This article first appeared in Capital, The Edge Malaysia Weekly on January 10, 2022 - January 16, 2022

THE degree of economic uncertainty in 2022 will remain very high. Unlike cyclical downturns that are more predictable and in line with common knowledge, the evolving situation of Covid-19 is essentially force majeure and that makes the planning of policy responses extremely difficult.

Countercyclical fiscal policies require not merely forward-looking plans, but sufficient economic buffers in terms of reserves, flexibility to raise debt and economic resilience for them to work effectively while maintaining confidence in the economy. The management of contingent risks are effective insofar as the economic capacity for unforeseen circumstances is available and in this regard, government balance sheets around the world are stretched after battling the pandemic over the last two years. Nonetheless, policy creativity has allowed most governments to scrape the barrel for the necessary public spending programmes.

The spectre of Covid-19 continues to loom over 2022. Developed nations have reported rising cases in recent weeks, while the threat of new virus mutations remains a risk. This has implications on the aforesaid ability of economic actors to plan spending programmes and implications on risk aversion by all stakeholders in any economy. This heightens the risk of hysteresis, whereby behaviour becomes enduringly changed, and in this situation, invariably cautious. In turn, this would lead to a depression in investment rates and raise the propensity for savings. Reinforcing this, corporate balance sheets and bank lending behaviour are showing both quantitative and anecdotal evidence of cash hoarding. This leads to strains on government budgets and by extension, the taxpayer, perpetuating a negative feedback loop.

Against this structural backdrop, the economy at the level of the business cycle should see a bounce going into 2022. While it is difficult to justify blue skies for the economy, the bar for a recovery has been set low. At the very least, growth in 2022 should recover from the low base in 2021. Furthermore, a more pragmatic approach to Covid-19 risk management could be adopted as economies cannot afford to remain ensconced with the same draconian degree of mobility restrictions as seen in the past. Given the rise in Covid-19 cases in Europe and the US, one could surmise diminished social and political will to backtrack on economic reopening, highlighting the difficult compromise between health and wealth.

A major uncertainty to be faced by all asset classes in 2022 is the shift in global fund flows between markets of lower yields (that is, lower returns and risks) and markets of higher yields (that is, higher returns and risks) due to changing interest rate expectations. This creates considerable uncertainties when the direction of asset returns remains unpredictable.

In the bond markets, rising inflation causes uncertainties in wealth preservation on already thin yields. The inflation increase in this case is made more difficult to forecast since much of it is driven by commodity prices, which have historically been very volatile and beyond the control of economic policy.

Volatility aside, Covid-19 has caused supply chain disruptions and shortages in labour that have led to higher costs being passed on to consumers. Also, companies that have yet to be fully plugged into the digital economy are unable to reap the benefits of lower costs and higher productivity from enhanced technological capabilities. Nonetheless, we could draw comfort that falling commodity prices should lead to a decline in inflation, at least from cost-pushed reasons. This had been driven by an ongoing deflation of the property bubble in China, a greater shift towards environmentalism and an easing of shipping costs as the initial boost from pent-up demand eases over time.

Consequently, the investment environment in 2022 is made particularly complex since the performance calculus emphasises inflation-adjusted returns, on top of risk-adjusted returns. Traditionally, emerging markets are seen as riskier than developed markets, as defined by development status and credit ratings. However, given the dominance of the inflation narrative in 2022, investors are likely to begin noticing that high and accelerating inflation is mainly situated in advanced economies, while developing economies are no stranger to high inflation. In fact, the long-term inflation trend and volatility in emerging economies has declined, leading to a convergence in inflation levels between developed and developing economies over time. Should this fact gain wider traction, the risk of fund outflows from emerging markets to developed markets could be ameliorated.

The concept of inflation-adjusted returns can be applied across several asset classes. For the equities market, higher returns in growth equities are more likely to be pursued. This may seem counterintuitive when higher interest rates are expected since this is the base case in 2022. However, the economic recovery remains uncertain and central bankers around the world are more likely to pursue the path of least resistance, especially when economies continue to suffer the after-effects of the pandemic.

Furthermore, 2022 will see several general elections around the world — in the US (the midterm election on Nov 8, 2022), in Asia-Pacific (such as Australia, South Korea, Hong Kong, the Philippines and Malaysia) and major European countries (for example, France and Austria). Usually, a conducive political system goes hand-in-hand with an accommodative economic policy backdrop that is supportive of riskier asset classes such as equities and emerging market currencies. This implies a brighter outlook for the adoption of more risk (for example, increased investments in emerging markets), especially in economies that are not complicit to inflation mismanagement. By extension, this would support inflows to developing Asian economies and investment-grade markets where fundamentals remain relatively healthy, namely Thailand, Indonesia, Malaysia and China.

A seeming contradiction is that emerging market debt levels are stretched, although high fiscal deficits attributable to the pandemic will be temporary and markets are likely to look past the tail risks that have occurred over the last two years. The scrutiny by international investors and monitors such as rating agencies would likely contain government budgets to reasonable levels, since few countries would be willing to pursue unsustainable policies and risk a capital exodus. By and large, sovereign downgrades, should they occur, are unlikely to have a major impact on healthy risk appetite as the economy embarks on a recovery. Usually, inflation and credit risks start worrying markets when they approach a significantly higher level, such as double-digit inflation (common in some emerging economies) and a crossover from investment-grade to high-yield ratings. Furthermore, the rare fact that inflation today is higher in developed economies certainly helps create a more benign outlook for developing nations.

While QE tapering and higher interest rates remain matters of concern, they are unlikely to change significantly in 2022, given the fragile economic recovery, populist politics in the light of the elections and lingering strains of the coronavirus. All asset classes, be it equities, fixed income, commodities or investing regions, stand to benefit from easy liquidity conditions. I remain doubtful that interest rates and monetary policy will return to a traditional cycle of ups and downs, since ageing populations, lower savings and investment rates, and productivity growth through technology leads to a propensity for structurally lower interest rates. This has been a recurrent theme for several decades and there is little to suggest otherwise. Even if interest rates were to rise in 2022, markets would be pricing in “what’s next”, only to be answered by the rattle of a rusty can being kicked down the road.

Dr Ray Choy is head of economics and research at Opus Asset Management. The views in this article are his own and may not represent the house view of the company. He welcomes connections on LinkedIn.

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