“Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.” — Paul Samuelson, Nobel laureate.

LAST QUARTER REVIEW

The fourth and final quarter of 2021 provided a mixed picture with some encouraging economic data, countered by continuing inflationary worries both in the US and globally and the fear posed by the latest variant of the SARS-Cov2 virus. While neither of these concerns stopped 2021 proving another excellent year in terms of risk adjusted returns for portfolios weighted heavily towards global equities, the likelihood of achieving comparable returns in 2022 will be dependent upon the first concern proving cyclical and the second remaining mild and less deadly as has been suggested by the evidence to date.

Last quarter saw Wall Street off to the races once more as the S&P 500 climbed 10.65%, the Nasdaq 100 8.28% and the Dow Jones Industrial Average (DJIA) 7.37%, while smaller domestic focused stocks as represented by the Russell 2000 climbed 1.86%. For the calendar year, investors in US equities did exceptionally well led by energy, real estate and technology sectors resulting in the S&P 500 climbing almost 27%, Nasdaq 100 21.39%, the DJIA 18.73%, and the Russell 2000 13.69%. Investors in US government debt fared less well as the yield on the benchmark US 10-year Treasury Note during 2021 climbed from 0.93% to 1.52%, reflecting the change in inflationary perceptions from this time last year.

In the UK, we saw a reversal in stock leadership as the large and internationally focused companies in the FTSE 100 assumed market leadership and climbed 4.21% during the quarter and 14.3% during 2021. Meanwhile the mid cap sector (FTSE 250) climbed 0.38% during the quarter and 15.04% for 2021, while smaller company stocks (FTSE SmallCap) fell 0.03% in the fourth quarter but proved overall UK winners for the year climbing 20.01%!

In the UK bond market, yields during 2021 on the benchmark 10-year gilt quintupled from just 0.19% to 0.97%. albeit the interest rate at the end of the fourth quarter was slightly less than at the beginning. The Bank of England (BOE) took most investors by surprise when its committee voted by a majority of 8-1 to increase base rates from 0.10%  to 0.25% during its December meeting.

The BOE expects inflation to remain around 5% through the majority of the winter period, and to peak at around 6% in April 2022, before falling back in the latter half of 2022. The BOE expects UK GDP to remain around 1.5% below its pre-Covid level, albeit with unemployment continuing to fall to around 4%.

The Federal Reserve at its December meeting of the Federal Open Market Committee (FOMC), resisted raising interest rates for now but announced it would end its pandemic-era bond purchases in March, paving the way for three potential interest rate hikes by the end of 2022, as policymakers voiced concerns over persistently high inflation against a backdrop of a steady recovery in the labour market. The central bank doubled the pace of tapering to $30 billion a month, putting it on track to conclude it in March 2022, and noted that risks to the economic outlook remain due to the coronavirus variant, while reiterating that interest rates will be held at record-low levels until maximum employment is achieved.

US economic data showed that annual inflation accelerated to 6.8% in November, the highest since June of 1982. This is the 9th consecutive month that inflation has been above the Fed’s 2% target thanks to a combination of rising commodity prices (driven by increased demand and supply shortages), wage pressures, supply chain disruptions and a low base effect from last year due to the lockdown.

The Fed reiterated that indicators of economic activity and employment have continued to strengthen. The sectors most adversely affected by the pandemic have improved in recent months, while overall financial conditions remain accommodative, in part reflecting policy measures to support the economy and the flow of credit to U.S. households and businesses.

The Fed also suggested economic prospects continue to depend on the course of the virus, and that both progress on vaccinations and an easing of supply constraints are expected to support continued gains in economic activity and employment as well as a reduction in inflation. However, risks to the economic outlook remain, including from new variants of the virus.

At its December meeting, the European Central Bank (ECB) announced that thanks to economic recovery it would reduce the pace of its asset purchases under its €1.85 trillion Pandemic Emergency Purchase Programme (PEPP) next quarter and wind down the scheme next March, as it progresses towards its medium-term inflation target. However, the ECB said it would increase fixed income buying under its longer-running Asset Purchase Programme (APP), by buying €40 billion of bonds in the second quarter, €30 billion in the third quarter, then from October onwards, purchases will be maintained at €20 billion, for as long as necessary to support the economy.

The ECB also reiterated that it remains relaxed about inflationary data despite the fact that consumer prices rose in November by the most since July 1991. Meanwhile the Bank of Japan (BOJ) at its December meeting left its key short-term interest rate unchanged at -0.1% and that for 10-year bond yields around 0% but decided to taper its corporate debt buying to pre-pandemic levels while extending emergency pandemic funding by six months in an effort to support the financing of small and medium-sized firms.

