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The Recovery continues despite Omicron.
Despite the persistence of COVID, major share markets delivered strong returns through to the end of 2021. The global economy clearly continues to recover, but the pace is easing. While the outlook remains positive, challenges remain, particularly as we assess the impact of the war in the Ukraine, the sharp rise in inflation and the emergence of new COVID variants.
Russia’s invasion of Ukraine
First and foremost, Russia’s military action in Ukraine is a human tragedy but there are of course both economic and investment impacts we must consider. Russia is the world’s third biggest oil producer and second-biggest producer of natural gas. Energy prices have surged on the back of the invasion but we’re yet to see if this will be sustained.
We expect that the war may see an acceleration of strategic trading alliances, and a further step away from the open global trading system, including the rise of China and tariff reductions, that has helped to moderate inflationary pressures over the last 20 years or so.
The holiday from inflation is over
One of the biggest challenges in our future post pandemic world, is the re-emergence of inflation, a risk that hasn’t grabbed headlines for many years, but the long holiday seems to be over. The combination of burst of pent-up demand and spending as many countries have come out of lockdowns, and disruptions to supply chains for everything from microchips to cars has meant many goods are harder to find, sending prices spiralling higher.
Both the US economy and inflation have been building up a head of steam with recent data likely ending arguments against the case for higher interest rates. The US economy grew by 5.7% in 2021, the fastest pace since 1984. This has been a strong comeback for the American economic engine despite the pandemic.
A lot of good news was packed into the 5.7% figure with unemployment falling to pre-pandemic levels, rising wages, businesses investing strongly and a lift in consumer spending. However, the bad news is that inflation, as measured by the US Consumer Price Index, was even higher, reaching 7% in December, the biggest number in 40 years. Inflation isn’t a US-only issue though, with inflation in many countries now higher than before the pandemic. Most central banks have inflation targets, usually in the 2-3% range, and it’s going to take some effort to pull back inflationary trends.
Further, given already high inflation, on the back of stressed supply chains, the invasion of Ukraine is adding to these pressures with oil and a range of commodity prices surging. These price spikes if sustained are not just inflationary they are a tax on growth. While central banks haven't had to raise rates on war-induced energy spikes in the past, with inflation already at eye-watering levels they won't be able to turn a blind eye like they could have done in the last 20 years or so.
We’ve been concerned about inflation for some time and that’s why we’ve been moving away from fixed interest assets and allocating funds towards ‘alternative assets’ with different return patterns to traditional assets. We also believe our alternative assets will react differently to a rising interest rate cycle when compared to how fixed income and shares will likely respond.
We ended 2021 looking at high vaccination rates and the re-opening of economies in full swing. Many of us felt we would be ‘living with the virus’ by now. However, Omicron has given us some food for thought, demonstrating that living with the virus may mean future bouts of lockdowns with the emergence of new variants.
Clearly we still have a way to go, and we shouldn’t downplay the impacts of Omicron, and additional more transmissible sub-variants such as BA.2, but our understanding of COVID and how to manage it improves each day and we should expect COVID to, eventually, become endemic, rather than the threat it currently poses. Meanwhile, Omicron has proven to be disruptive to supply chains as we’ve seen in empty supermarket shelves and the help wanted signs in store windows.
While society continues to adjust to Omicron, markets are now looking forward to a world which has learnt to ‘live with’ COVID, with growth assets continuing to benefit from this, despite the more recent volatility.
The challenges of the war, inflation and Omicron have contributed to the market jitters we have seen already in early 2022, but we shouldn’t forget there was an incredible surge in markets following the pandemic-driven recession. The more recent market correction was focussed across heavily leveraged assets (those businesses which had borrowed on the basis of zero and negative rates, now fearing these ultra-low rates are going to be steadily unwound) and should support returns going forward.
Trying to work out where financial markets go from here is challenging. We expect that market volatility could remain elevated for some months as the Russian military action plays out, likely undeterred by the current sanctions.
While we expect the war to be a relatively constrained event, the risk around energy and commodity prices remains the key risk to the growth outlook and global financial markets. That said, we are likely now returning to more constructive share market valuations, reflecting the progress that’s being made in removing central bank ‘emergency’ pandemic policy settings. It should always have been expected that the extreme policy support would eventually be removed.
So while the high ‘pandemic bounce back’, double-digit returns aren’t likely to continue, we expect we will likely see solid but more modest returns as the next phase of the recovery matures. All up, it’s still a positive market outlook story in the medium term.
Important information: This communication has been prepared by IOOF Investment Management Limited (IIML) ABN 53 006 695 021, AFSL 230524 as Trustee of the IOOF Portfolio Service Superannuation Fund ABN 70 815 369 818 (Fund). IOOF Employer Super is a Division of the Fund. IIML is part of the IOOF group of companies, consisting of IOOF Holdings Limited ABN 49 100 103 722 and its related bodies corporate (IOOF Group).
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