Monthly Market Commentary - January 2022

Our theme this month is the band Squeeze and other squeeze-related things. Inspired, if that’s the right word, by the suggestion that 2022 will be the year of the big squeeze (from a piece of work by The Resolution Foundation, December 2021), will we really find ourselves ‘Up The Junction’ this year, or perhaps, if they have overstepped the pessimistic mark, we will end up ‘Cool For Cats’? For those new to our January edition, this month we go a little light on the normal sections and add in (as above) a summary of the past year.

In the UK, 2021 was the year of hindsight as much as anything else. A rear view mirror approach from many investors helped drive returns, seeing the main UK index beaten only by the US among major equity indices. The view seemed to be ‘with recovery underway, let’s get asset prices to where they would have been if this had not all happened’ – we leave you to decide what ‘this’ was/is.

Omicron is having a significant impact, both negatively (due to its transmissibility, it seems likely supply chains and more will be disrupted significantly for at least the next few weeks) and positively (being ‘milder’ as regards the impact on health), meaning there are many who see 2022 as being near to ‘normal’. We will see. For now, we remain invested where we see the best opportunities – after all, the money we made on £1 yesterday can never be earned again by today’s £1.

We will continue to back our conviction, and we will always be prepared to change when change is appropriate, never for the sake of it. The ‘new year’ is an odd construct in many ways – for us, it is business as usual; we look forward to celebrating our 200th Monthly Market Commentary later this year – now that will be worth celebrating.

We increased our UK equity weightings last year and this helped portfolio returns. We have a bias for smaller companies but are happy to own across the cap spectrum. Sort of ‘when the cap fits’ …

For the coming year, we do see challenges, and we do recognise how well paid investors have been in the last two years, remarkable as that might be in the teeth of a pandemic. Having different assets that do different things in different conditions is a vital part of a good plan, and we never take a binary approach to any single risk in portfolios.

Term or word(s) to watch: share of wallet – this is the amount an average customer regularly devotes to a particular brand rather than to competing brands in the same product category. As we head into 2022, we see households facing a squeeze from higher inflation and taxes, leading to a challenging consumer environment that will create winners and losers.

In this type of market, broad figures on retail spending obscure the full picture if the share of wallet tells us that within the sector, consumers are spending 20% more here and 20% less there. Apart from the benefit of following trends (where the new kid on the block, if successful, may well gather more of the wallet short term), companies in fragmented industries with little or no product differentiation will not be able to pass on higher costs to consumers, leading investors to favour companies with significant pricing power.

As an example, software companies such as Microsoft or Adobe, which provide essential tools to companies, governments and households, are in a unique position because they can increase their annual subscription charges each year.

Overvalued? Too oriented towards growth and tech? Perhaps, but these characteristics have not stopped US equity indices producing another stellar year of returns in 2021. Continuing to voice objections to the US has seemed futile for some time, though it remains the duty of every responsible investor to wonder whether such extreme valuations will support decent returns. There are other issues when we peek below the bonnet and examine what has been happening in more detail.

One of the areas of concern of late is market breadth. Declining breadth in the market – that is to say a narrowing in the range of stocks performing well – has on occasion been a warning sign for a correction in prices. Famously, back in 2000, the breadth of the market continued to narrow until the remaining ‘performers’ finally cracked and the market crumbled – a market squeeze of sorts. On the other hand, there have been periods when a small group of stocks have driven markets higher for sustained periods without a resulting correction.

Whatever the balance of these arguments, a small cohort of stocks are clearly still driving the US market. Apple, Microsoft, Nvidia, Tesla and Google have accounted for more than half of the gains of the S&P 500 since April. A glance across at the NASDAQ index shows that more than 1,000 stocks are down by more than 50% from their highs of 2020 and more than three-quarters of all those listed are off at least 10%.

This is a market exhibiting a significant divergence of fortunes, but tellingly, on days when the VIX (equity volatility) index has risen strongly, stock movements have been much more correlated.

All of this points to embracing a discriminating approach. Strangely enough, if the aforementioned large names continue to drive the market it may mean that passives continue to do well, but if the trends observed cannot be sustained and those currently driving the market have a tough time, the opposite approach (active) will be favoured.

