Interactive Investor

UK stock market outlook 2022: reasons to be cheerful, despite rate risks

22nd December 2021 10:06

Graeme Evans from interactive investor

Uncertainty abounds around inflation and central bank rate strategies, but our City expert believes there’s a positive outlook for stocks in the coming year.

As the pandemic heads for a third year, the eyes of investors will be on inflation and whether prices can be brought under control without sharp rises in interest rates.

What started as a disinflationary shock in 2020 reversed in dramatic fashion during 2021 to leave UK inflation at 5.1% and the US equivalent at 6.8%, a sufficiently high level for the Federal Reserve to retire the term “transitory” from its commentary.

With the UK figure set to peak at 6% in the spring, hawkish central banks are now regarded as the market's biggest tail risk, as investors increase their cash allocation and become increasingly jittery about the valuations of high-growth stocks, particularly those in the tech sector.

The Bank of England hiked interest rates in December and may do so again in February, while the Federal Reserve has signalled the likelihood of three increases during 2021.

But with the uncertainty caused by the pandemic far from over, Deutsche Bank economists are concerned at the potential for inflation to become persistent over the medium term.

They point out: “Omicron adds to the winter wave of infections and will help push growth in Europe to the point of stagnation through the winter half before the robust recovery take-off again in the spring.

“However, with new social restrictions potentially compromising supply chains further and weighing on labour participation, the upside inflation risks will build.”

The UK economy is likely to have been the strongest of all the G7 economies in 2021, thanks to GDP growth of about 6.8% and a healthier than expected jobs market. But Deutsche Bank reckons the rate will slow to 3.5% in 2022, with the government's Plan B measures costing the UK economy roughly 0.4% in the first quarter.

Despite the risks around Covid-19 and the uncertain inflation picture, however, there are plenty of reasons for investors to still hold a positive outlook on stocks at the start of 2022.

The most compelling is the continuation of the TINA effect — There Is No Alternative — where shares remain attractive due to poor returns on cash and government bonds.

UBS Global Wealth Management noted recently that indications on the current state of the US economy remain encouraging and that the swifter pace of monetary tightening by the Federal Reserve has already been factored in by markets.

Earnings and pricing power have remained robust, despite the backdrop of significant supply chain pressures and labour shortages.

UBS expects equities to resume their upward course, and for some of the cyclical markets particularly negatively affected by recent developments around Omicron – such as Japan, the eurozone, energy and financials – to outperform.

At UBS's investment bank division, the expectation prior to the latest stock market volatility had been for the FTSE 100 index to finish next year at a record 8,000.

Its ”overweight” position on the London market was not clear-cut, however, as it is no longer a fan of domestically exposed stocks due to the Bank of England's advanced position in the rate hiking cycle.

For the FTSE 100 this is less of an issue given 77% of revenues come from overseas, while for UK lenders including Lloyds Banking Group the prospect of higher rates will support net interest margins.

Bank of America takes a more cautious view, based on UK equities tending to underperform in periods of sterling strength, energy underperformance and cyclical outperformance. A combination of these factors led the UK to lag its peers by 14% since March last year.

While Bank of America expects moderate underperformance of cyclicals versus defensives and some pound depreciation, it remains underweight on the UK due to expectations for energy underperformance caused by US dollar strength and weakening US growth momentum.

The bank said: “Our macro and sector assumptions point to 5% underperformance for UK equities by late Q3.”

The other key concern for investors at the start of 2022 will be the health of the China economy and whether Beijing can manage the ongoing debt crisis at property firm Evergrande without contagion setting in across the region.

However, speculation that China is planning further fiscal stimulus in support of the country's economic growth should underpin London's commodity-based stocks at the start of 2022.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.