Pandemic, policy, and prices: 2021 in review
Introduction & background
After another busy year, we can now reflect on how our macro views fared and what 2022 may have in store for markets. 2021 has been notable for the three Ps: the ongoing Pandemic, continued Policy support and rapidly rising Prices. Yet amidst high uncertainty, markets moved higher over the year. Those who predicted a swift return to normalcy were instead faced with the highest inflation in decades, a much-changed interest rate outlook, and a pandemic that is expected to wind on with ongoing mutations and vaccinations.
The recovery in asset prices throughout 2021 has not been uniform across asset classes, regions, sectors, and styles, stressing the value of asset allocation and the ability to be dynamic. As we look ahead, we expect the three Ps to continue to affect asset returns, albeit differently than in 2021.
Tug of war between Policy and inflation
At the turn of the year, we stated a preference for equities over credit, a positive outlook for cyclical sectors, and expected upwards pressure on government bond yields from higher inflation expectations. These themes have played out to varying degrees, detailed below, preparing us for a markedly different economic environment in 2022.
We expected strong equity returns in 2021, supported by ultra-loose borrowing costs for corporate projects, healthy consumer demand, and policy mitigating much of the potential economic scarring. US household savings remained twice as high as the historical average and consumers used excess income throughout lockdowns to reduce debt. While risks remained, particularly surrounding vaccine take-up, it was our view that policy would provide a backstop to economies and financial markets – the second of our three Ps listed above. Together, these views presented a powerful case for further equity upside, which played out. While we witnessed periods of volatility, they were mostly contained and presented some buying opportunities. In contrast, expected returns from credit were low and diminishing, inconsistent with the economic risks still prevalent. This is highlighted in the below chart, with valuations implying default rates significantly lower than prior crises. Our high conviction preference for equities was fitting, with global equities rising 18% to the end of 2021 while global high yield credit returned just 2%. Following a period of such strong returns and with the upcoming tapering of stimulus, we expect positive but more muted equity returns in the future.
Source: R&M, 1/29/21
We also noted asset allocation within equities would be a key driver of returns. 2020 saw sector returns deviate starkly, favoring those business models able to operate under social restrictions. But with vaccine breakthroughs providing a route out of the pandemic (the first of our three Ps), there were opportunities for cyclical companies to recover from their steep falls. At the turn of the year, cyclical sectors looked discernibly cheaper compared to defensive sectors and were set to be supported by the economic recovery. As a result, where we had discretion we targeted cyclical sectors, regions, and styles for much of the first half of 2021. These cyclical sectors rallied strongly throughout the first half of the year and regained much of their underperformance versus defensives, as shown in our indicator below.
Source: R&M, 1/29/21
Referring to our third P above - given stimulus packages dwarfed that of prior recessions we were watchful for a resulting rise in inflation. More critically, we considered policymakers withdrawing support in response to high inflation was the fundamental risk to markets. We believed higher inflation alone wouldn’t necessarily be detrimental for risk assets, and that has largely borne out - equities have continued to rise despite the highest US CPI since 1990. It was, therefore, important to assess the underlying drivers of inflation to determine just how sustainable we thought inflation could be. In line with higher inflation and economic growth, we expected government bond markets would price in fading central bank stimulus and higher future interest rates. As such, we expected government bond yields to rise throughout the year as economic growth rebounded, but not to such levels that higher yields would weigh on risk asset returns. This gave us confidence to maintain our strong preference for equity. We also expressed this view by largely maintaining low exposure to rising interest rates in the credit portfolio.
What surprised us?
While we expected supply chain bottlenecks to drive inflation higher, our base case was that inflation would moderate as supply chains caught up with demand. But delays in shipping and manufacturing persisted, resulting in higher-for-longer inflation, and bringing forward timelines of future interest rate rises. Remarkably, the largest inflation was in durable goods (for example used cars), bucking the longer-term trend of falling durable goods prices since the late 1990s. The pandemic strained global supply chains like never seen before. Who would have predicted that the price of a used car would rise above their new equivalent? But as policymakers remained committed to their policy frameworks, the uncertainty around inflation was evident in the government bond market. While volatility within equity markets was contained, government bond yields whipsawed and in Q1 2021 suffered their worst quarter of performance in decades.
Source: Bloomberg, 12/9/21
China also surprised markets with strict regulations, which had direct and meaningful implications on asset returns. The Chinese administration placed stringent measures on large technology companies, particularly those listed on foreign stock exchanges, and in tandem with the significant default of major real estate company Evergrande, caused Chinese markets (and broader emerging markets) to fall sharply. The steps the Chinese administration took to achieve their goals were profound and we must now factor them into any future allocations.
Source: Bloomberg, 12/9/21
Where do markets go next?
As we look ahead, we expect a year of leaner returns amidst the withdrawal of policy and expect inflation to continue to dominate the narrative. The latest variant of Covid-19 presents further challenges for governments worldwide, however we expect policymakers will once again pull levers to support economies and markets if forced to do so. We will continue to communicate our macro views as events unfold and will set out our 2022 outlook in more detail in January.
Investment advisory services are provided by River and Mercantile LLC, an investment advisor registered with the US Securities and Exchange Commission. It is a subsidiary of River and Mercantile Group PLC, a U.K. corporation.
The information and opinions contained in this document do not constitute investment advice and is provided for background purposes only. References to specific securities are provided solely as illustrative examples of the River and Mercantile LLC analytical methods, and are not a recommendation to buy or sell such securities. This information is subject to updating and verification. Portions of this presentation are based on data provided by third parties whom River and Mercantile LLC deems to be reliable; however, River and Mercantile LLC cannot guarantee the accuracy and completeness of the information.
PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE RESULTS.
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