2022 Global Outlook

We are entering a new market regime unlike any in the past half century: We see another year of positive equity returns coupled with a down year for bonds. The powerful restart of economic activity will be delayed - but not derailed - due to new virus strains, in our view. Central banks will start to raise rates but remain more tolerant of inflation. We see inflation settling above pre-Covid trends – we’re going to be living with inflation. We favor equities over fixed income as a result, but have dialed back our risk-taking given the wide range of potential outcomes in 2022.

Theme 1: Living with inflation

Inflation jumped in 2021 on the back of supply and demand mismatches. We see inflation settling at levels higher than pre- Covid whenever these supply bottlenecks ease. The chart shows that we see inflation persisting for years to come.

One driver of this: Major central banks are living with more inflation than they would have in the past, showing a much more muted policy reaction – our core view.

The Fed has belatedly acknowledged meeting its inflation objective to make up for past misses – something we had long argued had already happened. We expect the Fed to kick off rate hikes in 2022 but don’t see it reacting aggressively to inflation. We are watching how the Fed interprets its “broad and inclusive” employment objective to guide when and how quickly policy rates rise. The Fed’s mandate means it will want to see further progress on the return of people to the workforce – and we expect rate hikes to be gradual.

We see the rate increases as removing some of the stimulus added during the 2020 shock as the labor market heals back near pre- Covid conditions.

The ECB is in a different spot. It still wants to get inflation to settle at 2% rather than falling well short as it has for years. The ECB’s medium- term inflation projections are likely to settle below its 2% target. That suggests ongoing policy stimulus. We don’t see the ECB lifting rates for a few more years and think it will likely increase its regular asset purchases as the special pandemic program is set to end next year.

Climate change is part of the inflation story. A smooth transition to net zero is the least inflationary outcome compared with a disorderly one or business as usual, in our view. Climate change will likely mean a series of supply shocks playing out over decades.

Implication: We prefer equities over fixed income and remain overweight inflation-linked bonds.

Theme 2: Cutting through confusion

Our cutting through confusion theme is about keeping the big picture in mind – but also acknowledging the risks around our base case shown on page 4. We’ve never had an economic restart like this. Add repeated, outsized data surprises to the mix – both to the upside and downside – and confusion is natural among policymakers and markets adapting to a new reality.

At the same time, central banks are implementing new frameworks that change how they react to inflation. The risks arising from new Covid- 19 strains only add to the confusion. We cut through many possibilities to ask: What would it take for us not to be in this new market regime?

We see two key ways our new market regime view could be wrong. First, central banks might react differently. They could – in the face of persistent inflation pressures, perhaps tied to new Covid-19 strains – revert to their old response to inflation.

The chart shows how different our and the market’s view of future Fed rate hikes is from how the Fed might have reacted historically to the current mix of slack and inflation. In the past, we believe the Fed would have been pushing up rates in 2021 – again helping confirm this is a new regime.

Central banks could also be forced to be more aggressive if inflation expectations become de-anchored. We would be faced with inflation significantly above target, rising interest rates and falling growth: a classic stagflation scenario that is bad for both bonds and equities.

Second, we could be wrong about growth prospects. On the downside, perhaps a threat of repeated Covid- 19 waves derails the restart – and leads to stagnation. Or on the upside, an investment and productivity boom could lift potential growth and keep the macro environment disinflationary.

Implication: We trim risk amid an unusually wide range of outcomes

Theme 3: Navigating Net Zero

Our cutting through confusion theme is about keeping the big picture in mind – but also acknowledging the risks around our base case shown on page 4. We’ve never had an economic restart like this. Add repeated, outsized data surprises to the mix – both to the upside and downside – and confusion is natural among policymakers and markets adapting to a new reality.

At the same time, central banks are implementing new frameworks that change how they react to inflation. The risks arising from new Covid- 19 strains only add to the confusion. We cut through many possibilities to ask: What would it take for us not to be in this new market regime?

We see two key ways our new market regime view could be wrong. First, central banks might react differently. They could – in the face of persistent inflation pressures, perhaps tied to new Covid-19 strains – revert to their old response to inflation.

The chart shows how different our and the market’s view of future Fed rate hikes is from how the Fed might have reacted historically to the current mix of slack and inflation. In the past, we believe the Fed would have been pushing up rates in 2021 – again helping confirm this is a new regime.

Central banks could also be forced to be more aggressive if inflation expectations become de-anchored. We would be faced with inflation significantly above target, rising interest rates and falling growth: a classic stagflation scenario that is bad for both bonds and equities.

Second, we could be wrong about growth prospects. On the downside, perhaps a threat of repeated Covid- 19 waves derails the restart – and leads to stagnation. Or on the upside, an investment and productivity boom could lift potential growth and keep the macro environment disinflationary.

Implication: We trim risk amid an unusually wide range of outcomes

“Without a successful green transition everywhere, climate risk is unmanageable anywhere.”

Paul Bodnar Global Head of Sustainable Investing, BlackRock

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