December Investment Summary
December began as November had ended with concerns over the new Omicron variant and how it would slow growth and exacerbate supply chain issues. The markets wrestled with how governments would respond, and how central banks would deal with persistently high levels of inflation that showed no signs of being transitory. In fact, the developed world experienced its highest levels of inflation in decades with the UK at 5.1%, US at 6.8%, the Eurozone at 4.9 %, with Germany in particular experiencing 5.2% for the year.
Despite these worries, equity markets rallied higher mid-December and closed 2021 strongly as the early evidence was that the new variant, whilst highly contagious, was less severe than earlier variants. In sterling terms, the Dow was up nearly 4% and the S&P 500 up just under 3% while the NASDAQ fell 0.6% for the month. In Europe, the story was similar with the Euro Stoxx 50 up over 4% and the FTSE 100 up just over 4.5%. Even Asian markets, which have struggled all year, managed to eke out small gains as the Nikkei 225 rose 0.4% and the Shanghai index was up over 1%.
For the full year, US indices were the place to be as the S&P 500 led the way with a 28.5% return in sterling terms, closely followed by the tech heavy NASDAQ up over 23% for the year. European and UK indices returned low teens while Asian markets struggled. The Nikkei 225 and the Hang Seng indices were both down on the year in sterling terms, while the Shanghai composite rose over 9%.
The same three issues we have discussed for much of the year (the pandemic, inflation and central banks response to inflation) continued to influence the direction of financial markets. Both the Federal Reserve and the Bank of England admitted that inflation was perhaps not as transitory as they had been thinking and that a change in policy was warranted.
The Federal Reserve announced they would rapidly reduce their pace of asset purchases, so that as of end of March of 2022 they would no longer be buying any US treasuries or mortgage-backed securities. They also forecast they would hike interest rates three times in 2022. The Bank of England chose to hike rates by 15 basis points and suggested they might hike rates a further three or four times in 2022. It is doubtful any of these actions will make a significant difference to inflation in the near term. Indeed, should inflation remain around current levels then central banks may be forced to act more boldly.
Financial markets may even take matters into their own hands if the central banks are viewed as too soft on inflation. Financial markets responded by pushing bond yields higher, particularly in the front part of the yield curve. More concerning or perhaps more damaging to investor psychology (and their wealth) has been the sharp sell-off in a variety of the more speculative tech names. This sell-off will likely persist until fixed income markets calm down.
While we doubt that the Federal Reserve or the Bank of England will hike more than they have currently forecast, it is not clear how fixed income markets will handle the sudden disappearance of their largest single buyer of duration. Since the advent of the pandemic in 2020, the Federal Reserve has purchased over $1.75 trillion in US treasuries. This has absorbed a huge chunk of the US government’s enormous deficit over that period. They also purchased another $800 billion+ in mortgage backed securities, taking additional duration out of the markets. The absence of this bond buying programme is likely to have an adverse effect on fixed income markets.
Turning to Covid-19, early data regarding the Omicron variant appears to show that the worst of the pandemic’s impact is waning. The new variant, while spreading more rapidly than was ever anticipated, is not bringing with it massive hospitalisations and deaths. Vaccines are working to limit critical illness and governments appear to be shifting to a stance where we learn to live with the virus rather than shut down activity in order to halt its spread.
China, in sharp contrast to the US and Europe, has not come to this conclusion and has locked down huge swathes of its economy in an attempt to eradicate the virus. These lockdowns will likely have an impact on global supply chains, resulting in continuing supply chain dislocations, shortages and price increases for many goods. It is not all bad news in China as they have been modestly easing monetary policy to mitigate the ongoing slowdown in their housing and property markets. We expect the People’s
Bank of China to continue to provide support, which should prevent a broad systematic financial collapse. That said, Chinese growth will continue to slow, and the world will notice.
Looking forward, we continue to favour equities with a preference for companies with earnings and pricing power. We recommend avoiding large holdings in “disruptive” firms with no earnings. Short duration within fixed income is still preferred, although any overshoot by financial markets may offer some opportunities later this year. Finally, watch out for central banks’ attempt to remove accommodation as this will likely result in a period of heightened volatility for financial markets.
Jeffrey Brummette
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