2022 in review: Setting us up for a difficult 2023

The economy in 2022

For the second year in three, 2022 was characterised by a one-off event that completely changed the economic landscape. Whilst 2020, and to a large extent 2021, was derailed by pestilence, this year was dominated by war. Those of a religious persuasion might recognise these as the first two Horsemen of the Apocalypse. Most of our predictions were derailed by the Russian invasion of Ukraine which resulted in a bigger surge in inflation than anticipated and forced central banks to raise interest rates to their highest since the GFC. However, this year was not just about monetary policy: governments were forced into using an active fiscal policy to offset the worst effects of the cost-of-living crisis on households. However, it will not be enough to prevent recession in large parts of the industrialised world in 2023 and the continued rise in government liabilities may yet turn out to be a big problem in future.

Covid slipped down the list of things to worry about in 2022. In my year-ahead piece almost a year ago, one of the options I laid out was that the Omicron variant would prove to be the last hurrah for Covid, which would regress to become an endemic problem. That is indeed how things panned out in 2022 although as China opens up following its zero-Covid measures there is every prospect that global cases will start to pick up once more. We cannot yet be sure that we are out of the woods. However, I did expect that as Covid related supply shortages began to ease, inflation would slow towards the end of 2022. It has not worked out like that.

Newspaper headlines have been full of suggestions that recent events herald a return to the conditions of the 1970s, with a commodity price shock triggering a surge in inflation accompanied by increasing industrial unrest as unions push for higher wage claims. Whilst the parallels are attractive on the surface, a closer look at the evidence suggests the comparison does not quite hold up. One of the key differences so far is that real wage growth has been crushed by the recent surge in inflation whereas in the 1970s it remained positive (although we have been compensated with lower real interest rates). Here in Britain, the strikes that have hit train, postal and health services are a response to the fact that many workers are being squeezed very hard, two years after they were lauded as key workers who kept the country going during the initial Covid lockdown. Labour relations are going to be a problem for governments in 2023, particularly in France and the UK.

One way to think about the inflation problem in the short-term is that it is the outcome of a distributional conflict between firms, workers and taxpayers which will only be resolved when the various actors accept the outcome. Indeed all players have to accept that they will be made worse off: At issue is the extent of the losses they are prepared to bear. The fact that central banks have raised interest rates to combat inflation has complicated matters by raising the burden on households. My issue has long been that higher interest rates will do nothing to offset a supply-side inflation shock, although central banks have to be wary of second round effects, particularly where labour markets remain tight as is currently the case in the US and UK. But as pointed out by the journalist Sarah O’Connor, author of this article on why worker power has not strengthened in 2022, while central banks fret about a wage-price spiral, the current situation looks more like a living standards bloodbath.

On the basis that inflation slows in 2023, as base-year effects drop out of the annual calculations, and as European economies – and maybe the US – fall into recession, the calls for interest rate cuts will build. Central banks are unlikely to heed these calls, and maintain policy tighter than might be justified by economic conditions, which would be a contrast to the post-GFC period when they held policy looser than justified by economic conditions. Central bankers are paranoid about repeating the mistakes of the 1970s when they eased policy too early only for inflation to take off again.

A bad year in the markets

On the basis of data back to 1928, 2022 was one of the worst years for total asset returns with the S&P500 losing around 17% whilst returns on Baa corporate bonds were the second worst in history (beaten only by the collapse of 1931). It was not supposed to be this way. Indeed I expected equities to perform relatively well, largely because of an absence of alternatives. But the surge in interest rates and fears of recession well and truly did for markets. It is not usual for a year of losses to be followed by a second consecutive decline but it has happened before – most notably for equities over the period 2000-2002. I would like to say that things can only get better but we cannot be sure that they will.

2022 was also the year in which crypto assets were reassessed. Long-term readers will be aware of my scepticism regarding cryptocurrencies but I was not prepared to write them off at the start of the year on the basis that there seemed to be genuine retail interest in their adoption. But as the energy costs associated with mining Bitcoin continued to rise, they became an increasingly unattractive prospect. Matters were not helped by the bankruptcy of the FTX exchange amid allegations of fraud. As a result Bitcoin lost two-thirds of its value against the USD, to currently trade at 16558 – still almost triple my back-of-the envelope estimate of fair value.

