Despite the declines and disruptions due to new variants of Covid-19, 2021 has turned out to be a relatively positive year for economies and markets in most parts of the world. Growth exceeded its potential after the severe recession of 2020, and financial markets have recovered vigorously. This has been particularly the case in the United States, where stock markets have reached new highs, in part due to the ultra-accommodative monetary policy of the US Federal Reserve (although central banks in other advanced economies have continued their their own radically accommodating policies).
But 2022 could be more difficult. The pandemic is not over. Omicron may not be as virulent as previous variants – especially in advanced highly vaccinated economies – but it’s much more contagious, meaning hospitalizations and deaths will remain high. The resulting uncertainty and risk aversion will suppress demand and exacerbate supply chain bottlenecks.
Combined with excess savings, pent-up demand, and accommodating monetary and fiscal policies, these bottlenecks fueled inflation in 2021. Many central bankers who insisted the inflationary surge was transitory now have admitted that she would persist. With varying degrees of urgency, they plan to phase out unconventional monetary policies such as quantitative easing, so that they can begin to normalize interest rates.
The resolve of central banks will be tested if policy rate hikes cause shocks to bond, credit and equity markets. With such a massive build-up of private and public debt, markets might not be able to digest higher borrowing costs. In a crisis, central banks would find themselves in the debt trap and likely turn around. This would make inflation expectations likely to change upward as inflation becomes rampant.
The coming year also brings growing geopolitical and systemic risks. On the geopolitical level, three major threats must be watched.
First, Russia is preparing to invade Ukraine, and it remains to be seen whether negotiations on a new regional security regime can prevent the threat from escalating. Although US President Joe Biden has pledged more military aid to Ukraine and threatened tougher sanctions against Russia, he has also made it clear that the United States will not intervene directly to defend Ukraine against a attack. But the Russian economy has become more resistant to sanctions than in the past, so such threats cannot deter Russian President Vladimir Putin. After all, some Western sanctions – like a move to block the Nord Stream 2 pipeline – could even exacerbate Europe’s own energy shortages.
Second, the Sino-US cold war is cooling off. China is increasing its military pressure on Taiwan and the South China Sea (where many territorial disputes are brewing), and the wider decoupling between the Chinese and American economies is accelerating. This development will have stagflationary consequences over time.
Third, Iran is now a nuclear state on the threshold. He quickly enriched uranium to near-military content, and negotiations on a new or revamped nuclear deal came to naught. As a result, Israel is openly considering strikes against Iranian nuclear facilities. If that happened, the consequences of stagflation would likely be worse than the oil-related geopolitical shocks of 1973 and 1979.
The new year also brings several systemic concerns. In 2021, heat waves, fires, droughts, hurricanes, floods, typhoons and other disasters have laid bare the real implications of climate change. The COP26 climate summit in Glasgow offered mostly low-cost talks, leaving the world on track to experience a devastating 3 ° Celsius warming in this century. Droughts are already causing dangerous increases in food prices, and the effects of climate change will continue to worsen.
To make matters worse, the aggressive push to decarbonize the economy leads to underinvestment in fossil fuel capacity before there is a sufficient supply of renewable energy. This dynamic will generate much higher energy prices over time. In addition, the flow of climate refugees to the United States, Europe and other advanced economies will increase just as these countries close their borders.
In this context, political dysfunctions are increasing in both advanced economies and emerging markets. The midterm elections in the United States could offer a glimpse into the full-fledged constitutional crisis – if not outright political violence – that could follow the presidential vote in 2024. The United States is at near unprecedented levels partisan polarization, deadlock and radicalization, which poses a serious systemic risk.
Populist parties (far right and far left alike) are gaining strength around the world, even in regions like Latin America, where populism has a disastrous history. Peru and Chile both elected radical left leaders in 2021, Brazil and Colombia could follow suit in 2022, and Argentina and Venezuela will remain on the path to financial ruin. The normalization of interest rates by the Fed and other major central banks could cause financial shocks in these fragile emerging markets like Turkey and Lebanon, not to mention the many developing countries whose debt ratios are already unbearable.
As 2021 draws to a close, financial markets remain sparkling, if not downright sparkling. Both public and private capital are expensive (with above average price / earnings ratios); real estate prices (both housing and rent) are high in the United States and many other economies; and there is still a buzz around meme stocks, crypto assets, and SPACs (special purpose acquisition companies). Government bond yields remain very low and credit spreads – for both high yield and investment grade bonds – have been squeezed, in part thanks to direct and indirect support from central banks.
As long as the central banks were in unconventional political mode, the party could continue. But asset and credit bubbles could deflate in 2022 when policy normalization begins. In addition, inflation, slower growth, and geopolitical and systemic risks could create the conditions for a market correction in 2022. Either way, investors should remain on the edge of their seats during the most of the year.
Nouriel Roubini is Emeritus Professor of Economics at the Stern School of Business at New York University, Chief Economist at Atlas Capital Team, CEO of Roubini Macro Associates and co-founder of TheBoomBust.com. He was a former senior economist for international affairs on the White House Council of Economic Advisers during the Clinton administration and worked for the International Monetary Fund, the US Federal Reserve and the World Bank.
Copyright: Project Syndicate