The year began with COVID-19 as the biggest threat to the economy and has ended the same way. But along the road there’s been plenty of highs and lows, from lockdowns and fears of inflation, to the debt crisis in China spurred on by property giant Evergrande, and strong global growth.

There was also the local housing boom, debate around when interest rates will start rising again and overall, strong equity markets.

Throughout the year, Wall Street has provided strong returns, above 20 per cent. It was a solid year for equities in Europe. The S&P/ASX200 has been a bit more subdued, up about ten per cent. But if you add in dividends, you’re up about 15 per cent on a grossed up for franking credits basis.

It wasn’t such a good year for bonds though. Bond yields have increased, and that’s triggered capital losses for bonds.

If you’re a typical balanced investors in a superannuation fund, then up to October you were up, on average, by 11 or 12 per cent. That’s a reasonably good year.

Another factor in financial markets has been the growth of crypto currencies, which has triggered plenty of interest.

Looking forward, 2022 will probably be the year when COVID-19 goes from being a pandemic to being endemic, or something we’ve learned to live with. It will be something akin to the common cold or flu, but there will be setbacks along the way.

We expect ongoing economic recovery, solid growth globally in the order of five per cent which will be a little down from this year.

In Australia we are going to see good growth, particularly following the setbacks that have depressed this year relative to expectations.

The current spike in inflation is a major issue and we will see ongoing pressure on central banks. We believe the Reserve Bank of Australia (RBA) will start raising rates late next year. In any case we’re still going to continue to have very low interest rates next year.

In share markets, the broad trend is likely to remain positive, but we are coming into a tougher phase of the bull market. There’s going to be more volatility and more constrained returns.

COVID-19 is still high on the watch list for the share market. Inflation, supply constraints, China and elections in Australia, France and the United States are also on that list.

On the local election, the difference between the two major parties now is nowhere near as great as it was back in 2019 so it’s unlikely there’ll be as much riding on the result in 2022, as there was last time around.

COVID-19

COVID-19 is still causing real economic consequences. Even when there are no lockdowns, but the threat remains significant, people behave as if there is a lockdown, and that constrains the economy.

Globally the number of cases has been rising again, particularly in Europe and parts of the United States. And recently there’s been the Omicron strain.

The good news in Australia is that the number of cases have come down from their highs, both in Victoria and New South Wales, but they are still lingering at reasonably elevated levels.

What’s critical is the hospitalisation rate and that shows that vaccines continue to work. In Australia, 78 per cent of the total population – which includes infants and children – have had their first dose. And 73 per cent are fully vaccinated. That’s above the developed nation average and it’s still rising as other states’ vaccinations rollouts catch up to the ACT, Victoria and NSW.

The pandemic is not over yet, but the good news is that COVID-19 is likely to become endemic next year. Vaccines are so far highly effective in preventing serious illness but are less effective in preventing infection and transmission. We know efficacy against infections wanes after 4 to 6 months.

People are likely to require booster shots. If the hospitalisation rates stay low, hospital systems around the world will be able to manage as re-openings continue.

We still don’t know a lot about the Omicron strand of the coronavirus though doctors in southern Africa say cases are milder than Delta. The pessimistic scenario is that its more transmissible and turns out to be more virulent than Delta necessitating a rollout of new vaccines which will delay the recovery. The optimistic scenario is that it’s less virulent than Delta but takes over from it and squeezes that variant out of the system.

If hospitalizations and deaths are kept down, then the world is on the path to living with COVID-19. We are reasonably confident that is what we are going to see as we go through the next year, although Omicron and other variants could still cause bumps along the way, particularly if the pessimistic scenario unfolds.

Global growth

There are several reasons for optimism about good global growth over the next year.

There are signs out of China about more stimulus coming, albeit slowly. Easy fiscal policy continues around the world. It’s the same story for monetary policy even though some central banks have raised rates or started to slow bond buying.

There is still a lot of pent-up demand in economies. There is around $2.3 trillion of savings that have built up in the United States through the last 18 months. In Australia, accumulated savings are worth around $256bn. And of course, vaccines are working. Those factors together provide optimism about the global recovery over the next 12 months.

Inflation

The big increase in economic activity since the 2020 downturn has led to a shortage of goods across the economy. Consumers have been spending money on goods, because they haven’t been able to spend on services like they normally would. People haven’t been able to eat out or travel as much, for example.

At the same time, governments across the world have been compensating consumers for lost income, and possibly over-compensating.

As time went on, the lockdowns negative impact on economic activity diminished because businesses and consumers worked out how to deal with shutdowns. Also, during the most recent lockdowns, people better understood that it would be a temporary phenomenon.

The increase in demand from consumers has come at a time when production has also been constrained. Production facilities closed in areas like China which was still pursuing a zero COVID strategy. This led to disruption in manufacturing, and that’s why there were empty shelves in places like IKEA and Bunnings. In short, production couldn’t keep up with consumer demand for goods and that led to inflation.

Part of that is temporary. Goods demand won’t stay strong forever. Goods spending was brought forward, but there’s only so many new couches people want. A lot of that spending will now go back to services, as that part of the economy reopens.

Some of the indicators for supply shortages also look better. The Baltic Dry Index measures the cost of transporting bulk goods around the world. The index peaked in October and is starting to come down.

For the next six to 12 months, there may still be issues across the supply chain. Delivery of online orders may take a few extra weeks. But part of the inflation in the system is transient and supply issues are likely to start becoming less of a problem in 2022 as people’s spending shifts towards services.

Wages growth is starting to keep up with increased prices, especially in the United States. That’s reflective of a very strong economy. Their unemployment rate is about four per cent and indicators suggest it will remain strong in 2022. In Australia, wages growth hasn’t been as strong.

