Annual Investment Review
The return of inflation
Inflation significantly higher than expected
US inflation rose in November at an unprecedented rate in nearly 40 years. The price increase reached 6.8%. Many factors contributed to this surge, whether transitory or more structural.
At the same time, inflation in the euro area hit a record high in November at 4.9%, still propelled by steadily rising energy prices. It reached a level not seen since the launch of the euro.
Bond markets under pressure
The 10-year government bonds yields have globally increased. Continued asset purchases by the main central banks prevented a more pronounced bond correction given the level of inflation.
In the US, 10-year Treasury government yields have risen to 1.5% today from 0.9% at the start of the year. Yields have risen in the euro area and in Switzerland as well, but to a lesser extent. given these developments, bond markets remained in negative territory during most of the year, except for high yield bonds.
Credit bonds were also supported by central bank purchases, investors’ search for yield and their fundamental resilience.
Equity markets hit new records
Global equity markets have followed on their 2020 momentum. Regional markets, including Switzerland, hit new highs, driven in large part by strong corporate earnings and TINA (There Is No Alternative) investor mindset.
The appearance of the Omicron variant has caused trouble, causing a sharp rise in global financial markets volatility.
American technology companies have once again outperformed. They posted nearly twice the performance of the market.
The price of gold has been falling steadily since August 2020, briefly dropping below $1,700 an ounce in March 2021. It has since recovered and then moved sideways.
2021 will have been a turning point for the auto industry. All groups have announced that they want to turn the page on the combustion engine when until recently they wanted to replace gasoline and diesel with biofuels. But it is too late. Concerns about the climate, China (again) and its market have imposed a radical technological shift. There will still be a lot of talk about the electric car in 2022.
Beijing is becoming more authoritarian in business matters. The authorities are hunting down bosses who are too extroverted and critical of power. In addition, conflicts with foreign investors are increasing. A form of cold war is taking hold between Beijing and Washington. Internally, President Xi Jinping lectures the youth and threatens Western firms that refuse to comply with the specific rules laid down by Beijing. Chinese stocks show the worst performance among the major markets.
Expectations of a less accommodating US Federal Reserve – which materialized at year-end – have been a continued support for the USD. Emerging countries’ currencies have suffered from flawed vaccine policies despite central banks raising almost all of their key rates.
A tricky year 2021 for government bonds. Chinese government bonds confirmed their status as decorrelated securities. While those of developed countries posted negative performance. In the credit sphere, High Yield once again posted positive performances, while emerging countries underperformed.
A fantastic year for equity markets, with the Global Index posting a performance of over 20%. In this particular health context, emerging equities underperformed in large part because of China. The measures taken by the central government have failed to encourage investors to favor the region.
A year marked by rising energy prices, but not only. The cobalt has more than doubled. It is the preferred material for the energy transition towards a low carbon economy. Renewable energies and electrical mobility consume a lot of materials.
Developed world growth slows
December’s indicators provided a more solemn note to end the year, with growth momentum across the world’s largest developed economies revealed to have eased in the final month of the year. That said, overall manufacturing output rose, supported by an easing of supply constraints across Western economies, which also suggested that we may be seeing prices peaking in these regions. Service sector growth meanwhile came under pressure as the growing COVID-19 wave struck the US, UK and eurozone, while Japan saw service sector activity growth slow post the initial reopening boost. The latest COVID-19 Omicron variant developments add further downside risks to the year-ahead outlook.
Flash PMI surveys for December signaled a slowdown in the pace of economic growth in all four of the world’s largest developed economies, while still solid. A renewal of COVID-19 case growth in Western economies into the closing months of 2021 has affected service sector activity in December, with the European economies in particular finding their latest flash composite PMIs sliding further from their summer peaks, reached as the economies opened up from pandemic-related restrictions. Eurozone growth notably fell to a nine-month low in December with the German economy stalling for the first time in a year-and-a-half.
Supply constraints ease but overall price pressures remain broadly elevated
Suppliers’ delivery times continued to lengthen at a severe rate in December but eased off the November record to the lowest since August, suggesting that we be seeing a turnaround in the situation. The dip had been underpinned by a slower increase in supplier lead times across all but Japan within the G4 economies. The US, UK and eurozone all saw sharp easing in the rate at which lead times lengthened, with UK delivery times extending at the slowest pace since December 2020 and the eurozone reporting the fewest delays since January. US lead times meanwhile lengthened to the least extent since May.
