As 2021 comes to a close and 2022 begins, three recent headlines from the Financial Times newspaper neatly summarise the last twelve months and pose the key question regarding the next twelve:
• “Global stocks deliver third year of double-digit gains”;
• “Global bond markets on course for worst year since 1999”; and,
• “The key to 2022 will be how inflation is brought down”.
It has indeed been another year where investors were rewarded for being exposed to risky assets. Global equities had another banner year, underpinned by strong macroeconomic tailwinds and enormously stimulative monetary and fiscal policies. Across most of our strategies, we have had an overweight to equities. Therefore, we have participated meaningfully in this latest leg of a bull run that has been in motion – with some notable exceptions – since 2009.
Equities, once again, were led by an irrepressible US market which surged by 27% throughout 2021. In most strategies, our largest single allocation continues to be the US. Notably, the US equity complex has not been characterised by frenzied investors speculating with reckless abandon: 2021 earnings will almost certainly have risen by a greater degree than 2021 prices in the final tally. Moreover, this has not been a year where large mega-cap technology companies left others in their dust: the equal-weighted S&P 500 ended the year ahead of the standard, market-capitalisation S&P 500 index for the first time since 2016.
Nonetheless, while US equity valuations have not risen over the year, they remain expensive by historical standards. It is for this reason that we have held a somewhat lower allocation to the US than prior to the pandemic, in favour of other regions such as Europe, the UK and Japan. We also continue to hold a meaningful allocation to Emerging Markets (EM). While no region has performed as well as the US in 2021 – indeed EM, led by China, were a painful underperformer given Chinese regulatory crackdowns on technology companies and real estate woes – we remain sanguine about the long-term prospects of our equity positioning given more attractive valuations and a higher sensitivity to economic cyclicality outside of the US, even as the US remains our single largest position. With regard to EM specifically, the region is looking oversold from a sentiment perspective, often a precursor of outsized future returns.
While risk assets have basked in the sun, safe-haven assets – ironically – have experienced an annus horribilis. Ten-year UK government bond yields shot up from about 0.20% to end the year five times higher. That equated to a capital loss of about 5% (Bloomberg UK Gilt 7-10Y Index; Index Total Return Level). Investment-grade corporate bonds also lost money, but less than government bonds. In line with the trends of the year, the best performing credit was the riskiest variety, with high yield corporate bonds delivering positive returns.
Most strategies continue to hold some government and corporate bonds, though in a smaller proportion than we have traditionally. However, those we did hold performed poorly in comparison to risk assets. We also took some losses in 2021 on gold, and experienced flat or only slightly positive returns from our defensive allocations to hedge funds and our Tail-Risk Protection Note. Nonetheless, given a panoply of risks – elevated equity valuations, Covid variants, stubbornly high inflation, the potential for central bank policy errors, geopolitical risks such as those between Russia and Ukraine, and Chinese real estate contagion – we continue to believe our risk-taking should be tempered and we continue to hold a bevy of safe-haven assets. As always, should risk assets sell-off and our safe-havens rally, we would seek to exit the latter in favour of finding bargains in the former.
New Year, Old Problem
The New Year begins with an old foe, which is elevated levels of inflation globally. While growth is robust in developed economies, price pressures are acute. Consumer prices in the UK and the Eurozone have increased by c.5% this year; in the US, inflation is running at nearly 7%, the highest since June of 1982. This has left central banks, especially the US Federal Reserve (Fed), markedly reassessing its ultra-loose monetary policy for 2022: how aggressively central banks act to tame inflation represents the biggest risk for this year. This includes not just tapering off quantitative easing and raising rates (largely priced in), but also actively seeking to shrink its balance sheet (not priced in).
In a best-case scenario, liquidity remains ample and economic momentum is strong enough to withstand slightly higher rates. Moreover, in terms of balance sheets, central banks at first simply stop buying new bonds and hold the bonds they already own until maturity, thereby “running off” the balance sheet at a slow pace over time (i.e. effectively what the Fed did from 2014 to 2016). Eventually, they can resume “normal” open market operations with a bias to reducing the overall size of the balance sheet, actively selling more bonds back to the market than they buy (i.e. what the Fed did from 2017 to 2019). If done in an environment of sufficient economic growth, the result will likely be a “healthy deleveraging” which should not destabilise markets.
