By Gareth Gettinby

Risky assets performed well over the holiday period however this has not continued into 2022, with most major asset classes declining in the first week of the year.

As investors position for the year ahead there may be no alternative to equities, due to the low yield offered by corporate and government bonds. In an environment of an improving economic backdrop as the world moves back towards normality through 2022, equities should continue to provide a positive return; albeit it will be difficult to match the strong returns of 2021.

There are still several hurdles that investors will need to navigate during the next 12 months including central bank decisions and the realisation that ultra-loose monetary policy is coming to an end, elevated inflation, Covid-19 developments, ongoing global supply chain constraints and geo-political risks that seem to be never too far away.

Around the world many central banks are increasing interest rates to curb inflation. Investors remain focused on the US Federal Reserve’s ‘dot-plot’ that provides an indication of how many rates rise are expected in the future.

Current expectations are for at least three hikes in 2022. In normal cycles this would be the correct focus, but this cycle is far from normal and perhaps the focus for investors should be on the enormous amount of financial assets the Fed owns (commonly known as the ‘balance sheet’) that has increased due to it purchasing assets during the pandemic.

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This balance sheet has gone from $4.5 trillion in late 2017 to an eye-watering $8.8 trillion as it stands today.

Minutes from the recent US Federal Reserve meeting have fuelled the debate on balance sheet reduction. This would involve the Fed selling bonds in a process better known as quantitative tightening (QT). The minutes provided a clear signal towards an even more aggressive tightening path, and there is a risk that if the Fed sells bonds at pace, it destabilises financial markets.

How the Fed removes the punch bowl will have a big bearing on how financial conditions tighten. If the Fed is aggressive in unwinding the balance sheet this would have a significant impact on the price of government bonds and could cause a sharp sell-off in equities, in particular emerging markets given they are more sensitive to interest rate rises.

The more market-friendly approach is a cautious unwind that would see yields rising slowly – an approach that could see equities reach new highs.

Whilst history does not always repeat itself, when the Fed did QT between 2017 and 2019 the pace was $50 billion a month and this had very little impact on equities, albeit there was a sharp sell-off in the fourth quarter of 2018. It does feel that this time could be different.

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Covid-19 in some variant is here to stay for the foreseeable future. The most recent variant of Omicron has spread rapidly across the world and is now the most dominant variant across many countries.

The impact on companies will depend on the various strategies different countries are deploying to deal with virus. China for example is one of the world’s largest exporters and it continues to have a zero Covid policy. One of the world’s biggest ports, Ningbo, is in China and authorities there are once again enforcing a partial lockdown.

Into the end of 2021 supply chain bottlenecks were easing, however this lockdown is a setback that could potentially put pressure on the supply of goods.

The impact of significant supply issues is already causing further strain on companies. Many can pass the price rises on to the end buyer, but for technology companies that can’t get enough semiconductor components to meet demand, this is starting to impact their revenues.

For example, Apple chief executive Tim Cook last quarter highlighted that chip shortages had cost the company $6bn, and this is likely to be a trend when its earnings are released later this month. Price pressures of 2021 are likely to continue into the first half of 2022 and potentially longer, depending how quickly supply constraints are eased.

As 2022 gets out of the starting blocks there may be a number of false starts and hurdles for investors to overcome, as the Fed will be tightening into an elevated market and increased speculation on QT – which can only mean more volatility.

Gareth Gettinby is an investment manager with Aegon Asset Management.