Those in favour of the large tech names in particular will argue that it is absurd to make historical comparisons as the disruptive landscape they are shaping is like nothing seen before. Perhaps they are right, but there are signs that this market is going to face challenges soon.

We have modestly increased US allocations in places, mostly oriented towards more value funds that should benefit from the likely rotations in style, if not a shift in valuations, in the wider market. Of all the markets we look at, this is the one where valuations take most of our breath away – the Hourglass is due to run out of sand at some stage, so we remain watchful.

Europe enters 2022 with increasing case numbers of the Omicron variant of Covid-19 being reported across many countries. Various restrictions have been brought in to protect national health services. The Netherlands and Austria have seen strict national lockdowns, with the latter imposing different rules for vaccinated and unvaccinated citizens.

Elsewhere, Covid-19 passports are being used in France and Belgium and some activities are being prohibited in other nations, such as nightclubs being closed in Portugal and sporting events being played behind closed doors in Germany. While these measures vary, booster shots and encouraging the as yet unvaccinated to get vaccinated is the common strategy, which should see any negative economic effects suppressed.

Alongside the pandemic, inflation remains a concern for European economies. The European Central Bank (ECB) will be rolling back parts of their pandemic response scheme in March, stopping bond purchases in an effort to tighten monetary conditions. Alongside global supply chain issues, energy prices are also putting pressure on European inflation.

In particular, gas supplies from Russia have fluctuated and tensions around NATO and Ukraine could see this become a more political issue. European gas reserves are low and likely to be near empty after the winter. This has seen European prices become the highest in the world and shipments bound for Asia are being rerouted, including the first shipment of liquefied natural gas from Australia to Europe since 2009.

April also sees Presidential elections in France, where President Macron is likely to face a centre-right candidate in a second round run-off. Given the number of nation states in Europe, there does seem to always be an upcoming notable election, with Germany having one last year and Italy due to have general elections before June 2023. While there will be much media attention, the economic and market impact are likely to be muted.

The pandemic and inflation are the twin concerns for the European economy, and tensions with Russia need to be watched given the key gas supply. Politics will be in the news with the French election, but this is a normal backdrop when investing in Europe.

Towards the end of 2021, renewed uncertainty (over the Omicron variant) obscured an increasingly positive outlook for Japan. Although the main equity market ended the year under-owned by asset managers and lagging other developed markets, we believe there are reasons to be positive as we move into 2022. The panic over the new variant as well as the strengthening of the yen (often viewed as a safe haven during times of market turbulence) somewhat eclipsed the government’s significant effort to reinforce an economic recovery

In November, they announced a two-pronged fiscal stimulus approach with government spending and taxation policies designed to support the economy. There is a particular focus on boosting consumption with direct cash handouts.

The stimulus package is slightly larger than expected due to the strength of the Liberal Democratic Party’s victory in the general election, which returned Japan to a stable political situation.

A further reason to take a closer look at this somewhat unloved region is the powerful incentive for companies to overhaul their corporate governance structures thanks to significant revisions to the Japan Corporate Governance Code. The revisions made in June 2021 aim to place greater emphasis on the role that corporate boards and their committees should play in enhancing shareholder value as well as including sustainability issues such as climate change. The revisions to the Code provide greater clarity to the role boards should play in protecting minority shareholder rights – preventing a squeeze out – and raising company value. Further, the Code now includes a ‘comply or explain’ enforcement element. If companies want to become members of the Tokyo Stock Exchange’s coveted Prime section, which is expected to go live in April 2022, they will have to adhere to the Code.

We continue to own positions in Japanese equities as we see potential for a significant rebound over the next 12 months. We prefer actively managed funds as we expect winners and losers to emerge from the corporate governance transformation taking place over the medium term. You could say we have Japan ‘Labelled With Love’.

The disparity between the performance of stock markets in the east and west was stark in 2022, with Asian equities underperforming broad global equities by around 20%. The MSCI Asia ex Japan index is dominated by five major listing destinations. These are China, Taiwan, South Korea, India and Hong Kong. With a weighting of 40% of the index, performance is heavily reliant on Chinese equities. While 2021 was officially the year of the ox, it was more like the year of the dog for Chinese stocks, with the MSCI China falling 21%.

