Case 1: The Covid situation gets worse
In the case where a much more virulent strain emerges, we could quickly find ourselves back in the same situation as 2020 with stringent lockdowns and a big hit to the economy. Unlike 2020, however, we will not be facing a totally new threat; we have experienced Covid waves before and the initial reaction from governments will be to impose fewer restrictions than in March 2020. Accordingly, the initial hit to the economy may be less dramatic. But if the emergent strain proves to be more deadly, there will be a significant hit to confidence and the economy may not rebound quickly as people realise that the pandemic is far from over. In such a case, governments and central banks will be forced to open the taps once again, despite the recent surge in inflation, which will continue to put a floor under markets with equities pushing on to new highs.
Case 2: More of the same
A repeat of the 2021 pattern would see a huge rise in cases at the start of the year as the Omicron variant works its way through, followed by a dip during the spring and summer before another less virulent strain emerges in the autumn. Such an outcome would likely mean an uneven recovery with decent but not stellar growth in the spring and summer and a slowdown over the winter months. Covid restrictions would likely be eased in the first half of the year but, as case numbers mount, continued pressure on health services suggest restrictions will be tightened later in the year which would particularly affect sectors such as hospitality as a quasi-lockdown is implemented. In this environment central banks can be expected to ease back on the monetary throttle to curb inflation in the first half of the year but stand pat in the second half, taking some steam out of markets which push ahead relatively slowly.
Case 3: Omicron proves to be the last hurrah for Covid
In the best case scenario, Omicron is the precursor to the emergence of a much milder form of Covid which becomes an endemic problem rather like flu. Economic growth settles towards trend rates and central banks can afford to be more aggressive in tightening policy. However, high inflation in general and rising energy prices in particular will act as a drag on household incomes, with the result that even in this environment GDP growth remains relatively slow. Against that households may run down some of the excess savings accumulated during the pandemic which will act as a growth support. Inflation is likely to slow as supply issues are largely eliminated by end-year and markets lose momentum in the face of higher interest rates and less dynamic growth. We may even start to hear talk of excess supply and disinflation before the year is out.
Politics and geopolitics are back on the agenda
After two years in which the world has been preoccupied with managing domestic pandemic issues, global geopolitical issues are a matter of urgency for western leaders who are increasingly concerned about a more assertive Russia and China. Russian troops have recently been building up along the Ukrainian border and the US has expressed concerns that this could be a prelude to invasion. We have been here before, of course. Last April, Russia built up troop numbers close to the border only to pull back, so latest moves might simply be another chapter in Vladimir Putin’s power play. But they may not, and in the event of invasion there is very little militarily that the west can do in response. The US has talked of unprecedented sanctions, which the Russians would counter by weaponising gas exports. At a time when European gas supplies are in a parlous state, this could have significant consequences for global energy markets.
President Xi Jinping is the most powerful Chinese leader since Mao and sits at the head of a country determined to regain what it sees as its rightful position at the top table. Unlike in Mao’s era it now has the financial and military clout to back up its ambitions. Recent years have demonstrated that China has no interest in living within the strictures of the western-dominated economic architecture, as its behaviour at COP26 demonstrated, and it continues to make threatening noises regarding Taiwan. Unlike Russia, China has no need to throw its weight around to demonstrate its power. But like Russia, it is increasingly seen as a competitor to western interests and the failed policy in Afghanistan, culminating in the shambolic withdrawal in 2021, will only encourage China to press at the west’s weak spots in 2022 and beyond, leading to even more fraught relations.
Here in Europe, Emmanuel Macron will face his biggest test as he gears up for the French presidential election. Despite poor approval ratings, the polls suggest he will easily make it into the second round where he will face a runoff against either Marine Le Pen or Valérie Pécresse, the centre-right candidate of Les Républicains. The polls suggest he can beat either of them in the second round but the pollsters have been wrong before, notably in the German federal election last year which saw the SPD come from behind to beat the CDU into second place. Still, it would be a surprise if Macron were not re-elected to the Elysée Palace in April.
Another leader under pressure is Boris Johnson who faces mounting discontent amongst his backbench MPs. There has been speculation that a leadership challenge could emerge in 2022 which might happen if a combination of failed pandemic response policies and Brexit pain add to existing woes over political scandals. My own view is that Johnson will end the year in Downing Street. Ditching a third Tory leader in six years, before their term is up, will not play well with an electorate that appears increasingly restive, particularly when there is no obvious candidate to replace Johnson.
Markets: More upside but how much is already priced in?
There are good reasons to expect more upside for equities in 2022, albeit not at anything like the 2021 pace. Economic growth conditions remain favourable and earnings are projected to increase at a decent pace. A high inflation environment in the first half of the year may see a rotation towards inflation trades with gold appearing to be a natural beneficiary along with energy stocks. Up to three Fed interest rate hikes are expected in 2022 which may take the edge off equities, but an absence of Covid-related uncertainty would limit any downside.
Crypto will be one of the fascinating areas to watch this year. Bitcoin hit an all-time high above $67,566 in November and although it has since slipped below $43,500 it is too soon to write off the possibility that it can rally back above previous highs. Although concerns about the energy cost of mining persist, and China has recently cracked down on Bitcoin mining, there has been more widespread retail interest of late. Any wobbles in the equity market could certainly see renewed interest in crypto assets as investors hunt for yield. I maintain that the future of cryptocurrencies will depend on the extent to which central banks enter the field, and with the likes of the Bank of England and ECB looking seriously at the prospect of introducing a central bank digital currency, this may well place a floor under any downside for crypto assets in 2022.
What else?
There are a host of other themes that will move the needle in 2022. Environmental issues are one of them and the debate over how to manage climate change can be expected to make its presence felt. This has traditionally not featured much in near-term economic thinking but maybe 2022 will be the year that we pay more attention to the risks. 2022 is also World Cup year. Assuming it goes ahead, the tournament will start in Qatar in November rather than coinciding with the European summer, which will make things interesting. I am not going to pick a winner but with qualification yet to be completed I can confidently state that Portugal and Italy cannot both qualify.
As 2020 showed, unexpected events are the true enemy of forecasting and whatever happens this year, there will be some unexpected events that come out of left field. As Martin Luther King once remarked, “you don't have to see the whole staircase, just take the first step” which is a good way of saying that so long as our forecasts are not outdated before end-January, we can be reasonably satisfied.
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