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By Elwin de Groot and Bas van Geffen, strategists at Rabobank

List the season

‘Tis the (most wonderful?) time of the year to make up our lists, a tradition that probably chimes with many of our clients. For markets, 2021 certainly was a special year. Government bond yields, on balance, moved higher on both sides of the Atlantic, with 10y UST yields up more than 50bps and Bunds up 28bps. But in inflation-adjusted terms we saw new record lows, which attests to the impact of central bank purchasing programmes. The 10-y German inflation-linked bond is still trading at -2.22%, within a whisker of its record-low yield set on 17 November. The dollar was a winner in 2021 (+4% YTD in trade weighted terms), but there were many losers. In fact, most currencies fell against the dollar, such as TRY (-40%), ARS and CLP (-17%) to name a few. RUB and CNY were among the happy few that gained. For equity investors, the Mongolian stock index made a smash, turning in 119% in local currency terms (same when USD hedged), followed at considerable distance by a 74% gain (60% USD hedged) in the Sri Lanka Colombo All Share index.

The European STOXX 600 index can boast almost 20% gains in EUR, although half of that melts away when measured in USD. Staying with Europe, as we are in the final weeks of the year the European Commission seems to have embarked on a last minute dash to issue proposals and plant some seeds for next year. On Tuesday, EU Commissioner Dombrovskis added his weight to the debate on Stability and Growth Pact reform, which is expected to gather steam next year, as the current ‘freeze’ of its most pinching rules will come to an end in 2023. According to the FT, Dombrovskis said that EU member states will need to make “credible plans” to cut their debts although he also confirmed that Brussels is contemplating to keep ‘green investments’ out of the deficit metrics. So ‘green’ appears to be a way out for many of us!

Yesterday the EU executive also launched legal action against Poland over rulings by the Country’s Constitutional Court, incompatible with the supremacy of EU law. The EU have sought diplomatic solutions but its patience has run out. Earlier this year it already froze the 35.6bn of funds from the Recovery Fund available to Poland. Yesterday it took a next step towards fines. The Polish government has two months to respond but given that it sees the Commission’s injunction as an attack on its sovereignty, this battle should cast a shadow over European relations in 2022.

Last but not least, the Commission also took steps towards implementing the Global Minimum Tax deal that was reached in October, despite the stalemate in US Congress on overhauling the tax code. Clearly the EU are in a hurry to get this global tax initiative up and running given that a part of the financing of its 800bn Recovery Fund depends on developing a steady flow of alternative revenue streams, also called ‘own resources’. This gels with Dombrovskis’ earlier comments on the Stability and Growth Pact, which, clearly, will be a European theme next year.

Day Year ahead

This year will go down in the history books as a year of strong economic recovery. The GDP of a growing number of countries has returned to pre-pandemic levels, although the gaps between countries remain significant, with developing countries often drawing the short straw. This is partly due to the sectoral composition of the economy, the scope to support the economy through fiscal policy, and the capacity of medical care and access to vaccines. This is something to keep in mind as we unpack our presents under the Christmas tree.

Higher inflation, on the other hand, has clearly proved to be a global phenomenon. As such there seems to be little correlation between the ‘state of the economy’ and inflation rates, when we look at a cross comparison of economies. This underlines that much of that inflation is probably not the result of overheated “demand” in the economy, but rather the result of shortages of raw materials (and thus a sharp rise in commodity prices), other key inputs and, in part, labor.

The rise in global inflation is now one of the steepest in the past thirty years. The obvious explanation for the high inflation to some observers is a decade of quantitative easing by central banks. However, that does not explain why consumer prices have increased so much less over the previous twelve years. In our view the current inflation surge is largely the result of mismatches and whiplash effects. Structural problems, such as the limited competition in the container sector, the reliance on hyper-efficient yet fragile just-in-time production processes and the emphasis on outsourcing, were all exposed by the Covid-19 shock when the global economy rebooted. This also means that we should not underestimate further boosts to inflation in the coming year.

So will growth continue in 2022 or is a supply-shock induced recession on its way? After almost two years of the pandemic, the corona virus, and particularly the new Omicron variant, still casts its shadow over the economy, even though the latest reports support the notion that, whilst being much more transmittable, its health impact is considerably less. The past year has also shown that businesses and households can and do adapt to the new circumstances. Ongoing support measures by governments and central banks have obviously played a supporting role here as well.

Geopolitical risks, unfortunately, also remain a clear theme for next year. Through the coming winter months, the relationship between the West and Russia will be mostly in focus. Italian PM Draghi underscored this one-sided relationship once more yesterday, noting that Europe does not have the tools to deter Russia from an invasion of Ukraine: “Do we have missiles, ships, cannons, armies? At the moment we don’t and at the moment NATO has different strategic priorities.” That leaves sanctions as an option, but considering Europe’s dependence on Russian gas, Europe may feel just as much pain – both in terms of energy prices, and production capacity. NATO’s other priorities, as Draghi referred to Asia-Pacific, are geopolitical risks that should of course not be overlooked either. In recent history we have already seen that trade relationships are under pressure, and Covid has shown us how much the West currently relies on Chinese-made goods.

So the outlook for next year is very ‘bifurcated’, a theme we have regularly underscored in this Global Daily over the past year. We could enter a period of slow growth as the supply shocks and current high inflation rates sap demand (with the extent and speed of the slowdown in inflation that follows depending on whether there will be significant second-round effects of inflation on wages – here Europe and the US already seem to diverge). On the other hand, even though supply shocks keep pushing inflation higher, structural changes such as ongoing government support and investments (‘build back better’), and a (geopolitics or pandemic-inspired) break-up of global supply chains could mean that demand stays strong as well, pushing wages higher. Unless central banks intervene strongly that second scenario would imply structurally higher inflation for years to come. Navigating between these two extremes is going to be one of the biggest challenges for businesses, households and policy makers in the coming years. Tallying the latest shifts in global monetary policy, it seems that central banks are mostly starting to worry about the latter scenario, with the risks that a policy error could exacerbate the former – if an economic slowdown does indeed materialize.

In any case, there will be no ‘normal’ economic development in the coming year, in which most economic indicators have reasonably predictable dynamics. This means that we again have to take into account a very erratic course, in which supply and demand do not always get along, and adjustments in economic prospects according to the evolution of the corona virus.

On behalf of RaboResearch, Seasons Greetings!

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