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On the rise of everything

The Covid-19 pandemic remained a dominant force shaping financial markets in 2021, and omicron, the latest “variant of concern,” has surely rattled investors in recent days. Yet, barring another full-scale outbreak that shuts down huge swaths of the global economy again, it’s safe to say the virus’s toll on our physical, mental, financial and social well-being has receded significantly since the height of the crisis almost two years ago. And at least in the minds of investors, the pandemic should continue giving way to the economic side effects that have been spawned in its wake.

Rising inflation

In no way is this shifting focus more evident than in our current fixation with inflation, which has climbed to heights not seen in decades and may now represent the biggest threat to investors’ portfolios. While the economy is arguably stronger heading into 2022 than it has been in years, there is mounting concern about the trajectory of future growth, especially if inflationary pressures persist well into the new year.

In part, this is because higher prices for everyday essentials like groceries, gasoline, and home heating could eventually cut into demand for discretionary goods and services, which helps drive higher earnings growth in most economies. But perhaps the bigger worry is the eventuality of higher interest rates should inflation continue to rise. In this case, it’s less about distribution of demand than about a reduction of demand, because most everyone’s cost base – from consumers and small businesses to the largest corporations – becomes more expensive and cuts into their purchasing or earnings power.

Rising rates?

It’s to that end that so much attention is being paid to the U.S. Federal Reserve and other central banks these days. While several emerging market countries have already raised rates to combat higher inflation, most of their developed market counterparts have yet to pull the trigger. The Fed, for its part, now says U.S. inflation will linger longer than previously anticipated but still believes it will fall back closer to a rate of 2% over time. As such, it remains reluctant to raise its overnight lending rate anytime soon, if at all, in 2022, despite market expectations that are predicting two rate hikes next year, likely starting in the late spring.

In contrast, the Bank of Canada (BoC) should meet expectations by raising its key rate sometime in the first quarter. However, while the potential timing of its first hike since 2018 jibes with markets, the BoC isn’t signaling nearly as many rate hikes as some prognosticators suggest it should make in 2022.

Of course, who ends up being right will be the one of the big market-moving questions of the next few months. And to some extent, the answer lies in the ability of global supply chains to right themselves after months of disruptions tied to labour shortages, and pandemic-related manufacturing outages. But whether inflation subsides – and central banks aren’t necessarily forced to raise rates – may have just as much to do with rising wages as it does with supply shortages. While the latter seems like an inevitable fix over the next few months, higher labour costs are not so easily remedied and can lead to inflation that is much more persistent.

Granted, inflation isn’t always negative for markets. In fact, it may end up being a relatively positive economic condition if it moderates even slightly and leads to slow and measured rate increases that don’t hinder growth over time. Yet investors can’t rule out the potential dangers associated with stubbornly high prices, nor should they ignore the prospect of stagflation setting in – at least not entirely. While there’s little reason to believe economic growth will collapse over the next 12 months, it’s conceivable that it will likely slow from the torrid pace of expansion this past year. This may be true even if interest rates don’t rise as expected, or if omicron only ends up leading to minor restrictions on economic activity around the world.

Rising global growth

Beyond these two potential headwinds, global growth will likely continue to grow from here without the aid of more fiscal stimulus from governments. At the same time, many of the spending programs put in place over the past two years may result in higher taxes to pay for them. China, meanwhile, stands out as another potential drain on global growth, not only because the world’s second largest economy continues to grapple with production concerns related to energy and material shortages, but also because of its zero-tolerance Covid-19 policy and the ongoing regulatory crackdown on key sectors of the country’s economy.

In other words, caution is advised as investors head into 2022 – but not at the expense of optimism. While more subdued economic growth and higher market volatility may be defining characteristics of the year ahead, so too will the pockets of opportunities that arise in this type of an environment. Stock markets, for example, seem more likely than not to climb higher over the next 12 months, albeit hardly to the extent they did in 2021.

Investment implications

As such, we believe a bias of equities over fixed income within a 60/40 portfolio remains the most prudent allocation for now. In particular, we see some strong opportunities originating from countries like Japan and Europe, and view quality companies more generally as being better positioned to navigate the potential for higher interest rates and slower growth down the road.

That doesn’t mean fixed income is an afterthought. To the contrary, while government bonds may struggle if rates rise, they can still provide important ballast during periods of volatility. Moreover, alternative sources of yield, including private credit, can help pick up the slack and may mitigate losses.

All in, then, investors have a lot to consider heading into the new year, including the possibility of higher inflation, higher interest rates, higher taxes and higher market volatility. Yet, as long as everything doesn’t go too far up over the next 12 months, there’s reason to believe investment returns may rise, too.

Kevin McCreadie is Chief Executive Officer and Chief Investment Officer at AGF Management Ltd. He is a regular contributor to AGF Perspectives. Kevin McCreadie is Chief Executive Officer and Chief Investment Officer at AGF Management Ltd. He is a regular contributor to AGF Perspectives. Click to learn more about AGF’s fundamental, quantitative, and alternative investing capabilities.

Notes and Disclaimer

© 2021 by AGF Ltd. This article first appeared in AGF Perspectives. Reprinted with permission.

The commentaries contained herein are provided as a general source of information based on information available as of December 6, 2021, and should not be considered as investment advice or an offer or solicitations to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Market conditions may change investment decisions arising from the use or reliance on the information contained herein. Investors are expected to obtain professional investment advice.

The views expressed in this blog are those of the author and do not necessarily represent the opinions of AGF, its subsidiaries or any of its affiliated companies, funds or investment strategies.

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