In 2021, many of us piled into a buoyant share market using our pent-up savings. But investors might see lower returns in 2022, suggests Mark Riggall of Milford Asset Management.
Many have called the Covid-19 pandemic a once-in-a-generation event. For investors, the once-in-a-generation event was not the pandemic itself. It was the massive policy response from governments and central banks that followed it. This medicine, administered to a pandemic-stricken global economy, was so strong that it jolted the economy back to life and gave us a ‘V’ shaped economic recovery. Asset markets, including property, shares and even cryptocurrency, enjoyed stunning rallies as cash injected in financial markets and delivered to households found its way into investments. Investors were emboldened by a profit boom from companies enjoying the economic recovery.
Two big questions
As we look ahead into 2022, investors must consider two factors.
- Firstly, how quickly will policymakers withdraw their medicine by raising interest rates or taxes?
- Secondly, how quickly will the side effects of the medicine, namely a massive inflationary shock, take to wear off?
These two variables will be key to what we see in the financial markets next year. It’s worth noting that there were variations in different countries’ approaches, but by and large the template was the same around the world and so was the outcome – globally high asset prices and globally surging inflation.
Around the world, governments’ responses to the pandemic were bigger than anything seen since the Second World War. Cheques were handed out to businesses and households, so that incomes could weather the pandemic storm. These payments are now largely complete, but it’s likely that any further social restrictions will be met with further income support. Even if the pandemic goes away faster than expected, there seems to be little appetite to raise taxes on anyone. Last year’s government spending will not be repeated, but there’s unlikely to be a drag on economies from governments looking to balance budgets. So, households who’ve built a large store of savings needn’t be too concerned about governments asking for it back in taxes.
Shock and awe
The monetary response from central banks was an exercise in shock and awe. Interest rates were slashed to zero (or lower) globally, and bond market purchases dwarfed anything seen in the global financial crisis (GFC). This benefited economies because we saw a lower cost of borrowing.
For investors, low interest rates justified higher valuations on many assets, including property (through lower mortgage costs) and shares (with lower discount rates). In a world where bonds offer paltry yields, investors have increasingly been drawn to shares to get superior returns. Looking ahead, central banks have seen the surge in inflation and are slowly questioning the need for policies to stimulate their economies. This means fewer bond purchases, as well as interest rate hikes over the course of 2022.
It’s unlikely that monetary policy will be restrictive at that point, but it will be a fading tailwind for some time to come. For any investor, the starting point – current valuations – matter. On that front, share markets look broadly expensive versus historical profit multiples. Bonds are significantly overvalued. US government bonds offer around 1.2 per cent interest for the next five years. With markets expecting inflation to average over 3 per cent in that timeframe, the returns from bonds leave investors going backwards compared to the cost of living.
Household spending squeezed
The path of inflation is important for two other reasons. Firstly, higher prices will have an impact on our spending because our household budgets are squeezed. Secondly, some companies won’t be able to pass on rising input costs, which will reduce their profit margins. But with bonds unable to offer positive returns after inflation, investors will be forced to buy more shares because at least they give them the opportunity to deliver inflation-beating returns.
Not a good combination
So where does this all leave us? High valuations and fading tailwinds from policy are not a good combination for future returns. What’s more, the past two years have seen households investing significantly more into share markets as they’ve been adding their savings to funds and direct investments. All these factors lead me to the conclusion that investor returns next year are very likely to be lower than those enjoyed in 2021. However, the range of potential outcomes is particularly wide. We could see inflation subside quickly and policymakers keep interest rates low for longer.
A reopening global economy could see economic growth remain well above trend as consumers feel more confident and spend their excess savings. One thing is for certain, there will be surprises along the way. I’d suggest Investors focus on building long-term portfolios that can weather whatever storms come along.