Politics: Some right calls, some wrong

If I got anything right about 2022 it was that geopolitics would be at the forefront of the agenda after two years in which governments were preoccupied with Covid. I did point out there was a risk that Russia would invade Ukraine and that western relations with China would continue to fray. I also tipped Emmanuel Macron to get a second term as French President. However, the one call that went badly wrong was that Boris Johnson would end the year as UK prime minister. As I wrote at the time: “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.” I stand by the logic – Johnson’s departure will do the Tories no favours at the ballot box. But I could not have foreseen that Johnson’s replacement would themselves be replaced after a spectacularly incompetent fiscal plan was rushed through.

Last word

Tough times are now the order of the day. We survived the GFC, coped during the pandemic and are having to tighten our belts to deal with the most significant war on European territory since 1945. I look back fondly to the days of the Great Moderation when we had to invent things to worry about (who now remembers the Millennium Bug?). We can be thankful we got through 2022 relatively unscathed but as we look ahead to 2023, there will be bigger challenges ahead. Happy New Year to you all.

2021: Not great but could have been worse

As 2021 draws to a close, it has felt in many ways like a year in the holding pen as we wait for the pandemic to blow itself out. In the western world we have learned to cope with Covid to some degree and even though life is not back to normal the shock value which accompanied the onset of the disease in early-2020 has been conspicuous by its absence. Unlike 2020 when our year-ahead predictions were blown out of the water, an assessment of the predictions made at the start of the year indicates that GDP growth projections broadly met expectations and equity markets continued to power ahead. It was also the first year in four in which we were spared the spectacle of Donald Trump in the White House, thus taking some heat out of global politics. Not everything went according to plan, of course. One thing that was unforeseen was the huge surge in inflation which necessitated the Bank of England doing the unthinkable by raising interest rates.

Another year dominated by Covid

At the end of 2020 things looked grim on the Covid front. A year ago the world had registered 82 million cases and 1.9 million deaths. They got a lot worse in 2021: There are now 287 million registered cases and 5.4 million deaths. These are clearly an underestimate. Europe and North America together account for more than 50% of all cases and deaths, despite accounting for just 15% of the global population. This is largely attributable to better data recording and testing procedures in the developed world as countries with better developed health systems produce more accurate (or more properly, less inaccurate) data. It is also the result of the wilful underreporting of Chinese figures. According to the WHO, China has recorded just 131,315 cases and 5,699 deaths, of which just 1,045 have occurred since May 2020. The epidemiological profession relies heavily on accurate data to model the incidence of disease and project its progress. Fictional data from the region where the disease was first recorded does nothing to help the rest of the world cope with the pandemic.

One of  the great successes in 2021 was the rollout of the vaccine programme. I must confess in autumn 2020 to being somewhat sceptical that governments would be able to roll out the vaccine as quickly as they promised and that it would take until the second half 2021 before needles would start going into arms in a big way. As of today almost half of the world’s population has been fully vaccinated (two shots) with 23% of Europeans and 20% of Americans having received a third booster dose. The vaccine rollout across the EU started more slowly than perhaps it should have but by end-2021 the proportion of those fully vaccinated has caught up with the UK, whose government trumpeted the speedy rollout of its vaccine programme as one of the benefits of leaving the EU (spoiler alert: it wasn’t).

Economy on track but inflation is not

Largely as a consequence of the vaccine rollout, which reduced the extent to which governments were required to lock down their economies, the global economy has rebounded sharply and appears to have suffered considerably less scarring than I anticipated a year ago. After contracting by 3.1% last year, global GDP is estimated to have grown by 5.9% this year and is projected to grow by 4.9% in 2022. Although global GDP is back above 2019 levels, output in the industrialised world is not quite there yet (although US GDP has been above pre-Covid levels since Q2 2021). Nonetheless, compared to expectations in mid-2020, the recovery has been stronger than anticipated and owes much to the actions of governments and central banks in providing fiscal and monetary support.