We have documented the reasons behind the poor performance, which was particular pronounced for those assets listed offshore, throughout the past year. However, for the uninitiated, an increasingly aggressive stance from Beijing, both in terms of foreign and domestic policy has spooked investors. Furthermore, things may be slowing from an economic point of view, which has implications for Asia more broadly.

Elsewhere, India was the standout performer in 2021 and the International Monetary Fund is forecasting a staggering 9.5% GDP growth for the year ending March 2022. If the forecasts are correct, India would regain the title as the world’s fastest growing large economy. Yes, the figure is turbocharged by the rebound from the 7.3% fall last year, but it is impressive, nonetheless.

Despite enduring incredibly high levels of Covid-19 cases earlier in the year, Indian stocks finished the year 27% higher. However, it will not be plain sailing for President Modi in 2022. Industrial output has been slowing, on account of shortages, and there is still a significant amount of the population that are awaiting their first Covid-19 jab.

The term squeezebox is a broad one, referring to hand-held, bellow-driven, free reed aerophones. One such instrument is the Indian harmonium, which is one of the most important instruments in Indian music and is derived from similar instruments that were brought to India by missionaries in the mid-19th century.

In December, we took the decision to reduce and, in some cases, remove the direct allocation to China in portfolios, concerned by the direction of travel being pursued by the ruling Communist Party, wider economic growth prospects and the impact these might have on equities. We retain exposure to China directly for appropriate risk levels and indirect exposure comes through our Asia allocations. Our positive sentiment towards India remains unchanged.

We have written at length of the challenges facing emerging markets. Our concerns over the direction of US monetary policy and the difficulties posed by Covid-19 have led us to reduce emerging market debt exposure in some portfolios. Valuations do not seem to reflect the realities facing the asset class, but all of the ‘winners’ in the sovereign bond space in 2021 came from emerging markets. South Africa, China, Indonesia and India led the pack. It is true that some of these countries have scope to reduce rates further, of course, but betting on this after a relatively strong year and with latent currency pressures seems risky to us.

Most emerging market equities have found the going tough and 2021 was not a year to remember. Long term, the returns are not stacking up well relative to developed markets and investors are struggling to be tempted despite seemingly undemanding valuations. As always there have been winners in a challenged space and Russia takes the top spot here. Rising commodity prices, record international reserves and the fact that the central bank has already carried out rate rises have all helped; the market remains cheap.

Of course, these attractions would be rendered utterly worthless in the event of an escalation of tensions with Ukraine to the point of invasion. The likely sanctions that would ensue would see an exodus of investors from the asset class and make a repeat of 2021 impossible.

Talking of ‘squeezes’ , it is more than apparent how vulnerable Europe is to the gas supply squeeze that we could be placed under from Russia in the event of any deterioration in the Ukraine situation. Germany has already suspended its approval of the Nordstream 2 pipeline that would double its reliance on Russian gas imports – potentially a wise move but only time will tell. As Squeeze (the band) sang, ‘I asked of my reflection, tell me, what is there to do?’

Of course, Russia is not a microcosm of the wider emerging market space, but it does capture some of the disconnect between the opportunities and appealing valuations, on the one hand, and the idiosyncratic risks, on the other. If investors really get concerned about the US market being overstretched, it may well be that emerging markets catch a break and attract flows. This said, in an environment where the US corrects meaningfully, will we really be much safer in emerging markets? This seems less than certain.

As for China, which has attracted the most debate among our Asset Allocation Committee, the prospects seem increasingly uncertain short term. Indeed, we have removed specific China fund exposure in some portfolios and reduced it in others. The rapid recovery predicted by some has not transpired and uncertainties over government intervention and the property sector persist. Adventurous investors should probably maintain exposure; for others, caution is warranted.

For our first spotlight section of the new year, our focus is on smaller companies. Long-term readers will know that smaller companies are an area we are very positive on given the baked-in potential. Often under-researched, at least compared to global mega cap names, they give stock selectors the potential to invest in lesser-known names with bright prospects. Not all smaller companies are equal; we prefer an active approach here to identify those names that have much higher growth potential than large cap options, as they tend to have lower (but growing) market share and/or are in less mature markets/sectors.

