurozone equities outperformed in December (+5.8% for the EURO STOXX 50), followed by US equities (+4.4% for the S&P 500, which set a record on 29 December) and the Japanese indices (+3.5% for the Nikkei 225). Beyond the factors mentioned above, buoyant year-end data – particularly on employment – contributed to the gains.
Globally, utilities, consumer staples and real estate were the outperformers in December.
2022: Keep calm and carry on
The Omicron-led wave is driving renewed nervousness in equity markets, and even more so in bond markets where the implied volatility of US Treasuries (measured by the MOVE index) ended the year close to its highest level since the spring of 2020.
The change in tone from central banks, especially the Fed, and the prospect of reduced asset purchases (tapering) and higher key rates, led to big moves in yield curves.
Equities benefited from a favourable medium-term scenario. Domestic demand, supported by improved employment and household incomes, has been solid. This should allow corporate profits to rise and economic growth to exceed its long-term trend rate in 2022.
The growing consensus view is that the Omicron outbreak will have a limited impact and be short-lived. While it could prolong supply constraints and stymie demand for services, the view of central banks is that it will only delay, not halt, the economic recovery.
While exceptional quantitative easing (QE) policies are likely to end in 2022, central banks are likely to tread cautiously when it comes to normalising policy rates and the size of their balance sheets.
Prolonged high inflation is the main risk. A possible de-anchoring of inflation expectations would translate into higher bond yields and expectations of faster monetary tightening, creating a much less favourable environment for equities, especially as valuations are already high.