Interest rates

Australian inflation will become more of an issue into next year. On our forecasts, underlying inflation will get to about 2.6 per cent by the middle of next year, which is in the centre of the RBA target range. It’s likely to remain there and that’s why the RBA will raise rates at the end of next year.

Other central banks are also going to lift interest rates too. In the US, the Federal Reserve will hike rates faster than the RBA. About 50 per cent of central banks in emerging countries have raised interest rates in the last few months, and only 30 per cent in developed markets.

The talk about rate hikes around the world has led to rising bond yields at the front end of the curve, especially in the two to five years part of the curve. Ten-year bond yields haven’t moved up much.

We expect to see two rate hikes in Australia next year. That would take the official cash rate to 0.5 per cent which is still extremely low. We don’t expect rates to get back to more normal levels for some time.

It’s worth noting that household debt in Australia is at a high level and has been increasing over the past few years. It is running at about 180 per cent of income and that means Australians households can handle fewer interest rates hikes than they could have done previously, because they have to keep servicing and paying off that debt.

Equities

There are still more positives than negatives for equities.

Looking at the risks first. Coronavirus remains a negative as does tensions with China. The economic recovery will slow and that means weaker profit growth. And then there’s the short-term spike in inflation, which could become a long-term spike.

The positives are that vaccines are helping. Monetary and fiscal policy remains ultra-easy and low rates make equities relatively attractive. There’s still plenty of government stimulus coming and earnings expectations are still being revised up. In the United States, things are a bit calmer under President Biden and that’s a positive for markets.

Because interest rates are so low, bank deposit rates are also very low. Investors make the comparison – very low bank deposit rates or five per cent fully franked return on shares. That differential will remain for some time, because when interest rates do start to rise, it will be a gradual process.

But there will be more volatility and more constrained returns in equity markets over the next year.

Housing market

It’s been a phenomenal year for home prices and across houses and apartments, prices are up by about 22 per cent. Houses have done much better than apartments.

Why? There’s been falls in interest rates during the pandemic. There have been incentives for home building and first home buyers that’s led to a big rise in approvals and construction activity.

There’s been an economic recovery and more consumer savings. The value of government payments to people, or additional payments they received, is worth about eight per cent of GDP allowing people to accumulate money.

Also, as house prices have risen, there’s been afear-of-missing-out which drives more buying.

Regional Australia has done very well with prices up about 25 per cent on an annual basis. It shows the desire for people to move out of the city during lockdowns or re-assess what they really value. That trend is likely to continue over the next few years.

Higher interest rates from central banks are likely to go with the higher fixed rates already being experienced. That will happen across 2022 and 2023. There is potentially some level of over-supply, particularly in the apartment market, and migration numbers are not likely to be as high as they were pre-COVID-19 in the short term.

Over the next 12 months, home prices will rise by about five per cent across Australia but there will be a big divergence across states. Sydney and Melbourne are slowing already whereas some other capital cities such as Canberra and Brisbane are still doing well.

House prices are likely to fall in 2023 by about seven per cent. The main drivers will be interest rate hikes and affordability, especially across the major cities.

Aussie Dollar

Based on the purchasing power of parity, which looks at the difference between prices in Australia and the United States, the Aussie dollar is fair value at around 75 US cents. It’s a little bit below that now.

If the global reopening continues and global growth accelerates, then that tends to be negative for the US dollar. There might be some more upside for the local unit, especially if commodity prices stay strong.

However, if the US central bank moves on interest rates, that might keep the Aussie dollar a bit lower against the greenback.

Risks to the Outlook

The main risk remains COVID-19 and how it plays out. Hospitalisation rates are very important to watch. If hospital systems get strained, that can lead to a collapse in the economy.

It’s important to watch how children’s vaccines are rolled out, because kids make up around 20 per cent of the population. If you want the global reopening to fully proceed, children will need to get vaccinated.

There is a risk that inflation is less transient than expected, and central banks will need to raise interest rates faster than anticipated. That would lead to a big rise in bond yields and a repricing of assets that are sensitive to those yields. That includes real assets like property and infrastructure.

In terms of global growth rates, what happens in China is extremely important. We know the Chinese economy is slowing down. Where it normally would be growing at five to six per cent, it might be closer to three or four per cent. That means that over the next few years, there will be lower growth in demand for Australian commodities.

There’s also political risk globally. There are US midterm elections next year and the incumbent party often loses seats in the Senate, which means the Democrats may not end up with a majority. That’s why the Democrats are trying to push through their stimulus packages this year.

There’s also an election in Australia but that is unlikely to be a major driver of financial markets.
Geopolitics is also a risk- including the relationship between the US and China and tensions between Australia and China, which has recently been demonstrated by moves to diplomatically boycott the Beijing Winter Olympics. There’s also a French election next year and Germany has a new Chancellor, Olaf Scholz.

Conclusion for Investors

Cash is going to offer very poor returns of close to zero. Investors can also expect low return from bonds, given the low starting yield.

The trend in shares remains up, but investors should expect more volatility and more constrained gains in 2022.

Home prices have risen by around 22 per cent his year, but that will slow to five per cent next year as poor affordability and rising interest rates impact. Prices are likely to fall between five and ten per cent in 2023, depending on location.

Unlisted commercial property and infrastructure has been hit by work-from-home, e-commerce and less travel. But there is still strong investor demand. Industrial property looks most attractive within unlisted commercial real estate.

Finally, the Australian dollar is likely to be higher in 12 months’ time, trading around $US0.80.

Investors should remember it’s difficult to time markets. This means it’s important to have a well-diversified portfolio and to only invest in things you understand.