It is often assumed that in a “bullish” year for equities most, if not all, markets will rise, with the acceptance that there may be some small divergence between the performance of the major markets, but that they will all generally perform well. Equities behaved in this way through 2019 but then that correlation fell apart during 2020 and 2021. Over the course of 2020, the FTSE was down 14.3% compared to the S&P 500 which increased 16.26%, a staggering 30% difference. Then during 2021, the S&P again led the way, up 26.8%, but the Hang Seng Index this time (China) fell 14.1%, a 40% difference in performance.
It would be oversimplifying to blame inconsistent governmental Covid response alone for these major anomalies, although there can be no denying that the global pandemic has had the most significant part to play of any of the factors that have led to heightened volatility over the last 24 months. In reality though, the dispersion in returns between major world regions is more a function of idiosyncratic factors affecting individual stock-markets, some of which we will explore in this round-up of the year just gone.
January 2021 started well for equities, with a continuation of the rally in ‘value’ companies that started in November of 2020, after the election of Joe Biden and the announcement from Pfizer of a viable vaccine. The FTSE 100 started particularly well, outperforming the US and other major markets over the first few days of the year. The January 6th US Capitol insurrection and associated fallout then unsettled the markets until the end of the month, before a major market uplift started in February.
The structural rally in European and US equities was driven mainly by market expectations that the Covid pandemic would be brought under control with the rollout of vaccine programmes worldwide. As confidence grew in the unloved, Covid sensitive sectors of the previous year, (hotels, airlines, energy, financials), European, UK and US equities commenced a slow and measured rise. This positive economic outlook meant that volatility in the US markets subsided in 2021, with the S&P 500 posting just seven sessions where the index gained or lost over 2%. That compares to 44 sessions in 2020.
This positive economic outlook meant that volatility in the US markets subsided in 2021, with the S&P 500 posting just seven sessions where the index gained or lost over 2%. That compares to 44 sessions in 2020.
The main theme for the year, as lockdowns were lifted and the world awoke to a new “post-Covid” normal, was talk of escalating inflationary pressure. A combination of extreme pent-up demand from frustrated consumers who couldn’t spend during 2020, supply shocks caused by pandemic disruption (not helped by the container ship Ever Given blocking the Suez Canal – you really couldn’t script it!) and continuing quantitative easing (QE) in the US until November 2021 all contributed to rising inflation around the world. By year end, US inflation stood at a staggering 6.8% whilst in the UK, CPI was 5.1%.
Stock-market volatility fell dramatically in 2021
Inevitably, all eyes turned to the central banks to determine what these new aggressive inflation numbers would mean for interest rates. There was a great deal of debate as to whether this new inflation was mainly transitory, caused by short-term supply shocks that would disappear soon enough, or structural, caused by increasing demand as the world re-opened. The former, which was the stance of central banks for most of the year, should lead to no action on interest rates now whilst the latter would certainly call for higher interest rates now to cool inflation and to keep growth under control.
US inflation spiked to 6.8% by the end of 2021
The UK’s Monetary Policy Committee met on the 15th December and voted to increase interest rates by 0.15% to 0.25%, the first increase since July 2018. Yet during the same meeting the committee decided to also continue with their bond buying (QE) programme, softening the blow of hiking rates and signalling some uncertainty/caution as to whether they felt the recovery was sustainable.
The Federal Reserve (Fed) and The European Central Bank both elected to keep rates on hold in their December 2021 meetings. The US economy is approaching full employment and considering the expectation that jobs numbers will improve further over the months ahead it was perhaps surprising that they did not act now to raise rates. However, the Fed did halt new asset purchases (QE!) in November, a sign that they were preparing the market for rate hikes in 2022.
It would be dangerous to call the bottom of the interest rate cycle because Omicron could derail growth very quickly and therefore the major central banks are treading cautiously. However, it is now widely accepted that recent inflationary pressure has been driven by demand rather than supply, and markets now expect that US rates will be raised in two months’ time, for the first time since December 2018, and then twice more as we move through the year.
