2021 was a year of unexpectedly strong recoveries. The IMF, in October 2020, pencilled US GDP growth of 3.1% for 2021 – by last quarter that had almost doubled to 6%. Corporate profits were similarly exceptional, with US earnings for the S&P500 rising 40% from their levels a year prior. Perhaps most intriguing was global M&A, where the value of deals reached the highest levels since records began.
Set against these near bubble conditions, it is unsurprising global equity markets posted a third year of double-digit returns and bond yields rose. Higher inflation was the price we paid, but this did not stop 2021 from being another vintage year for equity investors.
We remained overweight equities and underweight bonds last year, but we were more cautious in our stock selection. We were underweight – relative to the index – US mega-caps, holding instead to our long-term thematic positions geared to climate change, automation and ageing. We were by no means absent the digital winners, we just did not hold enough. Therefore, while we made good absolute returns, relative to the index our performance looks conservative.
Do we now stick to our cautious equity approach or sharply increase global mega-cap positions? The largest US companies certainly delivered superior organic growth, pricing power and prodigious cash flow. However, this has led to some of the most extreme stock-price dispersion and equity concentration in stock market history. Against this backdrop, three issues concern us.
The true taper
In December central banks bought bonds at near record rates – but that is not exactly tapering. Things will change though in 2022. The accelerated wind-down of the Federal Reserve’s purchases began in January, while the ECB’s giant pandemic emergency purchase programme ceases in March 2022. The Bank of England’s programme has now ended, as have purchases by the Central Bank of Canada. In other words, open-ended quantitative easing (QE) by western central banks may soon be history. This opens the door to interest rate rises and quantitative tightening.
This fundamental shift in monetary policy will have huge implications – we should expect increased volatility, bond yields to trend higher and more speculative investments to struggle. Equity market leadership will also evolve. As the inflows of money into the system are reduced, flows into mega-cap companies may be impacted 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.
Omicron changes everything
It is now generally accepted that Omicron is more infectious but intrinsically milder. This 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 was asset prices tended to rise, despite the damage sustained by the real economy. 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 largely not triggered full scale lockdowns, leaving central bankers freer to continue tightening policy in the face of far higher inflation rates than in earlier phases of the crisis. Such a fundamental shift in policy response to the virus naturally has implications for market leadership. It suggests tomorrow’s winners may include more companies that benefit from tighter money (financials), from massive climate spending (industrials) and those offering meaningful alternatives to bonds (global income stocks). While this will not occur overnight, it is another argument the leadership we saw last year is not forever.
China is changing
China’s tilt away from the West intensified in 2021, with its greater assertiveness towards Taiwan, tighter security regime in Hong Kong and restrictive economic policies targeted at countries including Lithuania, Canada and Australia. Domestic policy was also challenging. Regulators were antagonistic towards internet companies and education providers, while credit and leverage restrictions amplified severe problems in the property sector. These policies contributed to a particularly sharp underperformance of Chinese equities, with the MSCI China index lagging the S&P500 equivalent by an extraordinary 50 percentage points last year.
More recently there have been tentative signs of a policy reversal. The Chinese central bank has now loosened monetary conditions through a reduction in banks’ reserve requirements, while vowing 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. It is a policy mix that argues for better returns for China-centric markets in 2022. It is also a reason to suspect the sharp underperformance of many Asian markets may be reversed – potentially attracting flows that were destined for US mega-caps.
Call for caution
All of the above still makes one assumption – that global inflation rates will fall back modestly above central bank targets by 2023. This is still our belief. Used car and gasoline prices rose by more than 50% in 2021 and that is unlikely to happen again, while bottlenecks in global trade have started loosening.
If we are wrong though, and risks are clearly to the upside, there is the real possibility of bond yields climbing sharply or interest rates being tightened more aggressively. Both could threaten the high valuations of the US technology and consumer sectors – and the correction could be sudden and aggressive.
Given the above, when it comes to equity selection in 2022, fortune may well favour the cautious.
Guy Monson is chief investment officer at Sarasin & Partners. The views expressed above are his own and should not be taken as investment advice.