In a worst-case scenario, liquidity dries up, economic momentum falters and central banks go too fast from “run off” to “sell off” (i.e. the European Central Bank’s experience in 2013 and 2014). Markets will likely respond to this
We believe the actual path will be closer to the former than the latter. Why? Primarily because we believe the underlying drivers of currently high inflation are not structural and are likely to ease once temporary factors are behind us – that will allow central banks to slowly tighten policy as opposed to a faster tightening.
One, most of today’s apparent surge is the base effect. For example, in January 2021, the price of a barrel of Brent Crude was close to $50 compared with $80 now. This has been the single largest factor in currently high inflation. Few expect oil prices to rise dramatically again (though admittedly it’s possible).
Two, there were also marked shifts to our consumption patterns, with post pandemic consumption of durable goods 34% higher in real terms (at its peak) than before, as spending on services was slashed. This overwhelmed supply chains and caused the rise in prices of many weighty components in inflation indices (e.g. used cars). Now, after having gorged on goods in lieu of services, consumption patterns appear to be trending back to normal and supply chain blockages, while still material, are easing, particularly in the post-Christmas period. There also appears to be no uptick in gauges of money velocity, indicating cash balances will remain high and consumers’ expectations for inflation are within reason (i.e. they are not rushing out to spend cash they consider depreciating in real terms). Low velocity also helps blunt the inflationary impact of rising money supply.
Finally, perhaps the single most important indicator of structural inflation is spiralling wage growth, which leads companies to raise prices, thus leading workers to demand higher wages (i.e. as occurred in the 1970s). The Organisation for Economic Co-operation and Development’s (OECD) Labour Compensation Per Employed Person hit 5.0% in Q1 2021, very high, historically speaking. However, it appears a peak may have been hit, or at the very least, a deceleration: Q2 and Q3 registered at 4.5% and 4.4%, though admittedly there are regional idiosyncrasies. Labour supply is likely to become more elastic over 2022 as ongoing crisis era benefits dry up and Covid-related restrictions abate. Of course, this could prove far too optimistic, but we believe our optimism is well founded.
We believe the case for increased risk-taking remains well supported given a robust economic backdrop, strong momentum and still tolerable valuations. However, we are cognisant of downside catalysts, some of which have been mentioned above. Therefore, we continue to hold a stable of safe-haven assets including cash, government bonds, gold, and defensive alternatives (e.g. low-volatility hedge funds, Tail Risk Protection Note).
As always, we are guided by the four pillars of our investment process:
- Economic regime: Our Leading Economic Macro Indicator (LEMI) suggests the global economy is in a state of Expansion, which is favourable for risk-taking. Admittedly, economic activity is largely dependent on the ongoing fight against the Covid-19 pandemic and the economy’s resilience to a tightening monetary regime. Vaccinations appear to be effective against the latest variants and are proliferating, and we believe the underlying drivers of currently high inflation are not structural, thus allowing central banks to slowly tighten policy and not derail a robust economic recovery.
- Valuations: Valuations for equities – the largest source of risk and return in most strategies – remain challenging in absolute terms. However, with global interest rates only expected to rise moderately in 2022, staying at historically low levels, the case for higher tolerance to valuations remains (i.e. the discount rate of future cash flows remains moderate).
- Momentum: Global equities are in positive momentum on the ten-month moving average metric that we favour. This is supportive of increasing exposure to the asset class.
- Sentiment: Of the indicators we follow, some, such as global equity fund flows, imply increased bullishness. Others, such as trade-weighted US Dollar, imply increased bearishness. Sentiment remains volatile and we continue to monitor it closely.
As ever, we are constantly monitoring markets. Should conditions change, particularly with the economic regime, or signals from our valuation, momentum or sentiment framework, we will adjust our asset allocation accordingly.