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Another year of global lockdowns, the emergence of new COVID-19 variants, stagflation fears, a major oil shock and regulatory reforms in China were just some of the headlines causing consternation for investors in 2021.

“In Australia, the vaccine-led recovery, removal of border restrictions and a combination of high levels of household savings and pent-up demand provide a strong backdrop for the domestic economy to solidify its rebound in 2022.”

Despite this, equity markets, as measured by the MSCI World Index, climbed a staggering 20 per cent, led by the United States where the S&P 500, for the first time in more than two decades, recorded its third successive year of double digit returns.

These gains were supported by incredibly strong earnings growth and the continuation of unconventional monetary policy and fiscal tools usually reserved for wartime.

As 2022 gets underway, ANZ Private maintains our broadly optimistic tone for risk assets but we would warn against any expectations of double digit returns from equities like those experienced in 2021. Rather, 2022 commences with a mild overweight to risk assets based on cautious optimism and a belief that, despite more moderate returns, equities should continue to outperform bonds and cash — albeit against a backdrop of heightened volatility, particularly in the first half as central banks continue the withdrawal of liquidity measures implemented during the height of the pandemic.

This expectation of moderate gains for equities is underpinned by an outlook of strong growth where robust consumer demand, elevated household savings accumulated throughout the pandemic and the continuation of relatively easy policy should see gross domestic product (GDP) rise globally by roughly 4 per cent in 2022. This will be led by Australia (5.1 per cent), the United States (4.5 per cent) and Europe (4.4 per cent). In China, growth is expected to slow to 4.6 per cent this year which, 2020 aside, would represent the weakest figure in modern history. This scenario represents a base case for 2022 – but as always there are potential downside and upside risks to any setting.

Inflationary pressures, and more precisely the reaction function of central banks, will perhaps be most telling for asset prices this year. In 2022, ANZ Private expects inflation to moderate in the second half from the highs seen in late 2021 as supply-chain dynamics begin to normalise and base effects continue to wash through the data.

Nonetheless, inflation is still expected to settle above pre-pandemic levels and this ‘stickier’ inflation will present an interesting dynamic for policy makers, particularly if growth shows any signs of dissipating earlier than expected. If inflationary pressures do indeed ease then this may release some of the need for central banks to hike so aggressively in the second half of the year.

Conversely, if supply-side pressures persist and inflationary pressures remain elevated into the second half then this could trigger a belief that central banks may need to tighten more aggressively than currently expected resulting in a strong risk-off scenario for equities. Here, growth is likely to be constricted which, alongside stubbornly high inflation, would present a very unpleasant hand for policy makers.

Historically, central banks have been able to loosen monetary policy to stimulate growth but with rates at historic lows across much of the developed world this lever remains partially redundant. The Bank of England (BoE) commenced its hiking cycle in late 2021 and should be joined by the US in early 2022. While these increases will provide central banks with some ‘dry powder’ for future crises, any hiking is unlikely to be enough to see monetary policy become the dominant policy tool for central banks in the near-term. Rather, fiscal policy looks set to become the tool of choice for policy makers in 2022 and the years ahead.

While there are downside risks to our cautiously optimistic outlook for 2022, any near-term pullback in markets is likely to signal a healthy correction from what are already ‘frothy’ global share markets. If conditions are attractive it may even provide the opportunity to increase risk assets further.

Home grown recovery

In Australia, the vaccine-led recovery, removal of border restrictions (both domestic and international) and a combination of high levels of household savings and pent-up demand provide a strong backdrop for the domestic economy to solidify its rebound in 2022. As a result, ANZ Private expects GDP to grow 5.1 per cent over the year in what would be the strongest annual domestic growth since the late-1980s.

Inflation continues to rise but is lagging other major economies. Here, the Reserve Bank of Australia (RBA) continues to articulate a patient approach, waiting for inflation to lift sustainably to the middle of the 2-3 per cent target band before hiking rates. Conversely, the market continues to challenge such rhetoric. Wages growth remains critical. Higher prices due to supply-side disruptions are unlikely to lead to sustained inflation pressure if real wages are falling. Things are looking up on the wages front though. After rising again during the Delta lockdowns, unemployment is expected to trend downward once again — reaching 4 per cent by the end of 2022. Underemployment is also expected to fall and this should place upward pressure on wages growth. Annual wages growth is expected to reach just above 3 per cent by the end of 2022.

Despite this, the pick-up is likely to be slower than in other countries like the US and therefore the impact of wages growth on inflation should be delayed. In 2022, global supply cost pressures are expected to moderate somewhat as supply chains adjust and spending switches from goods to services. This should ease Australia’s tradables inflation, offsetting the impact of rising wages growth, leaving inflation a touch below 2.5 per cent by the end of 2022.

ANZ Private’s wages outlook suggests inflation will return to 2.5 per cent by the first quarter of 2023 and rise further that year. This will satisfy the RBA that inflation is sustainably at the mid-point of its target band and so should trigger the first rate increase in the first half of 2023. ANZ Private thinks the RBA will increase the cash rate to 0.25 per cent initially and then follow with a further 75 basis points of rate hikes by year-end.

This doesn’t mean policy is on hold. The end of the term-funding facility and 3-year yield target have contributed to a tightening in financial conditions and subsequent sharp rise in fixed mortgage rates. The termination of the RBA’s bond purchase program (QE) — potentially as early as February this year — will further heighten market expectations the RBA will hike sooner than expected.

Risks currently appear tilted towards an earlier rate cycle. Downside risks centre primarily on the pandemic and specifically whether further outbreaks and more hostile variants could lead to prolonged lockdowns. Upside risks include the potential for spending to outpace already strong forecasts and the risk labour market tightening or wages growth acceleration occurs faster and earlier than expected.

Markets are currently backing these upside risks to prevail with almost 100 basis points of cash rate tightening priced in over the next year. Here, there is a clear mismatch with the RBA’s view the conditions for tightening will not be met until the end of 2023. Australia is not alone, with the US and others facing a similar dynamic. Like 2021, this stand-off between central banks and markets should remain a dominant theme in the year ahead.

Lakshman Anantakrishnan is Head of Investment Strategy, Private Banking & Advice at ANZ

Click here to read the full 2022 Outlook report

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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