Looking back on 2021
2021 was a year where the global economy got back on track, but maybe not as much as we had hoped, as the ongoing impact of the Covid-19 pandemic, and the consequences of it in terms of supply chains, have acted as a drag on growth. While countries lifted restrictions over the course of the year, the rollout of vaccines, with over 8.7 billion doses given by late December, has changed the trajectory of the pandemic. However, as the rapid spread of the Omicron variant that is currently overtaking Delta globally reminds us that with huge numbers of people still unvaccinated or in need of boosters even in developed markets, there is still a long way to go. All the same, the vaccination story, from the announcement in November 2020 that the Pfizer vaccine was effective, followed by similar news from Moderna and AstraZeneca and then the rollout globally in 2021 is impressive, though there remains much to be done, not least given the transmissibility of the recently discovered Omicron variant. Financial markets broadly ‘looked through’ the waves of the pandemic in 2021 thanks to the fact that there is a path to managing the pandemic through vaccinations but while future restrictions may not be as severe as we saw during the spring of 2020, the continued waves of the pandemic will act as a drag on economic activity.
2021 saw a strong rebound in the global economy, but the bounce was held back by the significant disruption to supply chains and labour markets. In turn this has led to some eye-watering levels of inflation across developed and emerging markets. The response has been a fairly consistent narrative from the main central bankers for most of the year that this is a ‘transitory’ phenomenon and will ease as we move into 2022. It would be fair to argue that a few years ago if you were told that US inflation at the end of 2021 would be almost 7% but interest rates would be at 0-0.25, the 10-year bond yield would be 1.6% and the Federal Reserve would be running quantitative easing (QE) at $105 billion a month you would likely be shocked. Yet that is where we find ourselves, and the US is not alone with such distortions. While many aspects of inflation may well be transitory, it is clear that the costs of living have increased, and how these feed into wage pressures is a key theme for 2022. Central banks are now pivoting towards an acceptance that some of this inflation will be around for much longer. They now have a fine line to walk in trying to normalise policy to a degree while supporting economic growth and maintaining their credibility while adjusting policy to bring inflation back towards their targets.
Financial markets have dealt with the uncertainties of 2021 and the concerns over inflation and changing central bank policy incredibly well. Equities have posted positive gains, once again led by the US while UK and European markets have posted solid gains though positive returns have been harder to come by across Asia, Japan and the emerging markets. Considering the inflation headlines, bond markets have also showed resilience, highlighting a belief that while inflation may be more persistent than we were first told, central banks have the situation in hand, and a slow withdrawal of monetary easing followed by gently rising interest rates, combined with an easing of the supply chain issues and base effects will see inflation ease. Is this scenario too good to be true? Time will tell.
Assessing the impact of the Covid-19 pandemic
It is too soon to judge the long-term impacts of the pandemic. Looking back, it was very hard to firstly predict or secondly position for the total shutdown of global economy but the huge intervention of central banks in late March 2020 and the news of vaccine efficacy in November 2020 were both signals for investors to become more bullish on the outlook. The pandemic has extended the period of ultra-loose monetary policy that has been with us since the Global Financial Crisis and has created distortions that probably feel normal to investors whose careers are ‘only’ a decade or so long. With money having been almost ‘free’ for the past decade we have seen significant outperformance for long duration assets be they in bonds or in growth parts of the market such as tech stocks. What feels ‘wrong’ has become normal. Can this last into a period of higher inflation and rising rates? Certainly, some tech stocks have the fundamentals to continue to thrive even with a higher cost of capital but in an environment of higher rates and central banks being less generous, we are not sure the same can be said for bonds that are not inflation linked or other asset classes in which there are clearly bubbles, not least crypto currencies.
Key themes for 2022
We hope that 2022 will see Covid-19 moving from ‘pandemic’ to ‘endemic’ in that governments continue to shift from ‘zero covid’ towards ‘living with’ Covid-19. This transition will take place only in an environment where vaccine take-up increases and there are no new variants that can escape vaccines beyond what we are already seeing with the Omicron variant. With vaccine production set to ramp up further in 2022, and pill-based treatments becoming available for those that do fall ill, the path towards Covid-19 becoming a virus that can be ‘managed’ is clear. The process however, will take time.
The outlook for global growth is a theme that will play a big role in driving investor sentiment and the direction of markets. In this respect the prospects are positve, notwithstanding the supply chain issues that look set to ease albeit in a far slower fashion than had been hoped for. The opening up of the global economy as travel restrictions ease will help cross-continent trade flows and outside of a new resurgence in the pandemic or other shock, the global economy should see another year of strong growth, albeit with regional variations.
Politics will always make headlines; while some events will be unforeseen, we can look to the election schedules for an indication of where there may be some volatility – France and Brazil both hold Presidential elections in 2022 and an election in Italy would be no surprise either. We also face mid-term elections in the US that, if polls are a guide, may well leave President Biden without control of Congress for the last two years of his Presidential term. Any success for the Republicans may embolden Donald Trump to push his 2024 campaign further. Looking to China, the 100-year anniversary of the Communist Party suggests the government will seek a smooth year, meaning that they will want to ensure an orderly restructuring of the property sector, which at 30% of GDP poses systemic risks to the economy. From the geopolitical point of view, China and US will be front and centre. China’s intentions over Taiwan remain unclear, as do Russia’s over the Ukraine. Whether these issues manifest themselves in 2022 is an unknown, but any aggression would be a significant test for the western political alliance.
Inflation is clearly another theme that will roll over into 2022 and we could see the credibility of the central banks tested as their ‘transitory’ narrative is retired should it become clear that developed markets have a more entrenched inflation problem. If this is the case, then there is likely to be fallout across financial assets as equities and bonds reprice for interest rates rising sooner, and faster, than expected.