One of the unexpected consequences of the post-2020 shock has been the huge surge in global inflation. There were suggestions in the early stages of the pandemic that the hit to the supply side of the economy was such that demand would recover more quickly than supply and that there would be a hit to inflation in the medium term. But this was not the consensus view (nor mine). As recently as April the IMF was reporting that inflation would “remain contained in most countries” and projected US inflation in 2021 at 2.3%: over the first 11 months it has averaged 4.5%, reaching a 39-year high of 6.8% in November. The reawakening of the inflationary threat will prove to be one of the major challenges facing monetary policymakers in 2022. I maintain the view expressed in mid-year that the inflation threat will fade but also maintain the view that higher inflation justifies the “case for taking away some of the extreme monetary easing put in place over the last year” – and the Bank of England has duly obliged, unexpectedly raising Bank Rate by 15bps to 0.25% earlier this month. The Fed is likely to follow suit in 2022.

Markets also performed in line with expectations

As predicted, global equities remain the asset class of choice – there really are few places to invest in this low returns environment that will generate the kind of boost that equities are able to give. The S&P500 surged by 27% in 2021 compared with 15% for the FTSE100 and 16% for the DAX. I suspect further upside is likely in 2022 although not at anything like this pace. Bond yields did edge up a little in 2021 in contrast to expectations, with the US 10-year yield up 59 bps on the year, but given the unanticipated surge in inflation that is not such a bad result.

Brexit not yet done

According to Boris Johnson, Brexit was “done” at the end of 2020 when the UK left the protection of the transition arrangements. But as I have long pointed out, Brexit is a process not a one-off event, and it is not going well. I will come back to this issue in 2022 but suffice to say the economic costs are making their presence felt. UK trade flows remain well below their pre-Covid levels whereas German trade has recovered back above these levels. Meanwhile, the OBR calculates that Brexit will cost 4% of output in the long-run versus a 2% hit due to the pandemic. The resignation of Lord Frost as the UK’s Chief Negotiator of Task Force Europe earlier this month, partly over the handling of Brexit, suggests that the process is not delivering what its most vigorous proponents expected. Nor are voters enamoured of the process with a mounting proportion increasingly viewing the vote as a mistake (chart).

Don’t forget environmental issues

For a brief period last month, environmental issues were all over the news as the climate disaster slowly makes its way up the agenda. But governments have not (yet) stepped up to the challenge. The real action on reducing carbon emissions has to come from China and India, with Asia accounting for over 90% of CO₂ emissions since 1990, but neither of them has a plan in place which will limit the rise in global temperatures over the next decade. Those who have watched the film Don’t Look Up, the current big hit on Netflix, will recognise the unwillingness of governments to deal with issues which clash with their electoral priorities. It is not just Asia which has to do more to deal with climate issues: Europe and the US will also need to act, largely because they are in a better financial position to do so. Perhaps what 2021 demonstrated (yet again) is that whilst we all like the idea of saving the planet, we are unwilling to pay the price – both financially and in terms of lifestyle change – to make it happen.

It has not been a great year by any means, but if you are reading this, at least you got through. A Happy New Year to you all and here is wishing a healthy, happy and prosperous 2022

The year from hell

You do not need me to tell you that 2020 was the year from hell. It will go down in history as the year of the pandemic – the biggest black swan event of our lifetimes. Even prior to the financial crash of 2008 we had some warning that problems were building up in the banking sector. But a year ago, apart from a few well-connected health professionals, the general public had not even heard of the coronavirus. Google search data reveal that it was only in the week commencing 19 January that there was a huge spike in interest in China. However, the rest of the world took another seven weeks to cotton on (chart above).

At the time of writing, almost 83 million people worldwide have tested positive for Covid-19 which has claimed the lives of more than 1.8 million. To put this into context, US deaths from Covid number almost 6 times those who lost their lives in Vietnam. In the UK, there are only 130 towns with a population higher than 72,657 – the current number of registered deaths in Britain. It became clear early on that this was a humanitarian disaster and until the vaccine is widely deployed, these numbers will unfortunately continue to rise. In this context, everything we thought might happen in 2020 was blown away by the ultimate in random events.

