January Market Thinking
January 13, 2022
Traditionally, Year Ahead pieces tend to take the form of a laundry list of predictions about ‘key market variables’, alongside some narrative to support why these might be slightly above, or slightly below, the consensus. Sometimes, the predictions are deliberately extreme, to generate attention, while at other times they are generated to support an existing view. For us, the January outlook is an opportunity to consider what, if anything, changed during the course of the previous 12 months and use that framework to consider what may happen in the 12 months ahead. In that sense, we are like the two faced Roman God after whom the month is named, looking both forward and back.
Overall we saw 2021 start optimistically with a rotation to value as a reflation narrative took hold, only to see it hit mid year by a number of issues including supply chain disruption, the US withdrawal from Afghanistan and a return to Covid related intervention from both Central Governments and Central Bankers. We also saw a clear statement from China that it has no intention of embracing the US economic and social model and instead is embracing ‘Common Prosperity’ and has no interest in allowing western hedge Funds and others to ‘extract rent’ from Chinese Consumers. This focus on the Chinese 99% attracted harsh response from the (US) 1% and US dis-investment from the Chinese ADR space was a significant headwind for those exposed to the underlying stocks around the Chinese Consumer. Thus ‘Zero China’ joined Zero Interest Rates, Zero Covid and Zero Carbon as policies adopted to varying degrees by western governments that ultimately sank the optimism around the reflation trade, as investors (rightly) saw them as delivering Zero benefit, save to the vested interests. Meanwhile many, especially in the US Military Industrial Complex, were also arguing for Zero integration between Europe, Russia and China and in doing so driving paranoia about ‘hostile states’ (although this has got notably quieter – as it always does – since the Pentagon Budget was approved).
We have passed Peak Zero…thankfully
However, to start the year optimistically, we would suggest that we look to have passed Peak Zero; Zero Carbon has been met with a pragmatic multi-lateral response in the form of adopting Nuclear Power -even to the extent that the EU Commission has essentially acknowledged the lack of logic in not allowing Nuclear as part of ESG given it is the only real solution to power generation without carbon di-oxide as a bi-product. The Fed has clearly moved on from Zero Interest rates, which is what is scaring the Bond Markets and even Swiss Bonds are no longer giving a negative yield for the first time in three years. Meanwhile Zero Covid, at least in the West, is over as an idea. Covid itself, having long passed as a health issue, is now a political issue and one that is facing a public backlash against the non Pharmaceutical Interventions (NPIs) that have dominated the last two years. Interestingly, much of the backlash has come not against the policy, but against the hypocrisy of government policies that were imposed on others and not observed by the ‘elites’. Perhaps the ‘two faced’ god Janus has another meaning?
As politicians try and twist away from blame, the Zero Covidians are being forced to retreat. Meanwhile, the increased bellicosity from the US has actually driven Russia and China closer together which is delivering some (largely bad) unintended consequences for Europe. Briefly, the Zero Carbon Policies adopted in Europe has forced the increased adoption of natural gas for base load, as nuclear can not be quickly ‘spun up’ to meet demand as and when ‘renewables’ fail to work (which is, frankly, too often). This is especially true in Germany, where Russia’s response has been to build the Nordstream 2 pipeline direct from St Petersburg to Germany, essentially bypassing the Eastern European countries like Poland, The Balkans and, especially, Ukraine that not only depend on Russia for gas, but also for the transit fees. US attempts to stop the pipeline for Geo-political reasons and also to sell its own LNG will do little harm to Russia, but a lot to Europe (see the lamps are going out). It has also pushed Russia into opening up the Power of Siberia route to China, which is now buying more, cleaner, gas to replace coal and thus acting as a competitor for energy.
The fact that China appears to be producing less product with cheap but dirty coal while demanding more cleaner gas makes it an important disruptor by both removing a deflationary impulse of a source of excess supply (goods) and introducing an inflationary impulse via increase in demand for gas.
