2021 was a year of unexpectedly strong recoveries.
The IMF, for example, in its October 2020 outlook, pencilled in US GDP growth of 3.1% for 2021 – by last quarter that had almost doubled to a red hot 6% (with similar upgrades across much of the developed world). Corporate profits were similarly exceptional, with US earnings for the S&P500 rising 40% from their levels of just a year ago.
Perhaps most intriguing was the level of global mergers and acquisitions where, despite virus restrictions and lockdowns, the value of deals agreed in 2021 climbed to the highest levels since records began more than four decades ago . Set against these near bubble conditions, it is not surprising that global equity markets posted a third year of double digit returns and that bond yields rose. Higher inflation was of course the price we paid (UK inflation started the year at 0.7% and ended at 5.1%), but this did not stop 2021 from being another vintage year for equity investors.
After a strong 2020 for us at Sarasin, we found last year more challenging. Yes, we remained overweight equities and underweight bonds (with little net exposure), but we were much more cautious in our stock selection. In particular, we were underweight (relative to the index) the narrow group of US mega-cap companies, mainly technology and consumer names, that led markets higher for much of 2021. We held instead to our long-term thematic positions geared to climate change, automation and ageing. We were by no means absent the digital winners (indeed digitalisation is also one of our themes), we just didn’t hold enough, particularly of the biggest (Apple) or the most fashionable (Tesla). The effect is well illustrated in Chart 1, which shows the performance of the traditional world equity index (weighted by market capitalisation), compared to an equally weighted index where each stock is accorded the same holding size.The underperformance of the latter since the spring of last year is clear and reflects the broad challenges we faced, despite many of our companies posting exceptionally strong growth of both earnings and dividends. So yes, we made good absolute returns for clients, but relative to the index, our performance looks conservative.
So, do we now stick to our cautious equity approach or, do we join the party, and sharply increase our global mega-cap positions? There are arguments for the latter – certainly the largest US companies have consistently delivered superior organic growth, pricing power and prodigious cash flow, all well in excess of the wider index. While this has rightly been rewarded by shareholders, it has now led to some of the most extreme stock-price dispersion and equity concentration in stock market history. Against this backdrop there are three specific issues that concern us:
We have hardly started to taper, yet
Last month still saw the world’s central banks buying bonds (QE), at close to record rates – that isn’t exactly tapering, or at least not yet. Things will change though in 2022; the accelerated wind-down of the Federal Reserve’s purchases (QE) will begin in January, while the ECB’s giant pandemic emergency purchase programme (PEPP) ceases in March 2022 (it will be replaced, but with a smaller programme). The Bank of England’s programme has now ended, as have purchases by the Central Bank of Canada. In other words, open-ended QE by western central banks, first deployed in 2009, may soon be history. This, in turn, opens the door to not only interest rate rises (three increases in 2022 and 2023 in the US) but also Quantitative Tightening as Central Banks allow their balance sheets to shrink by letting maturing bonds run off.
This fundamental shift in monetary policy will have huge implications for markets – we should expect volatility to rise, bond yields to trend higher and more speculative investments (some crypto-currencies, for example) to struggle. Equity market leadership will also evolve – in particular, as the inflows of money into the system are reduced, the flows into the mega-cap companies may be impacted, simply because of their sheer size. Highly valued equities also tend to underperform in a rising rate environment, as the discount rate applied to future profits rises. None of this will occur overnight but the direction of travel seems clear.
The market impact of Omicron is different this time around
It is now generally accepted that Omicron is more infectious than previous variants but also intrinsically milder. Yes, that means that Omicron will spread much faster and further than earlier waves, but will likely peak much faster too (one South African epidemiologist described it as more of a “flash flood” than a wave). Importantly for those hospitalised, the average hospital stay is up to 50% shorter and fewer need ventilation/ICU support (which is critical given the extreme capacity constraints that remain within hospitals).
This different pattern of infection has implications for global markets. In previous COVID waves, severe lockdowns led to weaker economic growth, but also to lower bond yields and massive central bank support. The result, on balance, was that despite the damage sustained by the real economy, asset prices tended to rise. In particular, generous liquidity conditions, coupled with work-from-home policies, tended to favour the US digital winners and associated global mega-caps. Today, the situation is different; Omicron has thankfully not triggered full scale lockdowns (Asia excepted) but it has meant that central bankers are freer to continue tightening policy, in the face of inflation rates that are far higher than in earlier phases of the crisis. In a worst-case scenario Omicron actually adds to these pressures (through tighter labour markets and supply disruptions).
Such a fundamental shift in the policy response to the virus naturally has implications for market leadership. It suggests that tomorrow’s winners may include more companies that benefit from tighter money (financials), from massive climate spending (industrials) and also those that offer meaningful alternatives to bonds (global income stocks). This is a big transition and again, will not occur overnight, but it is another argument that the leadership we saw last year is not for ever.
China – signs of policy reversal?
2021 was a year where China’s tilt away from the West intensified, including greater assertiveness towards Taiwan, a tighter security regime in Hong Kong and restrictive economic policies targeted at countries such as Lithuania, Canada and Australia. Domestic policy was also challenging; regulators were antagonistic toward internet companies and education providers, while credit and leverage restrictions amplified already severe problems in the property sector. Taken together these policies contributed to a particularly sharp underperformance of Chinese equities, with the MSCI China index lagging the US S&P500 equivalent by an extraordinary 50% last year.
More recently though there have been tentative signs of a policy reversal. The Chinese central bank (PBOC) has now loosened monetary conditions through a reduction in banks’ reserve requirements while vowing, along with all government departments, to take “proactive” moves to ensure “economic stability” - we read this as short-hand for a limited bail-out of the property sector, more loosening of monetary policy and less heavy-handed regulatory intervention. In short it is a policy mix that argues for better returns for China-centric markets in 2022 and potentially for their embattled technology sectors. It is also a reason to suspect that the sharp underperformance of many Asian markets may be reversed – potentially attracting flows that had been destined for the US mega-caps and Nasdaq.
And if inflation rates prove sticky?
All of the above still makes one assumption – namely that global inflation rates fall back only modestly above central bank targets, by 2023. This is still our belief, and certainly a number of factors will combine to push downwards on prices next year. Used-car and gasoline prices rose by more than 50% in 2021 and that’s unlikely to happen again, while bottlenecks in global trade have started to loosen up. If we are wrong though, and risks are clearly to the upside, then there is the real possibility of bond yields climbing sharply or interest rates being tightened more aggressively. Both, in our view, could threaten the high valuations of the US technology and consumer sectors – and the correction could be sudden and aggressive. This is not our base case, but the risks need to be monitored.
In summary, our policy is to remain overweight equities, but to be cautious in our equity selection. Long-term thematic credentials, robust progress on ESG issues and, where possible, sustainable dividend support are the characteristics we are prioritising. When it comes to equity selection in 2022, fortune, we feel, may well favour the cautious.