Asset Management

2021 WAS THE YEAR OF HINDSIGHT | THE REFLATION TRADE WORKED FOR EQUITIES, LESS SO FOR BOND INVESTORS

2021 saw strong gains made in most developed stock markets, as the global economy picked up momentum on the back of the delivery of vaccines.

Tom Elliot
Senior Investment Strategist
14 January 2022
6 minutes
Review

2021 saw strong gains made in most developed stock markets, as the global economy picked up momentum on the back of the delivery of vaccines. A rear-view mirror approach from many investors also helped – ‘with recovery underway, let’s now get asset prices to where they would have been’. The US stock market outperformed the UK and continental Europe, helped by investor interest in a handful of large tech-related stocks. Japan was a noticeable underperformer, its post-pandemic economic recovery appearing to be over by the autumn.

The MSCI World index rose 23% in sterling terms. A good year by any standard. By country, the US component of the index rose 28% and the UK was up 20%. UK small cap was up 15% (Source: FE analytics).

Emerging markets fared less well - the MSCI Emerging Markets (EM) index was broadly unchanged over the 12-month period, hurt in particular by weakness in Chinese stocks. This reflected investor unease over Beijing’s interference in business, corporate failures in the highly indebted property sector, and slowing domestic and global economic growth. China is now the dominant country within the MSCI EM index, so it matters. Indian equities did well but could not help emerging markets more broadly.

The year began with many global investors betting on the recovery/reflation trade and feeling generally optimistic towards risk assets. Despite a fresh wave of social distancing measures coming into place in the UK and elsewhere, a rapid rollout of Covid-19 vaccinations promised a ‘return to normal’ lifestyle for much of the world.

Furthermore, no major central bank, or government, wanted to upset the prospects for growth by tightening monetary or fiscal policy. In the US, Congress pushed through social welfare spending bills that delivered cheques directly to households; in the UK furlough and other business support measures were maintained until October.

However, shortages and rising prices hurt growth expectations everywhere. China and the US saw their ‘peak recovery’ occur mid-year, while the UK and the rest of Europe lagged.

A rise in energy prices and other supply-side problems drove inflation higher throughout the year. As the leisure, hospitality and travel sectors re-opened, shortages of staff pushed up wages in the so-called ‘recovery’ sectors. This had a knock-on effect in other people-facing service sectors, such as healthcare, but did not trigger a general rise in wages.

The UK’s departure from the EU (Brexit) caused disruption to UK-EU trade, and to trade across the Irish Sea, as companies adjusted to new physical border controls and paperwork. In October, the Office for Budget Responsibility estimated that Covid-19 will reduce UK Gross domestic product (GDP) by 2% over the long term, and Brexit by a further 4%.

Investors began 2021 by continuing to move into value stocks that would do well in a recovering economy, a trade that had begun two months earlier with the announcement of working vaccines. Cyclical value proved to be a better performer than deep value (i.e., financial and energy stocks compared to utilities and tobacco).

The main UK stock market was a beneficiary of the rush to value stocks, with mining stocks particularly strong. However, miners were caught in a rout in the second half of the year, as it became clear that global growth was slowing, and fears rose over the outlook for Chinese demand in particular. Global interest in energy and financial stocks at the end of the year contributed to a period of outperformance for the UK main market.

The NASDAQ tech-heavy index made new highs throughout 2021, despite rising inflation and expectations of interest rate hikes (which normally hurts sentiment for long-duration assets). The explanation lies in the dominance within the index of the well-known mega-cap names that are profitable, and therefore are ‘shorter duration’ than stocks that are yet to make a profit. Apple, Microsoft and Amazon alone account for around 30% of the NASDAQ market cap.

In fixed income, long-dated government bonds sold off in the opening months of the year, on the assumption that economic growth and inflation would lead to central banks tightening monetary policy. The 10-year Treasury yield rose from 0.9% on 1 January 2021 to 1.7% in late March.

However, over the spring and summer long-dated yields fell. The reflationary theme of growth and inflation refused to lift yields, and central banks appeared to be in no hurry to raise interest rates. The Treasury yield curve began a process of flattening, suggesting to some analysts that the bond market was buying into the central banks’ ‘transitory phenomena’ inflation narrative.

Eventually, the apparent stickiness of CPI inflation led to a re-assessment in the autumn of the risks of holding fixed income. Yields rose again, in anticipation of central bank monetary tightening. In December the central banks finally delivered: the Bank of England flinched first and raised the base rate (from 0.1% to 0.25%) for the first time since 2018; the Fed and the ECB both announced reductions to their bond purchase programs. There is surely more to come.

Gold peaked last year in January and traded in a range for the rest of the year. We feel it offers plenty from here.

Outlook

Stock markets have reacted badly to the published minutes of the Fed’s December meeting. The most frequent explanation given is that the minutes suggested a faster tapering of monthly bond purchases, by the central bank, than was indicated at the time of the meeting.

More likely, perhaps, is that many investors had become nervous over a combination of high valuations - particularly in the US tech sector - and recent downgrades to global GDP growth forecasts, so the Fed minutes offered an excuse to offload stocks, and lock in profits.

Looking further ahead, we anticipate positive returns for calendar year 2022, but much lower than last year.

We are in the growth stage of the global economic cycle: the ebullience of the recovery stage has gone, and profit margin growth has surely peaked. Global GDP growth is trending down to long-term rates. But there continue to be opportunities: the Bank of England has started to talk about sector GDP being more important than geographic, and we agree – this plays to several long-term themes which we follow closely, and support via our portfolios.

The cycle of interest rate hikes that has begun in the UK, and that seems likely to start in the US in the spring, may prove to be shallow if inflation rolls over during the second quarter of this year, which is the consensus view from the major central banks.

A shallow cycle of interest rate hikes would suggest that cash and government bonds are unlikely to become an attractive alternative to equities, so long as the economic recovery persists, and we have moderate inflation and negative real interest rates.

Value-driven stock markets may outperform those that are driven by growth sectors, such as tech. Could 2022 be the year that European and Japanese stocks outperform the US? 2021’s returns are gone, never to be earned again – we must look forward, and in doing so, we believe positive returns are possible this year, but will be harder to come by.

This article is for information purposes only. It is not intended to be an invitation to buy, or act upon the comments made, and all/any investment decisions should be taken with advice, given appropriate knowledge of the investor’s circumstances. The value of investments and the income from them can go down as well as up, and you may not get back the amount invested. Past performance is not a guide to future returns.

Mattioli Woods plc is authorised and regulated by the Financial Conduct Authority.

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