An easing of previously reported COVID-19 related production issues in Asia is likely to have ameliorated the global supply situation, although the COVID-19 Omicron variant’s reach into APAC economies continue to cloud the outlook going forward.
Elevated macroeconomy volatility
Pandemic and its consequential distortions are here to stay, as long as emerging countries access to vaccines is limited. The increase in macro volatility imposes a delicate change in economic policies. Inflation and the imbalances inherited from the pandemic increase the risks of a shortened and bumpy cycle. Decoupling between the G7 and China is intensifying. China engages in a politically crucial year. The generous valuation of most assets and the resurgence of markets’ volatility represent potential vulnerability, considering the considerable financial leverage of both institutional and retail investors.
Two diametrically different models
Chinese households’ savings are highly concentrated in cash and real estate – more than 50% of them. This gives perspective to the PBoC’s orthodox monetary and positive real interest rates policy. Politically, the Politburo could not tolerate the collapse of this sector, which would provoke potentially uncontrollable discontent. The US economy is highly financialized. Liquid and illiquid financial assets (PE, HF) represented more than 60% of household savings in 2020 (27+37). This is the consequence of financial repression. The economy/consumption would not stand a financial crash.
We consider three secular disruptors. 1) Climate – rapid – changes, which impose hectic transitions towards green(er) economies. This will fuel large investment packages, but also higher inflation, new regulations, corporate requirements, and taxes. Europe is leading the charge. 2) Technology. The relentless shift towards digitalization has a long-lasting impact on labor markets. 3) High Inequalities generate more labor friendly policies to re-gain a higher share of GDP.
In H1 22, a transition from stagflation to growth-flation in G7 will gradually take place and China will engineer a soft landing. Inflation and growth fears will continue to temporarily upset markets. Though less powerful, negative real rates / Asset Inflation regime will remain in place in 2022. Leverage players will add to short-term volatility, as they will further endure more adverse conditions with less exuberant liquidity.
Policy normalization imposes less supportive financial conditions ahead.
Monetary policy divergence is set to remain the dominant theme and driver of currency markets
Tighter monetary policy is coming to North America/UK and will differ from the rest of the world. An assertive FOMC cemented their hawkish pivot toward mitigating persistent inflation risks with a more aggressive policy normalization profile. Since the start of September, inflation forecasts and Fed Funds market pricing have been revised sharply higher in absolute and relative terms. The US economy positive output gap is amongst the reasons for the Fed move to front-run others developed countries in their policy normalization. The USD strengthening plays its part in tightening US monetary conditions. In a world where the European, Swiss, and Japanese central banks are late to tighten, the USD gains should largely come at the expense of the low-yielding currencies. While Q1 2022 is likely to see further USD strength, the story will evolve as the year progresses. We would not be surprised to see the USD best levels just reached ahead of the Fed first rate hike. By then, a lot is likely to be priced into the US rates curve, and the FX market.
Volatility regime shift
After months of successive steady declines and phases of stability, implied and realized FX volatility have just spiked. Over just a quarter, implied volatility has plunged to 5.5 – 5 percentile low of the past 2 decades – just before surging above 7. This is an impressive move in a context of a very-low-volatility regime, but still below its long-term average.
After the liquidity shock in March 2020 due to the COVID crisis spreading out of China, the massive monetary injections of central banks mechanically diluted FX market moves. The Fed having recently started and then accelerated its asset purchasing program tapering, it will remain an underlying force supporting higher FX volatility. Furthermore, the currency volatility is lagging other asset classes, like bonds. Given the wide monetary policy decisions, the volatility will no longer be under the control of central banks.
Fed hawkish pivot
The Fed executed a hawkish pivot by quickening the pace of tapering, while also building significantly more rate hikes into 2022/2023 than just a few months ago. Asset purchases will slow to $60bn in January with a target of full wind-down by March. Three rate hikes in 2022 are now implied by the dots (0.875%), another three in 2023 (1.625%) and two more in 2024 (2.125%).
While the change in near term rate expectations appears drastic, there are aspects that the Fed was simply pulling forward expectations, as the 2024 dot increased only marginally, while remaining below the 2.5% neutral rate.