Developed market central banks may be starting to ease back on some of the monetary largesse that has underpinned financial markets over the past decade but a big difference between the recovery from the Global Financial Crisis and the pandemic is that the fiscal support has not rapidly evolved into austerity. The US, Japan and the EU will all see significant fiscal stimulus in 2022 and it would come as no surprise if China saw a combination of monetary and fiscal measures to strengthen the economic backdrop amid the fallout from the property sector woes.
Can ‘value’ investing outperform again?
Value saw some strong performance over Growth from November 2020’s vaccine efficacy news and stretching into 2021 until the ‘reopening/recovery’ theme stalled in the late Spring. As confidence has ebbed over the strength of the recovery, and thoughts have turned towards inflation and stagflation we have seen Growth back in the ascendancy. But we shouldn’t write off Value just yet. The ‘stagflation’ narrative seems a little dramatic given the outlook for the global economy in 2022 in that growth will be well above trend, and while inflation may well remain elevated, potentially tighter monetary policy should be a positive for Value stocks,if nothing else because Growth will perform less well in an environment where the cost of capital is rising. If investors become more confident of the upwards trajectory of economic growth, and we do see interest rates rising gently, then the conditions can return for Value to see further outperformance of Growth.
Asset class performance in 2022; can the party continue?
Equities saw a strong year of growth in 2021 and a big question for 2022 is whether this momentum can be sustained. The biggest market performance in a cycle tends to be when economic and earnings growth is strongest, and we are likely to have already seen this in the past 12 months. So, the outlook may well be somewhat more subdued. All the same, this was not a normal recession and the recovery is equally unusual. The economic outlook for 2022 remains robust, so there is a reasonable argument that earnings still have room to growth further – maybe not at the super strong rates we have seen in recent quarters but possibly enough to keep ahead of analyst estimates. There remain risks though with lower liquidity because of the end of QE across developed markets and a tighter outlook for monetary policy. Equities remain our favoured asset class, but we think more subdued returns are ahead.
Bonds have appeared to us as being expensive for a long time now. While we have seen yields rise somewhat since the lows of 2020, given where inflation is right now, there is a case to be made that bonds still look mispriced. Bond investors either believe the central bankers that inflation is transitory, have a far more negative view on the economic outlook or maybe $250bn of asset purchases a month from the big four central banks alone in 2021 has kept a lid on yields. Our view is there is little risk/reward at these levels and even if inflation does stabilise, the liquidity and monetary policy environment that has been so supportive of bonds in the past decade is unlikely to be as favourable looking into the future. Our portfolios are underweight bonds.
Alternatives covers a broad variety of assets – in property we continue to steer clear of the larger and less liquid property portfolios. We still see opportunities in selected closed ended property companies and also in the absolute return space. But this is an area where we feel manager selection is extremely important as is understanding when and how funds will deliver performance.
Conclusions and Portfolio Positioning
We take the view that 2022 will see a continued recovery in the global economy but in the context of the very strong returns in financial assets since the lows of March 2020 that a lot of the good news is already ‘priced in’ while risks around inflation, central banks moving away (even at the margin) from loose monetary policy and geopolitical risks may not have been fully discounted. Even if we are able to move on from the pandemic itself and 2022 sees economic growth recoup all of the losses of 2020, the consequences will be with us for some time to come. While there are few asset classes and equity indices that appear ‘cheap’ we do hear plenty of positive comments from our underlying fund managers that at the stock picking level, opportunities remain. This should especially be the case in an environment where interest rates, even if only at the margin, are rising – as monetary policy tightens, the ‘rising tide that has lifted all boats’ should begin to turn, and this should allow for some differentiation between stocks, a scenario that should benefit active fund managers.
We go into 2022 with our portfolios still underweight in both equities and fixed income. Our theme of “cautious, but not bearish” remains true and with most asset classes certainly not looking ‘cheap’ we are mindful that after a strong performance run there are plenty of headwinds facing risk assets next year, even though we hope to see economic growth remain solid and not taken too far off course by whatever Covid related restrictions are imposed in the short term. Within equities, we continue to favour the UK and Asia. Both areas look relatively cheap and present significant stock picking opportunities. We are neutral in the US, which has retreated slightly from all-time highs – we look for a continued rotation from some of the tech names that have benefitted from a loose monetary policy environment. For now, we are neutral in emerging markets, but we continue to monitor China closely for signs of additional stimulus which may offset the negative sentiment around regulation. We are slightly underweight both Japan and Europe more as a function of better opportunities elsewhere than any strong negative views. In bonds, we find very little by way of compelling risk reward and continue to rely on our strategic bond managers to do most of the heavy lifting in terms of finding opportunities. At the margin, we do have some corporate bond, high yield bond and emerging market debt exposure. Property, where held, continues to find us seeking exposure outside of the mainstream funds; we continue to find opportunities in some closed ended products not least where income generation is required.
The fact that we enter 2022 much like entering 2021 with the spectre of pandemic related restrictions weighing on sentiment is somewhat depressing but we should remember that medicine, politics and society are clearly on a path to ‘living with’ this pandemic. As a result, the economic impact will diminish over time. 2021 taught us that despite the success of the vaccine rollout, this will not be a smooth ride, and Covid’s consequences will continue to impact the global economy and at times financial markets. 2022 will see investors need to get to grips with a changing monetary policy regime in response more persistent inflation. In this environment and given the strong returns of the past 18 months, we do see more headwinds for financial markets to make further progress but this should also be a more opportunistic environment for active management to prove its worth.
