Key points from the month:
- Strong 2021 for equities but should we expect more pauses for breath over the next 12 months?
- Bank of England pushes through small rate rise as inflation continues to tick upwards, despite Omicron uncertainty
- Eight potential hikes expected in the US over the next three years, culminating in a ‘neutral’ 2.1% base rate by the end of 2024
Omicron and Christmas parties (of the 2020 vintage) dominated newsflow during December, with uncertainty around the former broadly preventing much in the way of a Santa rally.
In the US, the S&P 500 index did manage one last record high late in December, registering close to 70 peaks over the year, and was up just under 27% over the course of 2021. The Stoxx Europe 600 index also remains near its all-time high after advancing more than 22%, and, with a more modest but still strong 14% gain from the FTSE 100 index, no one can deny this was an excellent 12 months for equities.
The 14.3% rise from the UK’s blue-chip index was the best since 2016 and went a long way to repairing the damage from a mirror image 14.3% decline in 2020, the worst drop since the 2008 financial crisis. As for the S&P, the index outstripped the Dow Jones Industrial Average and tech-heavy Nasdaq Composite with the widest margin of outperformance since 1997, only the sixth time it has beaten both in the same year (most recently in 2004 and 2005).
Striking a more cautious note, however, history suggests that after a gain of at least 20% by the US index, returns are comparatively muted over the following 12 months, with an average rise of around 8% according to Dow Jones data.
We remain positive on prospects for 2022 overall but, supporting the point above, highlight that in 2021 there was only one 5% correction – in September – and the fact falls of at least this magnitude have historically occurred three times a year suggests a pause for breath is likely, particularly if Covid infection numbers continue to rise. Early signs point to encouragingly lower hospitalisation numbers with the Omicron variant but we prefer to stick to managing client money as best we can rather than adding another voice to the reams of amateur epidemiology out there.
Despite fears of the new strain and anaemic UK GDP growth of 0.1% in October, the Bank of England (BoE) finally decided to pull the lever with a small interest rate rise of 0.15 percentage points, to 0.25%, after an eight to one vote in favour at its December meeting. The BoE also revised down expectations for GDP in 2021 by around 0.5%, leaving the figure still 1.5% below its pre-Covid level, with growth in many sectors restrained by disruption to supply chains and shortages of labour. Omicron is also likely to have depressed figures for December and the first part of 2022.
With a large spike in the 12-month CPI (Consumer Price Index) from 3.1% in September to 5.1% in November, the BoE cited significant upside news in core goods’ and, to a lesser extent, services’ price inflation. Expectations continue to creep upwards and inflation is now predicted to remain around 5% through the majority of the winter and then peak at 6% in April, with this increase predominantly driven by the lagged impact on utility bills of developments in wholesale gas prices. For now, however, CPI inflation is still expected to fall back in the second half of 2022.
These developments came as the International Monetary Fund (IMF) warned the BoE against inaction bias, urging policymakers to begin raising rates before inflation becomes ingrained. In its annual review of the UK economy, the IMF said recovery has been far stronger than expected and Omicron will likely only cause a ‘mild slowdown’ over the next quarter.
Meanwhile, safely ensconced in the US Federal Reserve for another four-year term, chair Jay Powell paved the way for the December meeting with comments in support of faster-than-expected withdrawal of asset purchases and rate rises, citing a strong economy and inflationary pressures. As expected, the Fed subsequently announced an earlier end to its bond buying, bringing the date forward to March (from June), and laid the groundwork for rate rises soon after. The central bank’s dot plot chart now shows three hikes expected in 2022, and another five in 2023 and 2024 (split three and two), as policy shifts back towards a ‘neutral’ 2.1% base rate.
Equities initially responded fairly positively to greater policy clarity and the belief seems to be persisting – pandemic allowing – that a range of assets can weather the pivot away from ultra-loose policy. Much of this earlier-than-expected tightening is driven by inflation running higher and longer than projected and the ‘transitory’ description has noticeably disappeared from the Fed’s lexicon.
October’s 30-year peak in inflation was swiftly followed by a 40-year high in November, rising 6.8% compared to the previous year as prices for petrol, used cars, rent, food and other goods continued to climb. Economists surveyed by the Financial Times expect US inflation to remain elevated well into next year, with the Fed’s preferred measure, the core personal consumption expenditures (PCE) price index, moderating marginally to 3.5% by December 2022. Almost two-thirds anticipate core PCE will still be above the Fed’s 2% target by the end of 2023.
We continue to stress that while headline inflation globally has risen sharply due to higher energy prices and temporary lockdown-driven supply shortages, the increase in core inflation has been less pronounced. In the face of concerns over tightening policy, it is also important to recognise this tightening cycle begins at historically low levels with emergency rates rather than at the lower end of a normal range.
Given all the concern about inflation, it is interesting to check in with Japan, which remains an outlier as so many other central banks start down the path towards policy normalisation. With low inflation rates in the country, having been mired in deflation for so long, no significant changes in policy are expected until April 2023 at the earliest when current Governor Kuroda’s term of office ends.
Among positive developments over the final month of 2021, US congressional leaders struck a deal that should lead to raising the federal government’s borrowing limit and avert another crisis over the US debt ceiling. More concerning is the ongoing struggles of Chinese property giant Evergrande, with the company starting to default on its many debt obligations. S&P has published a report stating more defaults beyond Evergrande are likely, with China’s corporate debt now almost a third of the global total at $27 trillion. The country’s debt-to-GDP ratio of 159% is markedly higher than the global average rate of 101%, implying huge contagion risks if these debts begin to turn bad. Beijing is preparing a 'controlled demolition' of Evergrande to protect its economy, with a slowdown in the Chinese real estate sector, which accounts for a significant proportion of output, potentially having a major impact on global growth.
Across our Multi-Asset funds and portfolios, we remain positive on risk assets entering the new year and continue to be bullish on the reflation trade that looks to be gathering pace again after a summer lull. Our goal has always been to prepare rather than react and this view plays into three long-term calls: global ex-US equities are more attractive than the US, small caps should outperform large, and value should outstrip growth – all running contrary to what happened for most of the 2010s.
Within equities, we see better value in Europe, where stocks are trading at attractive valuations versus the US due to strong earnings revisions and the region is also poised to benefit from a value/cyclical-driven market. The UK remains cheap and, more than a year on from the long-awaited Brexit deal getting done, is still a contrarian play despite strong signs of recovery from the depths of the pandemic. Over the course of 2021, investors pulled more than £8 billion from open-ended UK equity funds but we continue to see good value in our unloved local market.
Emerging markets remain a watchpoint as the regulatory shift in China has caused a re-rating in the region’s stocks, especially in the technology sector. This has made emerging market companies more attractive on valuations but they bring added near-term volatility, and investing in China will have to come with an understanding that the government is likely to treat certain sectors more favourably than others.
Overall, we expect equities to remain the main driver of returns and therefore continue to be overweight, while we remain underweight duration in our fixed income allocation as central banks prevaricate over the timing and extent of rate rises and tapering. There remains a split between bulls and bears with respect to economic outlook so we prefer to take a balanced, flexible approach where we can focus on long-term themes and build diversified portfolios able to perform throughout the cycle.
Key Risks