The ECB did not blink. The ECB will continue its purchases under its Pandemic Program at a slower pace than in the previous quarter and will stop them in March 2022. To avoid steep liquidity reduction in Q1, the ECB plans to temporary increase asset purchases under other programs until Q3 2022. The ECB is still expecting inflation to be transitory. A first rate hike will be delivered in early 2023.
The SNB policy rates will remain unchanged. It will continue to intervene in the FX market when necessary. The more inflationary context makes it less concerned about deflation. It should tolerate slightly higher CHF levels given its real term approach. The expected tightening of monetary policy around the world should give the SNB some relief, but not enough to consider tightening itself.
Emerging markets’ factors to become more supportive
Emerging assets have been penalized in 2021 due to a very slow vaccination process and to some extend by rising political risks premium. However Turkey and Brazil remain small contributorsto global EM.
The Fed tapering start has left some investors concerned about emerging markets (EM) vulnerability to a repeat of the 2013 taper tantrum episode. EM debt market is in a stronger position to absorb the 2022/2023 US monetary policy tightening. Conversely to 2013, most EM central banks have tightened in advance of the tapering.
Other factors can contribute to this relative resilience:
- The shape of current account balances has dramatically improved relative to 2013.
- The more recent flow dynamic has been nowhere near as supportive as back in 2012.
- Since 2013, EM sovereigns have tilted their issuance to the domestic market.
The gold rule: Don’t bet against stocks unless you think that there is a recession around the corner
We remain positive on equities in 2022. Historically, stocks have performed well at the start of a monetary tightening cycle. Economic growth will support stocks. We will become more cautious in 2023 with a more advanced economic cycle.
In 2021, risky assets benefited from abundant liquidity, low interest rates and a strong recovery in corporate results. We remain positive for 2022. The Fed is entering a monetary tightening cycle, but if history is any guide, stocks do well at the start of such a cycle.
Producer prices have risen sharply due to rising wages, labor shortages, disruptions in production and supply chains, and rising commodity prices. We will monitor the positive base effect from March 2022. We are already observing a process of normalization in logistics (transport prices are falling) and in production.
For bears, the moderate increase in US profits expected at +10% in 2022 and +7% for revenues could explain poor stock market performance in 2022. On the contrary, these growth rates will demonstrate the solidity of profits and revenues, because the base effect will be significant.
Despite rising operating costs (wages, raw materials, logistics), net margins will remain at high levels demonstrating the ability of companies to pass rising costs on to customers and improve productivity.
Driven by the pandemic and deglobalization (reindustrialisation in developed countries), companies are evolving by adopting new behaviors and/or business models, favorable to profits. In 2022, we are counting on a restocking in companies, an increase in household consumption and the positive effects of stimulus plans in the United States and in Europe.
Other positive factors for equities will be: 1) the large amount of cash parked in money market funds ready to revert to equities, 2) share buyback programs, and 3) mergers and acquisitions.
Oil and industrial metals have had a good resilience in the pandemic
In the long term, the absence of major projects, geopolitics and energy transition support the Supercycle. In October, the gas crisis in Europe and the coal crisis in China and India show that fossil fuels remain essential.
The prices of petroleum and industrial metals have held up well during this pandemic despite the Chinese economic slowdown, given that China consumes 50% of the world supply of industrial metals. 40% of the oil supply is controlled by OPEC +, while the supply of industrial metals has been disrupted by the pandemic and social crises in some mines in South America.
Demand increased in 2021 with the economic recovery and, for industrial metals, demand from the energy transition (electrification of vehicles, solar, wind) has been added. In 2022 and beyond, US spending on infrastructure will stimulate demand. The gas crisis in Europe and the coal crisis in China and India have shown that it will be difficult to reduce the consumption of fossil fuels at the risk of creating an economic decline through electricity production and/or social problems. In India, coal is a cheap source of energy in a poor country where imposing renewables is impossible.
Gold moves with real rates
Between November 2018 and June 2020, the price of an ounce of gold increased from $ 1,200 to $ 2,065 due to the fall in US 10-year real rate. Since July 2020, the US 10-year real rate has stabilized, as well as gold price: Gold holdings in financial products fell by 12% in 2021.
Gold suffers from competition from cryptocurrencies which are also financial assets and decorrelated with other assets. The development of inflation will be an important parameter for gold: an inflationary slippage would favor gold, while inflation returning to 3.5% in 2H22 would be unfavorable.
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