October was broadly positive for markets. Q3 earnings season in the US provided a boost to the stock market with over 80% of companies beating expectations. Economic growth remained solid as vaccine rollout progress continued with further lifting of restrictions in many countries. The month also saw several challenges: supply constraints, rising energy prices, higher inflation as well as nervousness around future COVID related restrictions in some other countries.
November saw a sell-off in its final week as a new COVID variant (Omicron) was discovered in Africa. Given the uncertainties of the variant, many countries swiftly reintroduced travel restrictions, but even before this mainland Europe was struggling with its 4th COVID wave with hospitalisations reaching concerning levels. Inflation continued to surge upwards, driven by rising energy prices and supply shortages. The COP26 climate meeting in Glasgow concluded with mixed success.
December saw more positive market sentiment, despite Omicron cases in the UK and the US rising sharply during the month. Data emerged to suggest that, despite its infectiousness, Omicron symptoms and thus risk of more severe health issues were much lower than previous variants. Inflation continued to push upwards across almost all major economies. This finally prompted many central banks to take action in the form of rate hikes and/or announcing the accelerated tapering of bond buying programmes, including in the US, UK and Europe. Bond markets were slightly surprised by this and as a result, fixed income yields rose over the month and bond prices fell.
Overall, the fourth quarter saw extremely strong market performance from western developed equity markets on the back of expectation-beating corporate profit upgrades, with the US leading the way. Asian equities and emerging markets struggled on the back of continued Chinese economic weakness, however. Bond performance was also subdued during the quarter. Market volatility, as measured by the VIX index, fell almost 26% over the quarter. Developed market equities (as measured by the MSCI World Index including dividends) were up 7% in sterling terms over the quarter. The FTSE 100 returned almost 5% over the quarter including dividends. Emerging market equities (MSCI EM Index) fell almost 2% over Q4. Global bond yields were roughly flat over the quarter with higher quality bonds as a whole (as measured by the Bloomberg Global Aggregate Index) also flat over Q4. Lower quality ‘high yield’ bonds, fell slightly (-0.5%) over the quarter. Energy commodities retreated over the quarter with oil falling 0.9%. Gold rose 4.1% over the quarter.
Diving into stylistic performance within indices, ‘high price’ securities (often described as ‘growth’/’momentum’/’quality’ companies) continued their stronger run of the second quarter, up almost 8% over Q4. Cheaper ‘value’ companies weren’t too far behind, up almost 7%. Smaller companies, however, lagged significantly and were only up just under 2% over the quarter.
The pound had a stronger quarter, up 0.4% against the US dollar, 3.9% against the yen and 2.2% against the euro.
Portfolio Performance Overview
The PortfolioMetrix Core portfolios had a subdued quarter. Asset allocation was a headwind, due to a relative underweight to strongly performing US equities and a relative overweight to weakly performing Japanese and emerging market equities. Active fund performance also detracted over the quarter. Full year performance was, however, stronger as was full year active performance which added about 0.5% for mid-risk portfolios.
Sustainable World portfolios had a weaker quarter, with their tilt away from larger companies and small tilt towards emerging markets both detracting. Full year relative performance was weaker than in 2020. They do, however, continue to enjoy significant long-term structural drivers as the world shifts to focus more on environmental and social issues.
As we move from 2021 to 2022, market concerns over COVID are diminishing to be replaced with inflation worries and fears over monetary tightening by central banks to deal with inflation. Equities and bonds fell modestly over the first week of 2022 as investors began to price in earlier withdrawals of central bank stimulus in the form of reduced central bank bond buying and higher interest rates. Previously high-flying tech stocks were particularly hard hit.
The outlook for inflation, which roared ahead in 2021 on the back of supply chain disruptions and energy shortages, is likely to drive market returns this year. The high recent annual inflation numbers (6.8% in the US and 5.1% in the UK in November) should come down later in 2022 as supply chain issues are resolved and due to base effects (2022 inflation will compare against higher 2021 prices rather than lower 2020 ones). The key questions for 2022 are: ‘by how much?’, and ‘how quickly?’.
Slower falls in inflation than expected risk it becoming embedded at higher levels than the 2% targets of central banks as employees start demanding higher wages to offset inflation and companies start charging more to offset higher wages and other input costs. There are worries that increasing rental costs in the US (a large component of CPI) could also lead to higher-than-expected inflation. This situation would require central banks to be more aggressive with their interest rate rises and quantitative tightening (selling bonds previously bought under quantitative easing), which would almost certainly be negative for bonds. Equities could also suffer in such a scenario, although their outlook would also be dependent on growth levels.
