Given we are in an Age of Transformation, it is unsurprising that the fast-moving flow of 2021 market and economic upheavals looks set to continue into 2022. While there are high expectations that the pandemic could finally be tamed, the impact of higher inflation and its consequences for the global economic recovery should ensure that markets remain difficult to navigate in the months ahead.

To help plot a course through these rapids, we explore the uncertainty about the path of the economy going forward and investigate how markets may react to the next phase of the economic recovery. We also consider whether sustainability will continue to create new investment opportunities and what other investment themes should be in focus over the coming year.

Restarting a stalled global economy is an awkward exercise. The ongoing Covid restrictions crimped supply, while the enormous fiscal and monetary stimulus boosted demand. The global economy is consequently struggling to squeeze robust demand through a narrow supply channel. The restoration of supply chains, reallocation of labour, and rebalancing of supply and demand will be critical factors in determining both economic growth in 2022 and the strength and persistence of inflation.

While some constraints on production may last longer than others (notably the shortage of semiconductors), they will be resolved eventually, enabling economic growth to revert to trend and easing pressure on inflation. On the other hand, labour markets may not return to where they were before the pandemic as the overall labour force could remain smaller. Productivity should eventually improve, but this will not happen immediately.

Ultimately, inflationary pressures are expected to persist into 2023 and could be strong enough to force central banks – notably the Federal Reserve (Fed) – to tighten policy sooner than projected.

Having exceeded expectations in recent years, equities may struggle to generate above-average returns in 2022. Winning streaks for US equities have never previously exceeded four years¹ and, given the US economy reopened from pandemic restrictions earlier than other parts of the world it could be argued that most of that recovery momentum has already taken place. On the other hand, reopening is still progressing in Europe and equities here could finally make up some lost ground versus their US peers this year.

Another critical asset allocation call is whether value stocks will begin to reverse their underperformance. The signs are promising given their valuation gap versus growth and the prospect of higher interest rates could provide a boost. However, we’ve seen this scenario before…

With the Fed being forced to act over inflation, government bond yields should rise. However, the increase in longer-term yields will likely be limited by capped inflation expectations and the Fed’s efforts to keep real yields low. Elsewhere in the fixed income spectrum, investment grade and high yield credit typically outperform government bonds during a hiking cycle, although the challenge of low spreads offers little potential for above-average returns remains. And there will be selective opportunities within emerging market (EM) debt, with EM high-yield bonds looking attractive from a valuation perspective, particularly in Asia which is still feeling the fallout from issues surrounding China’s property sector.

Private debt can also offer an attractive liquidity premium relative to listed bonds with a similar level of risk. Inflows into private debt were strong in 2021 and are expected to be fuelled by the ongoing explosion in merger and acquisition activity as well as financing the infrastructure behind the energy and digital transitions.

From a thematic perspective, the sustainable angle – the energy transition and environmental sustainability – will continue to be paramount. Although performance for the environmental thematic universe stumbled in 2021, companies generally delivered one of their strongest earnings seasons in 20 years as demand vastly outstripped supply. This means valuations are back to attractive levels, particularly for energy transition innovation stocks, and 2022 could see a substantial reversal of the previous year’s trading pattern.

Notably, recent volatility in gas and power prices has prompted the world to accelerate the build-out of renewable energy infrastructure, including wind, solar, energy storage and hydrogen, which is needed to both decarbonise economies and achieve energy and geopolitical security. At the same time, population growth and climate volatility are increasing the pressure on global food systems and causing food price inflation to rise. This could see investment in the restoration of lands and oceans become a top priority for policymakers and should be a core theme for environmental investors.

As the world’s fastest growing major economy, China is home to many innovative companies and is increasingly being considered a market that warrants a standalone investment allocation.

While a raft of issues could slow the country’s economic momentum in 2022, including slower export growth, further regulatory reform in line with the government’s ‘common prosperity’ agenda, a cooling property market and its ‘zero-Covid’ policy, there is less clarity on its medium-term outlook. The return of industrialisation in China, alongside structural changes including its ‘Go Green’ efforts, maybe being overlooked.

The manufacturing sector has regained policy favour under Beijing’s new reform tactics, with a focus on high-value manufacturing and hard tech production that supports the country’s strategic and high-tech development. Additionally, the nation’s efforts to drive industrialisation towards poor inland provinces could create economic momentum that is not currently being accounted for.

Finally, the government’s efforts to achieve carbon neutrality by 2060 are set to open up new growth sectors and investment opportunities to replace the ‘sunset’ sectors. China needs to upgrade its electrical grid infrastructure and develop energy storage systems to improve energy supply and distribution, as well as switching to more green electricity production.

The pandemic-led social and economic lockdowns may have triggered a seismic shift towards digitalising the way we work, consume and communicate. Yet, disruptive trends in technology are continuing to proliferate.

E-commerce has mushroomed, boosting web advertising and electronic payment services. Significantly, it has created a boom in physical and automated warehousing, as well as home delivery and more companies can be expected to integrate their physical and online channels. Big data, artificial intelligence, data analytics and cybersecurity are all now seen as essential tools to help overcome the complex economic, demographic and societal problems that many sectors face and nations need to act to prevent the digital divide in their populations from widening.

Moreover, the next iteration of the digital evolution, 5G tech, is set to transform how we use technology. Its superior speed and scale is expected to open up the market for smart connectivity in homes and businesses, as well the greater use of big data, AI and the automation of vehicles.

IT spending is expected to remain at a high level of growth in 2022, with top spending areas including cybersecurity, cloud migration, collaboration tools, and data analytics.

The flow of investment markets in 2022 may be tempestuous, but such turbulence represents an opportunity for canny investors.

At BNP Paribas Asset Management, we believe uncertainty creates scope for active managers to add value for their clients, which can best be harnessed through differentiated research to generate high-conviction positions. We are consistently investing in resources to enhance our culture and process for developing, stress-testing and ultimately translating investment ideas into meaningful positions in portfolios.

Of course, sustainability will remain at the very heart of our investment agenda and process. This means actively engaging with companies to deliver real change, as well as actively investing in securities.

We hope that our clients continue to join us in our efforts to finance the transition to net zero.