This, shift that occurred in 2021, together with other failures on energy policy has left much of Europe not only more dependent on Russia, but also facing dramatically higher energy costs. A greater focus on the real cost of zero carbon, like the real cost of zero Covid, is not going to be good for the purists. Nor indeed in markets, especially for the ESG crowd who had successfully positioned Green as being somehow ‘cost free”, not only to consumers, but also to providers of capital. However, after a tremendous run in 2020, last year saw a shocker for Clean Energy versus traditional energy, (to take one measure) with the latter outperforming by over 50%. Given the (obvious) demand and supply dynamics, it is difficult to see energy, and raw materials in general, giving up this momentum in 2022. This is going to make things quite difficult for this set of heavily crowded trades.
The other crowded trades for 2021 came in the second half, inspired in large part by the emergence of Web3 and everything to do with Blockchain and the Metaverse. A lack of liquidity together with high levels of leverage from retail investors (notably via short dated options) caused something of an ‘upward crash’ in q4, to be followed by a traditional one for many of the stocks before year end. We remain enthusiastic about many of the themes, however, and look forward to being able to participate on a better risk-reward basis.
Other Frameworks for 2020 season 3
We believe that, for investors, one further helpful framework for evaluating the history as well as the prospects for markets is to consider the returns of our Model Portfolios – on Bond Markets, Global Equity Factors and Global Equity Thematics – and how the assorted narratives have both affected them in 2021 and may (or may not) continue to do so in 2022 – or 2020 Season 3 as some are calling it.
Global Bonds had a bad year in 2021, indeed, for the Global Aggregate Bond index it was the worst since 1999. To some extent this is not surprising given the trajectory of inflation and the prospect of an end to Central Bank intervention, but actually much of the damage to global bonds last year occurred because of the stronger dollar. (Probably the one exception has been China, where both the bonds and the currency have outperformed.) In our model Bond Portfolio we actually saw a positive return, of 2.1%, against the benchmark Global Aggregate of -4.7%, helped by a focus on TIPs and US high yield. On a three year view, the model has volatility of 7.8% versus 4.25% for the benchmark and it is this extra ‘risk’ – largely associated with high yield bonds – that we believe generally helps to generate the annualised 3 year return of 8.9% for the Model against 3.6% for the benchmark. In 2021 however, while benchmark volatility was around the same, the Model had volatility of ‘only’ 4.3%, around half the ‘normal’ level and in this case it was a function of having limited exposure to the US long bond at key points. As the chart of the components shows, while the Global Benchmark, AGG, fell, it was relatively stable. By contrast, US long bonds, the widely regarded ‘risk free asset’ not only had the worst return of the components, but showed considerable volatility.
Bonds. Only TIPs delivered a positive return in 2021
For 2022 we would expect both of these trends to continue, indeed the year has started very badly for Bonds from both a total return and a volatility perspective, reinforcing our concern that Bonds are now simply trading instruments and no longer suitable for longer term investment vehicles (see The Real Problem with Bonds). Even without any change in the US$, most global bonds, with the possible exception of China, represent unattractive options unless you are forced to buy them by regulators and capital constraints. With the closest thing to conventional monetary policy and a narrative driving a strong Rmb, we would expect Chinese Government bonds to continue to do well. However, for those looking for ‘value’ in Global Bond markets, the potential narrative shift we would look out for in 2022 lies with Asian High Yield, particularly property, where the current (largely political) narrative about widespread property collapse is likely to prove too pessimistic.
Global Equity Factors
In reality, the big macro questions around China, Covid, Climate Change, Cyclical Recovery and Commodities are being played out more through Equities than the traditional top down areas like Bonds, Currencies and Commodities. During 2021, our Global Factor Model portfolio returned 16%, driven mainly by momentum and quality, factors such as size and Value had attempts to rally but ultimately struggled to gain much traction. An early rotation into a cyclical recovery trades struggled into the second quarter as a combination of supply chain disruption (now largely over) and a resumption of Fed easing caused an ‘upward crash’ in a lot of mid cap (and largely illiquid) US Tech names, driven in the large part by the smart Beta Thematic ETFs who bought them without regard to fundamentals as well as by aggressive day traders using options for leveraged exposure. (see The Problem for Stock Picking) Both these drivers came unstuck in q4 and the leverage and illiquidity that caused an upward crash subsequently brought about a more traditional, downward one. Looking at the components, we see only Quality at +24% beat the MSCI world return of 21%, indeed apart from a late run from Value, none of the factors ended the second half higher than at mid year. As a consequence, the model portfolio gave back the excess return over the MSCI world that it generated in 2020. However It is worth noting that the MSCI world currently suffers from similar concentration issues to the S&P500 (see The Problem with Passive Equities) – the top 10 stocks are all same US megacaps, almost entirely in Tech. It also has higher volatility than the Model Portfolio.
