A report card for 2021 together with some early thoughts on what 2022 might hold
Looking Back
Thankfully, for investors 2021 proved less ‘eventful’ than its predecessor. Although it has not always felt like it, the year has panned out broadly as expected: the virus ebbed more than it flowed, policy remained hugely supportive, interest rates stayed at rock bottom levels and corporate earnings recovered strongly. As a result, equity markets have continued to forge ahead. Taking the broad US equity benchmark, the S&P500, progress has been fairly smooth. At the time of writing, the S&P 500 stands at yet another all-time high, and on course for a gain of more than 25% for the year.
This brings us to our end of year review. Self-evaluation is a tricky task. A too-generous report card would raise eyebrows. The opposite would prompt people to stop reading – if last year’s insights were weak or wide of the mark, why read this year’s version? With that in mind we’ll try to steer a course through the middle.
In our December note last year we suggested that the rally that had begun in November, when the game-changing vaccines were announced, could continue. This was based on economies reopening, a corporate earnings recovery and continued, full-on, policy support all of which were supportive of further rises in asset prices. Putting this suggestion into practice, we recommended equity allocations within portfolios at close to their maximum tactical overweight positions. At the same time, however, we resisted the urge to jump on the rotation-trade that was then then underway – where investors were buying the shares of cyclical companies and taking profits from ’growth’ shares which had fared so well through the lockdowns. Our thinking here was that, although the virus was having a major short-term impact, it would not change the tide of economic developments already in place, in particular the forces that were pinning down bond yields and interest rates.
We admit that this view was sorely tested in the first quarter of 2021 when economically sensitive stocks continued to bound ahead and bond yields more than doubled. This left us scratching our heads and we marginally reduced duration (the sensitivity of portfolios to rising bond yields) to counter the risk of a continued rise in bond yields. Thankfully, as Q1 expired, so did the rally in bond yields. On 31 March, the US 10-year bond yield topped out at 1.74% (up from 0.93% at the start of the year) and from there eased back. It stands at slightly less than 1.50% at the time of writing. The rotation in stock markets also reversed, with growth stocks, despite their marked outperformance in recent years, taking up leadership once more.
This all suited our game plan, and, to cut to the scorecard (albeit with two weeks of the year remaining), our recommended asset allocations have proven broadly on the money, the funds have, for the most part, delivered as hoped, and our model portfolios stand comfortably ahead of the comparators.
In the interest of balance, we should note that we were blindsided by a few key developments. Most notable among these was the ‘Great Resignation’ which has seen many workers opting not to return to work after the worst of the lockdowns eased. This has had a meaningful impact on labour markets and feeds into our second ‘miss’ – the extent to which inflation has risen. Annual CPI inflation in the US is currently 6.8%, the highest in nearly 40 years, although crucially, as discussed below, this has not prompted a response from bond markets. The arithmetic of year-on-year data series always suggested a jump in inflation – but this is beyond our expectations. These two, together with the degree to which speculative bubbles are now a prominent feature of markets, are key considerations as we turn to the outlook for 2022.
Looking Ahead
While the experience of 2021 might be described as satisfactory, the developments above are, as would be expected, influencing our outlook for 2022. On inflation, there is a heated debate raging amongst central bankers, economists and commentators about whether the covid-induced surge in prices is transitory or risks becoming embedded in expectations – and therefore in future inflation rates. The answer, at present, is unknowable. However, inflation readings are making us, as investors, uncomfortable; what was already likely to be a gently tightening monetary policy backdrop in 2022 now risks becoming a bit less gentle. Indeed, we suspect that the Fed’s already tricky task of supporting full employment while at the same time maintaining price stability might have just become much harder. It seems likely to us that in the current economic environment, interest rates cannot be both low enough to keep the economy chugging along (and so supporting employment) while also being high enough to bear down on inflation. The challenge is further magnified if we consider that higher interest rates may not prove effective against the current bout of inflation – given that this is coming from supply bottlenecks rather than excess demand for goods. Nevertheless, for investors, economic growth choked off by higher interest rates aimed at addressing an inflationary problem would not be helpful for equity markets. A stubborn inflationary problem would be worse.
Closely related to this are fixed income markets. These have been extraordinarily quiescent through 2021. As our chart shows, bond investors usually demand, and receive, compensation for higher inflation. That is, yields and interest rates move higher to adjust for the bond holder’s lost spending power resulting from rising prices. This has not happened this time around, thus far. Bond investors are accepting negative returns when inflation is taken into account. However, we should acknowledge the risk that this will change if inflation doesn’t ease substantially in 2022.
US 10-year bond yields, interest rates (Fed funds) and CPI Inflation
Turning to the Great Resignation, or the disappearing labour force, this may well be a key determinant in the path of inflation from here. However, understanding exactly how it factors in is unclear at present. Individuals voluntarily withdrawing from the labour force may well mean that unemployment rates are lower – helping central banks to claim that they are hitting their employment targets. However, the very same phenomenon is likely to cause wages to rise, undermining central banks’ mandate to deliver price stability. These dynamics will need further analysis, though perhaps only time will tell the extent to which the trend is temporary or has elements that will permanently alter the economics of the labour market, wages and thereby inflation.
Our final development is much more straightforward. We see speculation in many corners of the investment world. While we confess to spending little time thinking about cryptocurrencies, we are cognisant of the very large sums now invested in this space. Thus, the potential losses were this area to deflate are unlikely to leave wider financial markets unscathed. Meanwhile, in equity markets, very highly priced new issues, loss-making concept stocks, meme stocks and SPACs (special-purpose acquisition companies) all suggest that investor discipline is being compromised in the search for attractive returns. Historically such periods have not ended well, and we are therefore treading with greater caution.
In summary, we view the prospects for 2022 as somewhat less cloud-free than 2021 and we are currently recommending asset allocations are tweaked to reflect this. It also seems likely that the coming year will be one where greater proactivity is rewarded.
We will of course be in touch with updates on developments and further changes of view. In the meantime, we would like to wish everyone a very peaceful and healthy holiday season.
Economic data and market statistics all sourced from Refinitiv Datastream as at 13 December 2021. This document does not constitute advice or a personal recommendation or take into account the particular investment objectives, financial situations or needs of individuals. This document is not intended for further distribution. This document has been prepared with all reasonable care and is not knowingly misleading in whole or in part. The information herein is obtained from sources which we consider to be reliable but its accuracy and completeness cannot be guaranteed. No responsibility is taken for any losses, including, without limitation, any consequential loss, which may be incurred by anyone acting on information in this document. The value of investments and the income from them are not guaranteed and can fall as well as rise and clients may not get back their original investment. Where investments have particular tax features, these depend on the individual circumstances of each client and tax rules and are subject to change in the future. The opinions and conclusions given are those of Heronsgate Capital LLP and are subject to change without notice.
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