Strong global growth, as well as being inflationary, would at least support equity prices through higher corporate profits. The worry is that overly aggressive central bank monetary tightening could choke off growth as debt (government, corporate and household) becomes more expensive to service. Global total debt levels have mushroomed since the global financial crisis and COVID (the Institute of International Finance measured this at over 350% of global GDP from 320% pre-COVID), so the global economy is more sensitive to higher rates than it used to be.
On the other hand, faster than forecasted falls in inflation would allow central banks to be less aggressive in raising rates, something that would likely support bonds, as well as other asset prices as long as the reason for inflation falls wasn’t a downturn in global growth.
Inflation is thus perhaps the key macroeconomic indicator to watch in 2022, but don’t forget to watch growth figures too. Forecasts for these are certainly healthy. The IMF expects 4-5% growth levels for 2022 for the US, UK and Europe – far more than pre-COVID levels which averaged around 2% (although these higher levels are in part catch up for the falls seen in 2020).
There are, of course, risks to current generally rosy growth levels. COVID certainly isn’t going to go away completely with the best-case being Omicron marks the beginning of the disease becoming quickly endemic and no more serious than flu (although note that this doesn’t mean harmless – the World Health Organisation estimates up to 650 000 people die globally each year due to flu complications). Whilst becoming endemic is the likely long-term outcome for COVID, there could still be bumps in the road on the way there in the form of new variants that cause further economic disruption. That said, the current trend on COVID is positive – despite Omicron, global daily deaths are roughly half that of last (northern-hemisphere) winter.
Another risk to global growth is China, currently cracking down on overheating in its systemically important property sector which, given the high debt levels involved, could lead to weakness in the Chinese economy. And given the size of the Chinese market for goods and, in particular, commodities, weakness could easily impact negatively on global growth.
And when it comes to risks, don’t forget geopolitics. Russian troops are currently massing at the border of Ukraine, possibly in preparation for an invasion, which could disrupt energy supplies to Europe given Russia’s importance as an exporter of natural gas and oil (as well as many other commodities). The Chinese military has also recently stepped up its testing of Taiwan’s defences, also possibly in preparation for an invasion (Taiwan, through national champion TSMC, is one of the largest suppliers of the microchips used in cars and most everything else nowadays). In addition, a new nuclear deal with Iran is proving difficult to negotiate, with higher oil prices reminding the world that the middle east remains extremely important to the world economy. All of these situations have the potential to flare up in 2022 with dramatic effect.
Despite these risks we are cautiously optimistic around our portfolios. Given inflation, it remains tough to make an attractive case for cash and bonds from a returns perspective, although they do remain crucial for diversification and for controlling risk in portfolios. The case for equities is stronger as expectations for company earnings growth remains robust both this year and next.
That said, valuations are a challenge for some regions in absolute terms, particularly US equities. However, relative to bonds (comparing equity earnings and dividend yields relative to bond yields) even US equities look reasonably valued based on historical ranges.
We continue to favour a balance of equities in portfolios for growth, albeit tilted away from more expensive parts of the market like the US and towards cheaper parts like UK, Japan and Emerging Markets. For the majority of clients, holding some bonds and some cash remains useful to control risk and in case of the unexpected. We also continue to diversify portfolios as much as possible through the judicious use of less mainstream asset classes like high yield bonds, emerging market bonds, listed property and infrastructure.
Data: Monetary Policy* (Rates & Extraordinary Measures)
A few developed market central banks, including the Bank of England, joined emerging market central banks in raising interest rates to combat inflation. In addition, the US Federal Reserve and ECB started tapering their bond purchases as a prelude to likely raising interest rates sooner than markets had previously anticipated.
Data: Global Economies
GDP figures released in the fourth quarter were for Q3 2021 and continue to be volatile given different patterns of COVID disruption and government support. They generally show reasonable growth though. Inflation increased during the fourth quarter almost universally whilst unemployment generally fell as restrictions were lifted and economies continued recovering.
Data: Asset Classes
It was a strong quarter and year for western developed market equities, but Japanese equities in pound terms were subdued and emerging markets fell. Commodities paused for the quarter but had an extremely strong year overall fuelled mostly by gains in the energy complex and, in particular, natural gas. Global listed property and global listed infrastructure also performed well over the year.
