Real Return: Outlook for 2022

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December 2021

Newton’s Real Return team considers the investment implications of higher inflation and a central bank regime shift.

“What is the most important event/data or threat you will be watching in 2022?”

Heading into 2022, the Federal Reserve’s (Fed) decision to lean into recent market weakness with more hawkish policy rhetoric and tightening liquidity conditions has prompted us to watch developments here carefully. As we move through the year, growth may slow as the Fed’s tapering program comes to an end and interest-rate hikes in the United States commence.

While we believe the process of rate tightening will be a gradual one and policymakers will be data-dependent, maintaining a “Goldilocks economy”—one that is neither too hot nor too cold—will be a challenge. We think any policy mistake is likely to have profound repercussions for asset classes, given the rich valuations across the board heralded by the historically low level of interest rates.

Toward the end of 2021, economic momentum looked well underpinned, as pent-up demand was unleashed and the Covid pandemic transitioned to an endemic phase, with little appetite from politicians to lock down economies again. Companies remain in a restocking cycle, and while this may have been setback by supply-chain bottlenecks, encouragingly we have started to see signs that pressure on supply chains is easing, which suggests that we may have seen the peak of supply-side inflation. Further out, we see the potential for corporate capital expenditure to rebound, while government investment in infrastructure, particularly in those areas related to climate change, looks robust.

Finally, while emerging markets have lagged in terms of rolling out vaccination programs in 2021, and thus been more vulnerable to the Covid-19 Delta variant, this situation appears to be improving, resulting in many of these economies having catch-up potential, although, as always, there is a need to be highly selective.

Sustainable themes will be high on the agenda, as the urgency of issues such as climate change places the spotlight on environmental, social, and governance (ESG) credentials of companies. We believe ESG is essentially “finance 101,” and such considerations are valuable elements of the overall mosaic of information on a company. Investors increasingly will demand that greater attention be paid to these aspects, as well as their being reflected in a company’s valuation. While some areas such as renewable energy have been eclipsed in the recent past by the stellar performance of equity markets, the balance may shift as equity supremacy ebbs.

Currency also may have a role to play for some investors, with the potential to use the US dollar as a risk-reduction tool, although our views on the direction of the currency are not skewed decisively in either direction. In the near term, we think dollar strength is likely to represent a headwind for assets such as gold and emerging-market debt, diminishing the appeal of these assets. Moreover, in the case of gold, competing flows for other alternative currencies such as bitcoin, along with the potential for rising real rates, make the commodity less attractive. 

In summary, we consider that while the economic recovery should continue, most of the good news is currently in the shop window. We acknowledge that, from a macroeconomic perspective, persistently high inflation can carry the seeds of demand destruction and also run the risk of policy error on the part of central banks. Moreover, China represents a significant source of uncertainty with its new agenda of “social prosperity” and the likelihood that the quantity and composition of economic growth it generates is set to change from here. This will have repercussions, and necessitates vigilance and careful analysis for investors.

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