We prefer to be active rather than passive when it comes to smaller companies, as there are a lot of ‘lower potential’ companies in the small cap index. These might include national champions, with no desire to expand further, or companies that are not leading players in their industry or are in sectors that are in decline.

While we are still positive on the long-term prospects, relative performance of smaller companies indices to larger companies has been much closer over the last five and ten years, compared to the sizable outperformance of the 2000s. The most significant reason for this is the makeup of the indices – there is a much lower weighting to technology and in particular the FAANGs group of companies that have driven performance of large cap.

While at index level, smaller companies have not shone as brilliantly over the last decade, we continue to believe that with a strong active manager, this area can handsomely reward longer-term investors. We have exposure to small cap names in most of our medium- to longer-term portfolios.

It was a tough year for the global bond market, with the broad Barclays Global Aggregate Bond Index, which tracks $68 trillion of government and corporate bonds, enduring its largest decline since 1999. Two key questions occupied the minds of bond investors in 2021 and appear to be persisting into 2022. The first is ‘how durable is the economic recovery from Covid-19?’ and following on from that ‘if growth is sustained, how persistent will inflation be?’ The US yield curve gives us some insight into how market participants might be thinking about both of these issues.

Most would argue that we find ourselves in an economic upswing that could have years to run, given the quantity of stimulus pumped into the global economy. However, the yield curve tells us something quite different. Indeed, what is troubling investors is that the yield curve is actually pretty flat. This means that investors are relatively comfortable with locking in a return for a longer period of time, signalling a lack of confidence in prospects for growth. Why is the yield curve quite so flat when economic growth appears so strong?

Well, that takes us back to the two aforementioned questions relating to the durability of the recovery and inflation. With the global economy laden with debt and still in the midst of a pandemic, central banks face something of a tightrope walk as they seek to tackle rampant inflation, and this is clearly troubling the bond market. Tighten monetary policy too aggressively and the implications for companies and consumers could be grave, with interest costs spiralling. Fail to take enough action and inflation could persist at high levels, again, with significant consequences.

A short squeeze is typically associated with equity investment but can occur in bond markets too. When bond yields fall to a particular level, some market participants may be forced to cover their short positions by buying bonds, causing bond prices to rally. Owen Biddle, bassist, is the newest (and therefore shortest tenured) member of the band Squeeze.

We remain discerning in our approach to fixed income, given what we see as elevated levels of valuation in places. In December, we reduced our exposure to emerging market bonds, in favour of convertible bonds for our Balanced clients, seeing greater opportunity for growth in the latter. Investors need to remember that fixed income presents risks too, not just equity investing.

Gold, silver, platinum and palladium all stumbled in 2021, despite what appeared to be a promising backdrop. We might have expected rising US spending, soaring budget deficits and a pickup in inflation to create a weaker dollar. This serves the metals well as they theoretically protect against a fall in the purchasing power of the greenback. Well, on many metrics the dollar was not especially strong but other global currencies fared even worse and the US dollar index gained around 7% in 2021. On this basis, gold is still doing its protective job for some – it is up over 2021 when assessed in euros and yen.

Platinum and palladium have failed to keep up with other industry-sensitive commodities and have been held back by semiconductor shortages impacting the automotive industries. Recovery here is likely to herald a brighter period for the metals though the issues of oversupply could persist. Things have changed quickly as only six months ago these markets were seen as being in a state of undersupply. Palladium has been hard hit as automakers have switched to platinum as an alternative means of reducing toxic emissions from petrol engines.

Most of the positive action in the commodities space has come from where there have been supply side issues. The strength of oil and gas has been well publicised, and we are going to need ‘not so green’ energy sources as we make the transition to the renewable world. But lithium has been the real standout given its importance for renewable batteries. Copper, nickel and aluminium have been less spectacular but also benefited from these trends. Separately, the strength of agricultural commodities is perhaps a cause for concern given the impact of much higher prices on societies (see the ‘Arab spring’ for an insight into potential consequences) – wheat, corn, cotton and especially coffee have all registered substantial gains.