Until now, investors have taken all of this in their stride, which we found surprising because in the short-term markets don’t usually like talk of rising interest rates. This either means that there will be a short-term market drop when rates are finally raised in the US, or that there has been so much build-up to global rate rises that investors have already predicted this and factored it in. We hope that the latter holds true! Either way, inflation and the consequences for interest rates is the hottest topic as we enter 2022.
So, with inflation running high in developed market economies and stock-markets creeping steadily higher, why were these gains not mirrored in Asia, and particularly in China, which suffered double-digit declines in value over the course of the year?
As the world’s global manufacturing hub, Chinese GDP understandably suffered from the Covid related slide in global demand and was duly impacted more than many other economies. By year-end GDP growth had slumped to 2.1%, having never fallen below 6% for the previous 30 years.
It was a miserable year for Chinese markets, lagging world markets by the biggest margin since 1998
Whilst Covid was a major contributor to this market decline, the wheels really came off over the summer, starting in late July, when the Chinese government announced a series of new regulations affecting various sectors. The first of these was a ban on companies making profit from the education technology (‘EdTech’) sector. Other reforms followed shortly afterwards, including (in order of date introduced) increased welfare for food industry delivery drivers, greater regulation of “pop-up” ads on apps, a crack-down on speculation in the computer chip industry, “unfair competition” legislation regarding the internet, tougher rules on the use of customer data and limits to children’s use of computer games, amongst many others. It felt like a sweeping range of reforms that had been planned for months as part of Xi Jinping’s new wave of societal ‘purification’.
Chinese GDP growth fell to 2.1% in 2021, having been consistently above 7%
Source: World Bank
These new laws feel idealistic and aspirational, and the speed and wide-ranging nature of the changes has been the envy of many western governments, however equity markets have been badly rocked by the news. Whilst good for consumers and society, new regulation is seldom good news for investors and the severity of the changes and the autonomy that the Chinese government demonstrated with these announcements left the Chinese equity market badly affected. The tech sector in particular took a hammering and led to a bear market in China (a fall of 20% or more) by the 20thAugust. In fact, from the February peak, Chinese equites had fallen by 40% by the end of August.
Then, to compound the problem, Chinese listed property company Evergrande, saddled with 570bn Yuan of debt, missed various debt payment deadlines, and cancelled a special dividend, citing liquidity issues. All the while ratings agencies were steadily downgrading the company to junk status with talk rife of a “probable default” and unpaid salaries at various divisions of the conglomerate. It was the last thing that the Chinese markets needed, the inference being that other property companies would follow Evergrande into the mire shortly and that there would be contagion into other sectors.
We wrote in detail about these issues in our August overview and do not wish to labour the point that China has experienced a catalogue of relatively unconnected woes that have directly impacted the Chinese equity markets this year, at a time when other equity markets have been performing well.
Japan (reflected by the Nikkei below) was the other market that performed relatively poorly in 2021. Japan had outperformed in 2020 due to Covid containment, but the Delta variant took hold last year and with at the time less than 5% of the Japanese population fully vaccinated (compared to over half the population in the US and UK already double jabbed), Japan struggled.
Initially, Japan’s vaccination rates severely lagged the other developed markets
Source: CLSA, John Hopkins University, IMF
As a result of these low vaccination rates the Government introduced a state of emergency in Japan in April, and this was not lifted across the predominance of the country until September. Under the state of emergency economic growth slowed markedly, as people were urged to refrain from non-essential outings and to avoid going to crowded places, while restaurants and bars were asked to close by 8 p.m. and were unable to serve alcohol.
This coupled with criticism of the handling of the situation in the run up to the Olympics led to some major political changes, most notably the resignation of Yoshihide Suga, the Prime Minister who had replaced Shinzo Abe just a year previously.
Japanese markets were down 2% by mid-August when developed markets were up an average of 15%. Since then, the Japanese market has kept pace with most developed market peers, due in part to the appointment of Fumio Kishida to replace Suga as Prime Minister and a rapid rollout of the vaccine, with nearly 80% of the population now double jabbed.
China and Japan were the only two (admittedly large) blots on an otherwise immaculate copy book, dragging down the average return from equities considerably. In general, however the strong performance from UK, US and European equities meant that equity markets as a whole performed well during 2021.