In the currency markets, the dollar DXY index (a basket of foreign currencies) closed the quarter at 96.67, marginally up on three months earlier but almost 7% higher than it where it began 2021. The dollar strength reflects investor expectations the Fed will tighten monetary policy faster than other central banks, while the US economic recovery remains resilient and more robust than others.

In energy markets, oil was flat for the quarter but up more than 50% for the calendar year, and effectively a major contributor to inflationary pressures. However, the price of gold bullion fell 3.65% during 2021 suggesting that if the current global inflation is secular (as most respected market analysts suggest) and not cyclical (as most central bank economists believe), then the traditional mine canary has yet to recognise this!

GDP Data shown are to the 30^th September 2021; Interest Rate, Equity & Bond Index Data are to the 31st December 2021; Equity Indices used: US – S&P 500, UK – FTSE 100, Eurozone – Euro Stoxx 50, China – Shanghai Shenzen CSI 300, Japan – Nikkei 225, Germany – Xetra Dax; Sovereign Bond Indices used: S&P US T-Bond, S&P UK Gilt Bond, S&P Eurozone Sovereign Bond (Eur), S&P China Bond, S&P Japan Government Bond.

CURRENT CONSIDERATIONS

As we look ahead to 2022, it is worth pausing and reflecting upon the extraordinary equity gains made in global equity markets over the past year. Most commentators and advisers, including ourselves, were understandably cautious heading into 2021. With hindsight, it is tempting to think that we might have been a bit more adventurous in our asset allocations until we ponder the timeless advice of Paul Samuelson on sensible capital preservation investing which remains at the heart of our advice and investment ethos.

Our current analysis suggests there are three key considerations in 2022 that should inform our decisions, namely inflationary expectations, equity asset allocation, and the prospects for sterling relative to the dollar. Other risk considerations that will assist our analysis include political, geopolitical, and the SARS-Cov2 virus (and its variants).

Undoubtedly, the most important of these considerations remains whether inflation will be transitory or prove a permanent fixture, and ultimately drive interest rates and the cost of living inexorably higher? One of the most renowned and respected economists in history, Milton Friedman said in 1963 as he was touring India, “inflation is always and everywhere a monetary phenomenon.”

Accordingly, as cited in a recent article in The Economist, “Friedmanites are convinced that inflation will be transitory”. The article titled “Of Milton and money” however, suggests that they may be wrong as fiscal stimulus from government as opposed to purely monetary stimulus via the central bank has now seemingly morphed into the monetary phenomenon that historically has been responsible for lasting inflation.

Referencing the $10.8 trillion fiscal stimulus implemented globally (equivalent to 10% of GDP), the article asks, “does the experience of the pandemic show that inflation is really fiscal? One way in which fiscal stimulus boots inflation is by strengthening households’ and firms’ balance sheets, thereby making them more likely to spend.”

On the other hand, historical data confirms that in the nearly 60 years since Milton Friedman made his famous comment, everything that has happened since (at least until now) has only validated what he was saying, and especially during the late 60s and 70s of the great inflation, and thus proving that inflation is money. When it comes to inflation, the bond market historically has been the most consistently reliable observer of the monetary reality identified by Friedman and supported by more than a century of data.

Perhaps we are witnessing a paradigm shift in the true definition of inflation as The Economist article appears to suggest quoting David Andolfatto of the St Louis Fed who in December 2020 in reference to US Treasuries said, “it seems more accurate to view the national debt less as a form of debt and more as a form of money in circulation”, while warning Americans to prepare themselves for a temporary burst of inflation due to the unprecedented fiscal stimulus that would be issued as a result of the pandemic.

The Economist article concludes its analysis by revisiting an early nineties theory known as the “fiscal theory of the price level that says the outstanding stock of government money and debt is a bit like the shares of a company, its value (i.e. how much it can buy) adjusts to reflect future fiscal policy. Should the government be insufficiently committed to running surpluses to repay its debts, the public will be like shareholders expecting a dilution. The result is inflation. The past decade has shown that when interest rates fall to zero, it takes more than just QE to escape a low inflation world.”

The considerations thrown up by The Economist and others who share the view that a paradigm shift may have occurred is serious food for thought. It is however hard to believe that, if this is the case, then why has it not been recognised by the bond market? If the inflation we have experienced in 2021 really is secular then surely yields in the US Treasury market should be soaring, but instead the yield on the benchmark 10 Year Note is just 1.55% barely changed over the quarter while the interest rate on the 30 Year Bond is just 1.96% and not very much higher than the 1.66% it stood at twelve months ago.

