Could 2022 get better from here? It’s certainly hard to get worse!

In this article, we will examine the causes of recent volatility and a forward-looking scenario that could see investor sentiment improve.

First off, here’s some good news. 

History shows that the share market always recovers from drawdowns and in due course goes on to make new all-time highs. But there is no hiding from the fact that so far 2022 has been a torrid time for investors in the majority of asset classes. 

Bonds and shares have both suffered sharp sell offs. June has seen most developed countries share markets drop into bear market territory. It’s been countless decades since share markets had such a bad start to a year. For the bond market, it's been several centuries since bond performance was this bad.

Times like these can be particularly challenging for investors in our part of the world. As investor sentiment deteriorates and correlations between share prices and markets across the world tighten, business fundamentals are temporarily irrelevant. 

What matters most is what the S&P500 does overnight, that determines how our market performs on the day. 

At least an American investor can wake up and hope the day is going to be better for their share portfolio. In New Zealand, we wake up to see the S&P500 down and before we’re even out of bed, we know its going to be a bad day for our share portfolio. 

It's worse when a really weak Friday in the US spurs on a bad Monday to start the week. Worse still? Having a peek to see how the US is trading in the middle of the night. That could lead to more than a few sleepless nights.

The cause of this current chaos is the trifecta of doom that has unfolded in the past 6 months. Around the world, governments and central banks overstimulated the global economy. Demand has been more than supply - creating inflation that was not “transitory”. Indeed, central banks being behind the curve was the first leg of the trifecta. 

The second leg was the invasion of Ukraine which triggered energy and food prices to rise sharply which further fueled inflationary pressures. 

And to complete the trifecta, China’s decision to lock down whole cities for months to eliminate the virus further exacerbated supply chain issues, further fueling inflation.

The chart above really visualises the problem created by the trifecta of doom. It shows monthly US inflation readings, they annualise each month. You can see the deflationary pressures that the government and central bank were dealing with in 2020, energy prices fell due to the lock downs and travel restrictions. Moving forward, you can see the steady march higher through 2021 and now into 2022. 

The latest reading shows annual inflation is running at 8.6% with forecasts suggesting a top out at 9% in the next couple of months. It is not finally forecast to start moderating back down until late 2023.

That moderation is forecast to be quite rapid, due largely to the sharp spikes of the first half of this year become harder to replicate going forward. This is the silver lining to the story - especially if central banks can get their monetary policy setting to get demand and supply closer to some sort of equilibrium. 

This is what they have been trying to do in recent months. 

When the European Central Bank moves early next month that will have over 60 central banks around the world raising rates in 2022. The concerted and widespread nature of these moves indicates a global determination to get inflation under control. 

The other aspect of the moves that also shows that determination is how quickly central banks are raising rates. This month the US Federal Reserve increased by 0.75%, the first such move in 28 years, which took its funds rate up to 1.75%. If, as is now expected, they move another 0.75% at their next meeting their funds rate will have reached 2.5%. 

The path ahead is starting to look very much like come the first quarter next year interest rates will have risen to 3-4%, varying by country, and inflation will have dropped to 3-4%, again varying by country.

If this comes to fruition, central banks could have inflation under control by early next year. Then, the damage caused by the trifecta of doom should abate. 

Also, worth noting that markets tend to look ahead by six to nine months which means that if this is the planned path forward, we could see volatility easing as we move into the second half of 2022. 

After that, it's all about how the global economy bears up under the likely cooling off in demand. But that is a matter for 2023. Right now, most investors would settle for the second half of 2022 to be a little kinder.