Financial markets: 2021 wrap-up and 2022 outlook

So how did financial markets perform in 2021?

It was a year in which there was a noticeable contrast between the performance of our domestic markets and international markets. The New Zealand bond market returned -5.7%, while the global bond market returned -1.2% on a hedged basis. This can be attributed to the fact that our central bank was one of the first to commence its interest rate tightening cycle, while most central banks offshore were still considering when to pull the trigger on this.

Similarly, the domestic equity market returned 0.2%, while the global equity market returned 24.5% on an unhedged basis. This can be explained by a number of factors such as:

a) the higher proportion of interest rate sensitive stocks in our market versus offshore;

b) the lower proportion of cyclical stocks in our market versus offshore;

c) and some stock-specific stories such as index-heavyweight Fisher & Paykel Healthcare producing a flat return for the year, and A2 Milk Company’s -50% return.

Highlights from the last quarter

The final quarter of 2021 saw a noticeable increase in volatility due to the emergence, in November, of the Omicron variant of COVID-19. As one commentator aptly put it, the initial reaction from financial markets was to “shoot first, ask questions later”. The concern was of course that this new variant could lead to more disruption, restrictions, and lockdowns, which would stifle economic growth. Also, the timing wasn’t good, as Europe was in the midst of dealing with its fourth wave of coronavirus infections. However, as more became known about the new variant, volatility returned to normal levels. Although the Omicron variant is more contagious than the Delta variant, markets seem to have taken some comfort from it appearing to be less severe.

Another interesting development has been the changing view of central banks on inflation. For much of the past year, as economies reopened, the thinking was that the higher rates of inflation being reported were only temporary in nature. Countries such as the US and Germany, to name a few, have seen the highest year-on-year inflation numbers (~6-7%) since the 1980s and 1990s.

However, continued pressure on supply chains and tight labour markets have made central bankers worry that higher inflation may be more persistent. In December, this led the Bank of England to commence its tightening cycle by raising its cash rate from 0.1% to 0.25%, thereby joining the central banks of New Zealand and Norway, which had already embarked on this path. In the same month, the Federal Reserve (Fed) in the US announced that it would bring forward the winding up of its quantitative easing programme from June to March. In doing so, the Fed has positioned itself for an earlier start to its tightening cycle, now likely to be in March 2022.

What’s the outlook for 2022?

For starters, we think we’re in a much better position now than we were a year ago. Economies are at various stages of reopening; a greater percentage of the developed world has been vaccinated; and antiviral treatment drugs such as Pfizer’s PAXLOVID should significantly reduce the risk of hospitalisation for those with COVID-19. As the year progresses, vaccination rates in emerging economies are also likely to increase. Against this backdrop, the global economy should continue to recover from the pandemic and deliver above-average growth.

However, as always there are a multitude of risks… some known and some unknown. Regarding the former, the two obvious contenders that stand out for us are inflation and COVID-19. As already mentioned, higher inflation is weighing on the minds of central bankers and they’ll look to tighten monetary policy to address this. During the first few weeks of the new year, the yields on US government bonds moved sharply higher in anticipation of the Fed commencing its tightening cycle.

On the COVID-19 front, we expect supply chain issues to continue for some time. For example, my nephew who lives in Canberra, was telling me that his local supermarket had run out of meat because of the high rate of absenteeism (due to the Omicron variant) at poultry producers and abattoirs. We also don’t know how many more variants of the virus (and letters of the Greek alphabet) there will be this year, and how severe, or not, they will be.

In conclusion, tighter monetary policy to address concerns about inflation will likely act as a headwind for bonds this year, but the continued reopening of the global economy should provide support to equities. As we know from past experience, what makes sense today doesn’t always play out due to a number of unknowns that invariably arise. As investors, that’s the risk we take by investing in bonds and equities, as opposed to keeping our money in a bank account. The reward, for those of us who stay the course, are well diversified, and have a long investment timeframe, should be higher returns.

Any views expressed in this article are the personal views the author and do not necessarily represent the views of BNZ, or its related entities. This  article is solely for information purposes and is not intended to be financial advice. If you need help, please contact BNZ or your financial adviser.

Neither Bank of New Zealand nor any person involved in this article accepts any liability for any loss or damage whatsoever which may directly or indirectly result from any, information, representation or omission, whether negligent or otherwise, contained in this article.