BUT WHAT ABOUT OTHER ASSET CLASSES?
Bonds had their worst year since 1999. The Barclays Global Aggregate bond index, which is a basket of corporate and government debt worth $68tn, fell by 4.8% over the year, driven by major declines in US Treasuries and other government bonds. The 10-Year US Treasury yield rose from 1.1% to 1.5% over the year as investors sold bonds aggressively, with the prospect of higher inflation and rising interest rates driving the declines over the period.
It was the worst year for bonds since 1999
Rising inflation is usually a bad sign for bond markets and cash, due to the fear of real capital erosion caused by rising prices. Whilst it may be too early to call the end of the 40-year bull market in bonds with absolute certainty, if inflation persists conventional bonds will continue to struggle in 2022.
Commodities typically perform well during periods of high inflation and last year was no exception. Lithium, crude oil, coffee and copper all had a stellar year, rallying hard in 2021 as the world economy opened-up again in March triggering aggressive demand for raw materials. The so called ‘reflation trade’ where investors aggressively buy cyclical sectors that recover well after a period of economic shock certainly helped commodities steal the show in 2021. However, gold had a miserable year, falling 4% as investors flocked to risk assets like equities and away from perceived safe havens. Concern remains about the oil price, which rose by 50% over the course of the year and which, at $80 a barrel, represents a risk of higher inflation still for those economies such as India that are large net importers of oil.
The UK commercial property sector saw growth of 3.8% in Q3 of 2021, the highest quarterly growth rate since Q1 2010. The recovery in the sector was, like commodities, triggered by ‘reflation’ as the pandemic abated. Challenges remain around the structural shift in the office sector as a result of flexible working but generally the outlook is now far more promising, even with the Omicron variant sparking short-term concern about possible lockdowns in 2022.
Other points of interest during the year included the David vs Goliath battle for Gamestop, where retail investors’ posts on the Reddit online forum resulted in the share price rising by 700%, wounding many big hedge funds which had shorted the stock. Also, Cryptomania continued with the combined value of Bitcoin, Ethereum and Solano reaching $3tn over the summer. It was also a record year for mergers, with M&A activity jumping 63% to $5.3tn over the year. Global food prices hit 10-year highs and big tech became even bigger, with Apple, Google, Microsoft, Nvidia and Tesla accounting for more than a third of the S&P 500’s total return.
SO, WHAT’S IN STORE FOR INVESTORS OVER 2022?
Covid is of course still relevant, and the human impact remains devastating, yet the markets have ultimately shrugged off Omicron and have treated the virus as yesterday’s news. It would take a big negative shift in sentiment for the pandemic to have a material impact on markets this year. Of far more importance to markets today is inflation and the pace of rising interest rates, and this will doubtless be the primary driver of volatility over the year ahead.
Over the last few years, investors have largely ignored traditional valuation metrics such as price to earnings ratios (P/Es), that have been used for decades to assess how expensive a company is relative to the market. Yet with P/E ratios at record levels across many sectors, investors have still been piling into equities at increasing rates. Why? Partly due to the escalating interest in the tech sector – typically businesses which are very expensive when considering their current earnings – but which promise massive future earnings tomorrow, rendering their valuations today irrelevant. But this huge momentum with equities is also a function of fixed interest investments (bonds) looking increasingly bad value (and risky) in an environment of rising inflation.
Neither are good reasons to support increasing equity allocations strategically, but it is hard to argue with the weight of market sentiment in the short-term – equities remain one of the best means to beat inflation over the years ahead.
Whilst we remain positive about the outlook for equities generally, one trend to watch out for within equities is a strategic move away from ‘growth’ sectors like tech and towards ‘value’ sectors like energy and financials. If concern over the Omicron variant wanes further and interest rate rise expectations are brought forward, this will probably facilitate a greater move to ‘value’ companies at the expense of ‘growth’. Again, we have written about this concept at length in several past overviews and indeed, at the time of writing, we have started to see this trend developing already in 2022. In any case, positioning portfolios to be more inflation-proofed in the current environment is definitely prudent.
Bowmore Asset Management Ltd is registered in England. Registered number 0905 1799. Authorised and regulated by the Financial Conduct Authority.