Bonds on the whole struggled both the fourth quarter and year as global interest rates rose. Inflation-linked bonds performed well, however, benefitting from increased inflation fears.
Note: The above returns are total returns, including dividends and interest payments. Asset classes with the “HDG” label are currency hedged to pounds sterling, which means that foreign currency movements are removed whilst those with the “£” label indicate that we are reporting returns to British holders which includes the effects of the foreign currency moves non-UK listed securities are exposed to.
Data source: Financial Express
Indices used: 3m GBP LIBOR, GBP hedged version of FTSE World Government Bond Index, GBP hedged version of FTSE WorldBIG Corporate Index, GBP hedged Bloomberg Global High Yield Index, GBP hedged version of FTSE Global Emerging Markets US Dollar Government Bond Index, MSCI North American Index, MSCI Europe ex-UK Index, FTSE All Share Index, MSCI Japan Index, MSCI Pacific ex-Japan Index, MSCI EM Index, FTSE Global Core Infrastructure 50/50 Index, FTSE EPRA NAREIT Global Index and S&P Goldman Sachs Commodity Index
Data: Indices, commodities, Currencies
FTSE 100 is an index of the 100 largest companies by market capitalisation listed on the London Stock Exchange. Crucially, whilst these companies are priced in sterling, the majority of their revenues comes from outside the UK making the FTSE 100 more a global, rather than domestic UK, index.
MSCI World Index is used to gauge global developed market equity performance. This is heavily influenced by US equity performance which, as the world’s biggest equity market, makes up more than half of the index. Not to be confused with the MSCI All Country World Index, which includes both developed equities and emerging market equities.
MSCI Emerging Market Index measures emerging market equity performance.
Bloomberg Global Aggregate Index represents global investment grade bond markets, mostly made up of government bonds.
Chicago Board Options Exchange Volatility Index (VIX) is a measure of implied volatility in the S&P 500 Index (how volatile market participants expect big US equities to be/how risky they view them to be). It is also known as the “fear index” – with higher numbers crudely representing “more fear” in markets and lower numbers crudely representing “more greed”.
Brent Crude oil prices are a key indicator of movements in the global oil market, the world’s most important commodity as it is such an important input into economic activity (in providing energy and as a raw material in production of materials such as plastics).
Data Source: PortfolioMetrix, Bloomberg
*Glossary of Financial Terms
Hedging back to sterling: The risk of currency fluctuations can be removed by “hedging” the foreign currency back to the pound. In this way, a UK investor holding a US government bond or bond fund would not experience changes to the pound to US dollar exchange rate and their holding would be a lot less volatile/risky.
High yield: High yield debt is rated below investment grade and is riskier. It has a higher yield to compensate for this additional risk.
Monetary Policy: The decisions central banks make to influence the supply of money in an economy, primarily the setting of base rates in the economy, but also through certain extraordinary measures such as quantitative easing.
Quantitative easing: Quantitative easing refers to expansionary efforts by central banks to help increase the supply of money in the economy (and help indirectly lift the economy). It involves the central bank purchasing financial assets, mainly government bonds.
Quantitative tightening: A mechanism for decreasing the supply of money in the economy to cool excess growth (above a stable level). It involves the central bank allowing purchased bonds to mature or in more extreme cases selling previously purchased financial assets.
Quarterly vs annualised growth rates: Some national statistical agencies prefer to quote country growth levels in a quarter as an actual quarterly rate (the estimate of growth over three months, x, sometimes referred to as “on quarter” growth) whilst others prefer to quote the growth over the quarter on an annualised basis (i.e. assume the growth over three months continued for a year, approximately 4x). Unless specified otherwise we quote only annualised rates using actual calculations rather than the simplified approximation of annual rate = 4 x quarterly rate.
This document is only for professional financial advisers, their clients, and their prospective clients. The information given here is for information purposes only and is not intended to constitute financial, legal, tax, investment, or other professional advice. It should not be relied upon as such and PortfolioMetrix cannot accept any liability for loss for doing so. Any forecasts, expected future returns or expected future volatilities are not guaranteed and should not be relied upon. The value of investments, and the income from them, can go down as well as up, and you may not recover the amount of your original investment. Past performance is not a reliable indicator of future performance. Portfolio holdings and asset allocation can change at any time without notice. PortfolioMetrix Asset Management Ltd is authorised and regulated by the Financial Conduct Authority. Full calculation methodology available on request.
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