For 2022, we have once again started the year with a strong rotation towards ‘value’, indeed the ratio of Value to Momentum has shifted almost 10% in favour of value since early December in a manner very similar to last year, when it swung 12% in q1, before fully reversing during the latter part of the year. Part of this is, once again a shift to the reflation theme and particularly towards energy, where is is becoming increasingly clear that supply and demand point to higher prices across the board. It is also buying into the Banks narrative once more – the same belief in the end of Fed intervention that is worrying bond markets is being played out through financials. Generally though, the Global Factors are currently looking in the lower half of the risk range suggesting a still positive overall environment.
By contrast, the longer duration Thematics are all looking high risk as we start 2022, after an essentially flat year in 2021. When looking through a Thematic lens, we see that after a tremendous 2020, when the recovery from the initial Covid panic delivered returns of almost 50% for the year as a whole, our basket of Thematics struggled to make much headway overall in 2021. Partly this was a function of the longer duration of some of the components such as Clean Energy and Digital Health, as well as the hit to the basket of Emerging Market Consumer stocks due to the change in Chinese government policy over a number of the US/China ADR stocks, leading to a dis-investment wave in the second half. Gold, which we might have expected to have done better in a risk off environment, or even one that (correctly) anticipated higher inflation, failed to do very much. In part we think that this reflected the increased institutional interest in Crypto, in particular BitCoin, as a competitor form of long term tail-risk hedging. It looks like Gold holdings are now being split with BitCoin (and Eth).
Looking into 2022 we see that almost all of the Thematics are currently at what we would define as risk level 5, i.e. we would not be invested in them at this moment. Only Robotics and Gold are currently invested, the rest are currently in cash. We still believe in the underlying narratives, including also the inclusion of a new FinTech theme, but need to see greater evidence of an end to the shake out and a reduction in risk premia generally before reinvesting in these longer duration Assets.
To conclude, we would suggest that many of the things we are supposed to be worried about do not actually matter – well at least not in the way we are supposed to be worrying about them. Covid, is no longer a health issue, but it remains a political one and ongoing attempts to avoid or deflect blame will continue to impose a political risk premium. Inflation is not a problem for Bonds – the Fed not buying them is – but instead is important in terms of margin outlook for equities as supply and demand resets. This is strongly linked to China, which is not (as the US Navy would have us believe) an expansionist military power, but rather a source of inflation/reflation in the west, through a combination of being a new competitor demanding clean gas rather than dirty coal and no longer being a provider of dis-inflation in the west via an excess capacity for producing consumer goods.
The Fed equally is not so much fighting inflation as actually removing a source of dis-inflation as it starts to raise the cost of capital to something approaching neutral, which should actually be good for banks, so long as the Fin Tech innovations and greater adoption thanks to lockdowns do not disrupt them too rapidly. The US political system meanwhile will revert to normal with the mid terms and act to prevent anything much happening, while the European Elections are likely to be fought on more of a nationalist and less of an EU level. Meanwhile, to the extent that we care about man-made CO2 as part of energy production, we can be pleased that we have ‘solved’ that aspect of Climate Change by agreeing to use more nuclear power – a welcome signal of pragmatism. Crypto (everything appears to begin with C) is important, but not as a stand alone asset class, rather it is part of the emerging ecosystem of Web3, along with FinTech in general and the nascent, but ultimately enormous prospects around the MetaVerse – the ultimate emerging market.