Global markets have recovered remarkably well following unprecedented fiscal and monetary stimulus. Couple that with global vaccination roll-outs and the result is an accelerated pace of economic recovery that is set to continue and broaden in 2022.

However, if Covid has taught us anything, it is that life can be pretty unpredictable.

Even as Ireland and other economies across the world were preparing for a post-vaccination spending boom, the Delta variant reminds us that we are not always fully in charge.

It is a timely reminder at a point when investment sentiment is optimistic to a level that is bordering on euphoria.

The reasons for optimism are understandable; a strengthening global economy driven by substantial pent-up demand, generally rising household savings and accommodative Central Bank policies, but there is a fine line between optimism and complacency.

Record Growth but some complacency

On the one-hand, positive signs abound as economic growth heads for multi-decade highs, companies report strong earnings, and volatility recedes. At the same time, rising input costs and strong demand are fuelling inflation. SSGA’s Market Regime Indicator — a proprietary tool to gauge the market environment and investor sentiment — indicates a worrying level of complacency among investors.

Shocks can and do occur and those don’t need to be of the scale of the ongoing global pandemic to warrant caution. Slower burn issues, such as inflation and rising interest rates are also grounds for a measure of caution.

 

Householding spending will be key

The current levels of savings built up in much of the developed world (and even in parts of the developing world) will take time to make its way back through the economy. In Ireland alone, the Central Bank estimated that household deposits increased by €15.7bn between March 2020 and February 2021 as Covid-19 restrictions curbed spending. A large portion of these savings may be more akin to deferred spending than precautionary savings; this is delayed spending, not lost spending. The final impact of the unwinding of those household savings is yet to be seen.

Across the global economy the release of pent-up demand has so far been heavily skewed in favour of tangible goods. During the second half of 2021 and going into 2022, we expect to see a strong swing towards services that should support a fuller, broader, continuing recovery.

However, the pace and extent of that recovery may vary significantly. Spending could turn out to be considerably higher if there is a swift recovery from the pandemic. While a slower recovery could encourage households to hold on to the savings for longer.

 

Inflation – transient or sustained?

While most of the inflation spike at the moment is transient in nature, SSGA suspects that the new normal for inflation over the next two years will be higher than pre-Covid.

Here in Ireland, the latest figures from the Central Statistics Office (CSO) point to inflation running at 1.7pc year on year in May — an acceleration from the depressed impact of the first lockdown. Ireland is not alone in experiencing inflation driven by base effects and pent-up demand.

Worldwide this will be one of the major focus points — how enduring and high its trajectory is will determine Central Bank rates and asset purchases with implications for most assets — especially bonds and stocks.  

Optimism with caution

At SSGA, our central view for risk assets is arguably the most optimistic we have held in recent years because of the strengthening global economy, pent-up demand and ultra-accommodative central banks.

As the growth differential between the United States and Europe starts to narrow and emerging markets continue to make progress against the Covid threat, US market leadership is likely to give way to a more international scope. Strong earnings prospects and less-stretched valuations will continue to add to the appeal of European equities.

Against a surging economic backdrop, however, the market is currently treading a fine line between optimism and complacency. Such complacency can potentially leave the market more prone to being rudely awakened by, and overreacting to, potential shocks that can occur — be that the impact of the global pandemic, of geopolitical tensions or the myriad of other possibilities.

Markets will also be maintaining a watchful eye on inflation, interest rates and bond yields, to establish whether the current US experiment of letting the economy ‘run hot’ raises concern over the market’s confidence for a smooth exit from one of the biggest monetary policy exercises in history.

In summary, we expect the positive economic momentum to continue into 2022 thereby supporting markets. Those markets have admittedly come a long way and now need to continue to deliver solid earnings growth. Investors face a broadly favourable backdrop but also need to keep an eye on some evolving risks.

 

Desmond Lawrence, Senior Investment Strategist, State Street Global Advisers