Market volatility in 2022 is likely to be elevated, driven by portfolio allocation decisions as investors react to major changes in the risk management landscape.
Financial and real asset holdings are a huge multiple of one year’s GDP. Small shifts in portfolio preferences can involve the re-allocation of trillions of dollars, moving markets.
Many investors and portfolio managers will undoubtedly stay their course in 2022. Others, though, may consider whether to make changes in their portfolios given (1) the shift toward a more neutral policy at the Federal Reserve, and (2) the abrupt change in the inflation landscape that occurred in 2021, ending over two and half decades of relative price stability.
Real GDP is likely to decelerate materially after the 2021 rebound year. This is totally natural, as steadier, slower growth typically follows a rapid rebound. The implications are that the GDP slowdown is unlikely to be related to the shift in Fed policy towards neutral.
The Covid-Omicron impact in 2022 remains unclear. We are still learning how infection and hospitalization rates will shift with this variant or others that may follow. However, the policy bias appears to be to avoid a repeat of the spring 2020 shutdowns, which reduces the probability of a return to economic distress.
While measured inflation may abate a little as 2022 progresses, the overall rate of inflation is likely to remain well above central bank targets, suggesting continued pressure for the Federal Reserve to follow-through on its forward guidance to revert to a more neutral policy stance. Indeed, federal funds futures suggest three to four quarter percentage point rate hikes in 2022 are possible.
Putting this all together, risk management will be key as investors adapt to a more neutral Fed and a changed inflation landscape. Potential asset flows due to portfolio shifts, essentially a Great Re-Balancing, are likely to serve as the key drivers for elevated market volatility in 2022.
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