At the moment, the US Treasury bond market is telling us unequivocally, that no matter how high energy prices or other essential living costs may rise in the short term, these are unlikely to persist, due to the existing levels of debt. The yields that prevail in the US Treasury bond market are saying that it is not secular inflation, but a temporary trend based upon short term increased demand and restricted supply shock factors that will eventually work their way out of the system.

The unprecedented debt problem combined with the inability (at least currently) of the Fed to monetise Treasury debt issuance means that the sectors of the US and global economy that have seen the unprecedented inflationary pressures (such as energy, transport, and other commodity related industries) have simply taken more than their share (temporarily) from consumers while starving other sectors of cash from customers in a zero-sum economy. Admittedly the unprecedented $10.8 trillion fiscal stimulus has temporarily contributed to the inflationary phenomenon but the bond market is clearly signalling this will not have a lasting impact.

Meanwhile, adding to the likely erroneous secular inflationary conclusion, many analysts and economists presume that because some large foreign investors and governments (e.g., China, and Russia) have been selling Treasuries on a massive scale, this will result in the US Treasury bond market and the dollar collapsing. The reason this is has not happened is because these analysts have been ignoring the phenomenal power and influence wielded by the shadow banking eurodollar.

As we have commented on in previous “Market Views”, Eurodollars are simply offshore dollars that the Fed and American monetary authorities have no control over or arguably even know the true extent of. As long as the greenback remains the official reserve currency of the world, these offshore dollars will remain popular with the majority of non-US governments and major corporations using them as a form of insurance against a dollar shortage.”

Supporting the message from the US bond market that the current inflationary pressures are likely to be transitory are data from umpteen other global bond markets including the eurodollar bond market. Ironically, these markets are suggesting that we shall soon have deflationary conditions back in control, which eventually will lead into some sort of downturn, if not global recession, and almost certainly end any potential for secular long-term inflation.

FORWARD OUTLOOK

Accordingly, while the data we analyse and monitor on inflation continues to suggest that the increase we have seen in 2021 is likely to be short-lived and cyclical in nature, we shall keep a close eye on developments and in particular any change in the bond market’s perception of inflationary trends. If our current views prove correct, and we see disinflation or even a return to deflation in 2022, any interest rate rises adopted by the Fed are likely to short-lived and reversed before too long with similar actions being taken in the UK, EU and other developed economies.

In the meantime, we believe that equities continue to offer the most attractive opportunities on a relative valuation basis when compared to investment grade government and corporate bonds, property and alternatives (including infrastructure, private equity, commodities, precious metals) as a consequence of superior attributes in risk reward, yield, and liquidity.

Whilst in some sectors, valuations on Wall Street in particular are the most expensive seen for some time, we believe the US economy will continue to lead the current global recovery and justifies a significant allocation for most portfolios. Maintaining a well-diversified and appropriately balanced portfolio is, however, fundamental and we will seek to provide a mix of both growth and value stocks, both from the US and other equity markets, including the UK large cap sector which remains significantly undervalued on a relative basis at this time.

Our third key consideration when determining asset allocation for the year ahead is sterling and its likely strength or weakness in the international currency markets and especially relative to the dollar. This is probably the most difficult of the three to forecast as its performance will depend greatly upon a number of factors including GDP growth, UK base rates relative to other countries (and especially the US), economic obstacles thrown up by the virus (hopefully none) and the budget and trade deficits.

For now, we shall be taking a neutral view on sterling and shall likely only revise this should there be a significant shift in the key exchange rate. Additionally, we remain comfortable from a portfolio diversification perspective in continuing to include some exposure to balanced Fixed Interest funds investing in a combination of blue-chip government debt markets (primarily US Treasuries and UK gilts) and investment grade corporate debt exposure.

As always, investment risk is at the forefront of our advice and, whilst it is often necessary to undertake adjustments in portfolio allocation to maintain individual preferences, we are confident that our advised portfolios remain well placed in meeting our clients’ needs.

Finally, from all of us at Ash-Ridge Asset Management, we wish you and your loved ones a Happy, Healthy, and Prosperous 2022!

Copyright © Ash-Ridge Asset Management 1^st January 2022.

Data Sources: Bloomberg; Brookings Institute; Economic Cycle Research Institute: Financial Sense; Financial Times; German Federal Statistical Office; Hoisington Investment Management; Macro Voices; National Bureau of Statistics China; Office for National Statistics; Real Vision; S&P Indices; The Cabinet Office Japan; The Economist; The Federal Reserve; The National Bureau of Economic Research; Trading Economics; UK Debt Management Office; US Debt Clock.org; Wall Street Journal; Zero Hedge.

The Market View reflects our in house assessment and views and is posted for client interest only. Please refer to our Terms of Use at the bottom of this page.