There is significant uncertainty in the metals arena. The impact of monetary policy is a driver in some areas while the unclear path of global recovery is the main determinant for others. Exposure seems warranted with our preference remaining for gold and its potentially protective role in portfolios. We were never using gold purely as inflation protection, rather as a way of diversifying portfolios in times of extreme stress for risk assets – further complications from Covid-19 and possible U-turns from central banks might present opportunities for it to prove its worth.

Concentrating today on residential, 2021 has been a strong year for UK property prices. In fact, house prices grew at the fastest pace in 15 years, with Nationwide Building Society estimating the increase at 10.4% for the year. The average house price rose by the largest amount since Nationwide started collecting the data in 1991, by £23,902 to £254,822. A combination of government initiatives, changing working arrangements and the prospect of higher interest rates have been contributory factors, though the increase has been more pronounced for some.

From a regional perspective, London has been something of a laggard. The pandemic has caused some to question their living arrangements, particularly those with the ability to work from home. This has led to a record £55bn being spent by Londoners on acquiring property outside of the capital, according to the estate agent, Hamptons. The migration of some out of the capital has helped to put upward pressure on the prices in commuter towns.

Unfortunately, there are several reasons to suggest that 2022 might not be such a strong year for house prices. The decision by the Bank of England to raise interest rates is likely to cool the market somewhat. A more hawkish approach by the central bank could cause difficulties for borrowers and the market more generally. With this in mind, Halifax has predicted house price growth of 0–2% for 2022, a far cry from the double-digit growth we enjoyed in 2021; halcyon days indeed!

Supply of new housing stock remains tight and pressure on margins from cost inflation for housebuilders does not help the situation. We remain positive on the prospects for the private rental sector and there are several vehicles through which we can gain exposure, though our prime property asset in portfolios remains commercial.

Determining whether an energy source is green or not is far harder than you might imagine. In the UK, for example, Drax operates biomass plants that garner energy from burning wood pellets. The company receives subsidies from the government on account of being a green energy source, on the premise that the forest regrowth that follows leads to carbon neutrality. Considering that the wood pellets are derived from a waste product of the timber industry, it is easy to make a case. However, when you take into account that their Yorkshire plant is one of the biggest emitters in Europe, it complicates matters somewhat.

Indeed, the European Commission is grappling with a similar argument over the classification of gas and nuclear power. Proponents argue that the two energy sources help transition to the use of cleaner power, but opponents are far from convinced and claim that the move is ‘greenwashing’ and waters down the value of the green classification.

The proposal has put France and Germany on a collision course. France currently derives a staggering 70% of its electricity from nuclear power, though plans for this to halve over the next 15 years. Germany on the other hand is only a few plants away from completing its programme to phase out nuclear power altogether. If the proposal gets sufficient backing from EU members, then it will become law in 2023.

Nuclear energy remains an evocative topic for many, and the proposals supposedly hold such plants to the highest standards and require strict waste disposal plans. While it may have its place in the energy mix, we can’t help but wonder whether this is indeed a textbook case of attempted greenwashing, with governments around the world increasingly under pressure to meet climate change targets.

Currency played second or even third fiddle in 2021, with Sterling (despite volatility throughout the year) ending pretty much where it started against the US dollar, for example. Even the aforementioned volatility did not amount to much, so what can we expect in 2022?

First, we may have to expect the unexpected – it seems increasingly clear that even as the whole world gets to grips with Covid-19 and everyone expects a better year this year than last, economic recovery is very much in different gears in different countries – and currencies may well bear the brunt this year. Then you have central bank opinions (and therefore actions or otherwise) on ‘local’ inflation.

Even calling the direction of the US dollar, the world’s fiat currency, is tough – there are good arguments for a strengthening dollar, and for a weakening dollar. We will explore these in coming months.

The Monetary Policy Committee of the Bank of England flinched – and the UK base rate was raised from its all-time low of 0.10% to 0.25% – probably less of a rise than had been expected just a few weeks earlier, and no doubt in response to the 5.1% inflation read, mitigated only by the rise of Omicron!

We cannot see the UK base rate being lower at any point in the next few years, which doesn’t mean we should be bracing for the rate to be anywhere near that last seen in early 2009 either (north of 4%, anyone?). Rates are now a weapon; inflation is the enemy at the gate. So far, the Bank is throwing paper planes; expect arrows rather than boiling oil next.