If we learned anything in the course of 2020 it was the distinction between risk and uncertainty. As the economist Frank Knight wrote in 1921, “there is a fundamental distinction between the reward for taking a known risk and that for assuming a risk whose value itself is not known.” The idea that risk is something that can be priced but uncertainty cannot is something that I have been pushing for many years. We learned in 2008 that we had been pricing risk incorrectly when the risks in the far tail of the distribution came to define the central case. But as much as we might have adjusted our subjective assessment of risks in the following decade, nothing could have prepared us for the events of 2020.

Starting with the economics, forecasts are conditional on the information set available at the time. Since we had no information on Covid in January, the economic forecasts made at the start of the year were quickly rendered meaningless. However, once governments began to implement their lockdown plans, forecasts adjusted very quickly and projections produced in the spring gave us a very decent guide as to how events turned out in 2020. For example, the consensus projection for this year’s UK GDP growth was 1.1% in January 2020. By May this had been slashed to -8.6% with the projections made by financial institutions averaging -9.3%. At that point we only had GDP data through to March and we were flying blind with regard to much of the data and I would regard this as an acceptable outcome. One thing that surprised me with regard to European economies was the extent to which unemployment remained relatively contained despite the massive collapse in output. This was a result of schemes put in place by governments to place a safety net under the economy, and very welcome it was too.

The downside is that there was a huge deterioration in government finances. Government borrowing across the EU, for example, is predicted by the European Commission to expand from 0.5% of GDP in 2019 to over 8% in 2020 (it will be even higher in the UK). In the euro zone, the debt-to-GDP ratio is projected to rise from 86% in 2019 to over 101% in 2020 and to rise further over the next couple of years. To put this into context, in the seven years following the crash of 2008 the debt ratio rose by 30 percentage points of GDP to 95%. High levels of debt are a legacy of the corona-induced recession that will be with us for years to come and will undoubtedly have a big influence on fiscal thinking in future. That said, the role of the state in providing support to the economy very much came back into fashion in 2020. I rather suspect that electorates will not take kindly to fiscal austerity in the near future, having endured it for much of the past decade.

It was certainly a dramatic year in equities. A year ago my view was that “equity markets would appear to be due a correction” but “unless we experience some form of major random shock, it might be too pessimistic to expect a bearish correction.” In early February I questioned why markets were ignoring the risks posed by the coronavirus. By March, we got the long-awaited correction as investors understandably panicked as liquidity dried up in much the same way as it did in 2008. This time, however, the authorities were prepared and pumped in liquidity as if it were going out of fashion. The surprise was just how quickly markets rallied thereafter with US markets rallying to record highs late in the year (chart below). This was in part driven by FAANG stocks as the likes of Amazon and Netflix had a “good” crisis but most sectors benefited to a greater or lesser degree. For all the concerns regarding excessive valuations my year-ahead call that “equities remain the asset class of choice” means that so long as an expansionary monetary policy depresses returns on other assets, it is hard to see why investors will dump them.

On the politics front, the UK left the EU as expected and did so with a trade deal that at various stages throughout the year appeared very elusive. The year also marked the end of Donald Trump’s tenure in the White House. A year ago I was unsure how the US election would pan out: The polls suggested Trump would lose but it was never certain that the Democratic challenger would be able to pull off a win. Now that Joe Biden is about to move into 1600 Pennsylvania Avenue this will likely mean an end to the Twitter-based policy environment that has characterised the last four years. It is unclear whether this will be bad news for Twitter Inc. On the one hand they have lost one of their highest profile brand ambassadors. On the other, it may take some heat out of the fake news allegations that have dogged the company thanks to the President’s unfiltered use of social media. 

There are now just a matter of hours to go until we can say goodbye to 2020. I am sure I speak for everyone when I say the end can’t come soon enough. Here’s wishing us all a happier new year.