Within this article, James Sellon, Co-Founder and Managing Partner, MASECO Private Wealth, reflects on 2021 breaking down the year into three major themes.
A year ago, on Christmas Day 2020, I filmed a video of our family during lunch, asking each person the most topical question of the time: Where would the world be [from a Covid perspective] a year later? I watched the video during the holidays and was surprised to see the many diverse and different views. Unsurprisingly – the optimists were optimistic, the pessimists were pessimistic and the seemingly uninformed were…accurate!
It got me thinking of the folly of making short-term predictions and it reminded me of the words attributed to the eminent physicist Niels Bohr, ‘Prediction is very difficult especially about the future’.
Rather than looking forward, if we reflect on 2021, I feel the year can be broken down into three major themes:
- US versus Chinese equities
- The dispersion of equity returns
- The emergence of inflation
US Equities versus China
Blink and you might have missed it, the final months of 2021 proved a solid finale to a very strong year for US equities, with some of the largest funds ending the year up a staggering 28.73%.[1] These returns outperformed the returns in International Equities (+13.00%)[2] and Emerging Markets (-3.63%).[3]
Emerging Market returns were weighed down by poor performance from Chinese equities, which in some instances fell 20.56%.[4] In some of the typical Emerging Market index Chinese equities make up more than 30% and were the main negative contributor to this asset class. What is interesting is that if you exclude Chinese equities Emerging Markets in aggregate were actually up circa 8.54%[5] last year.
In my opinion, there are a few reasons China performed poorly. Evergrande Property Development Company (with an estimated $300bn of total liabilities) defaulted on interest payments and is currently teetering on the brink of collapse and Chinese officials tightened their regulatory grip on e-commerce and education platforms, causing the share prices of related companies to tumble (Alibaba down 48.96%[6] in 2021). What I feel is interesting is the noticeable different medicine being prescribed by Chinese and US officials to alleviate potential malaise. In the US the medicine has been more stimulus – in China it has been actions to deflate bubbles/speculation. The result of these two different responses is, in my opinion, some of the most noticeable divergences in stock market performance in recent history. The difference in performance between the Chinese and US equity markets for 2021 was around 50.47%.[7]
Incidentally, the Emerging Market funds that most of our client’s invest in delivered a positive 5.83%[8] return (due to their value and small factor tilts). And, the explicit factor tilts to small and value securities in Emerging Markets delivered double digit positive returns of 14.58% and 12.41% returns respectively.[9]
All in all, it was the US that lead the charge in equity returns, dominated by significant growth in earnings from Microsoft and Google, which masked the re-pricing some of the 2020 stay-at-home stocks that were trading on eye-watering valuations (Zoom (-45%) and Peloton (-76%)).[10] Interestingly, the darling of 2020, Amazon, delivered only a 2.38% return for the year!
Dispersion of equity returns
As most of you know we make strategic tilts in our equity exposure towards stocks that are fundamentally cheap (value), stocks that are smaller than the overall market (small caps) and stocks that are generating higher profits than the market (profitability).
The first three months of the year saw cheaper companies (value) outperforming the market as the world continued to re-open post Covid. But, as the year progressed, these securities gave back their relative lead. Over the rest of 2021 Google, Microsoft, Apple and (dare I say it), Tesla dominated market returns. Even with the strong returns of some of the mega-cap stocks the growth and value indices ended the year roughly neck and neck. The takeaway from this is that a few growth securities delivered outstanding returns, but most growth securities underperformed the index. These few high returning securities were in the mega-cap space, so tilting the portfolio towards smaller companies would have generally meant underperformance versus the broad market.
Interestingly, a similar story played out in International and Emerging Markets. However, as these jurisdictions lack the stock specific compounders of Microsoft/Google/Apple the shape of market returns was different. Without these big stars to hold up the growth side of the market, value companies and smaller companies outperformed their indices.
When we look at the performance of stocks that illustrate profitability they generally performed in line with market indexes over 2021.
Inflation
The major macro story of the year was the emergence of inflation as something to live with rather than a factor to ignore. Every one of us has felt the real impact of inflation on our day to day lives, whether it is the price of raw materials, diesel or broader supply constraints pushing up prices. The emergence of inflation has impacted the bond markets with US High Grade and Government bonds posting negative returns for the year (-1.54% and -2% respectively). However, Inflation Protected Securities and High Yield bonds posted positive returns (5.17% and 3.99% respectively).[11]
Whilst inflation is being felt in the real world the bond markets haven’t taken much notice with the 10 Year Treasury yielding 1.6%, roughly the same level it was in the run-up to Covid. We wrote extensively in the last quarter of 2021 as to the arguments for transitory or more permanent inflation. Today, the bond markets seem to be suggesting either transitory inflation, or the potential for the Fed to undertake sufficient bond purchases to keep a lid on interest rates.
In the real economy the impact rising prices will have on labour costs is the bogeyman. In some firms 60% of corporate costs are wages so if wage costs increase there will be pressure to raise prices or suffer profit margin pressure. It is a tug of war – with wage inflation one either gets price rises or corporate profit margin pressure. The Fed has a very difficult tightrope to navigate in 2022.
Outlook for 2022
The global economy recovery post Covid is likely to continue but most likely at a slower pace. The supply constraints will likely take longer than expected to repair, central bankers could be forced to combat higher inflation figures with higher interest rates.
I feel US equities have performed well, a lot of good news seems to be factored into share prices, corporate America has to deliver or share prices could come under pressure. Absolute valuations are high by historical standards and one would expect that rising Treasury yields would also act as a headwind to returns. In a world of negative real yields (you lose money by holding your funds in cash) and low absolute yields investors will continue to be sucked into real assets (like equities) to protect themselves. This is likely to underpin equity valuations.
It should be noted that not all equities are treated equally, and some stocks are commanding valuations not seen in the past. Kailash Capital published research recently showing that 30% of all US stocks are now trading at valuation levels of over 10x Price to Sales (this is expensive). At MASECO we do understand that today’s companies are far more profitable than the those of the past and that interest rates are at rock bottom levels. However, this doesn’t change the fact that the more you pay for a security the lower the expected return all other things being equal.
We do not know what will move markets in 2022 but, with what we know about the market today, we believe a portfolio tilted towards inexpensive (value) securities, less focus on the mega-cap names and with a tilt towards profitable companies investors have a very good chance of strong relative returns over the medium term.
[1] Koyfin – SPY ETF – Total Returns – Year End Dashboard 2021
[2] Koyfin – IDEV ishares MSCI EAFE ETF – Total Returns – Year End Dashboard 2021
[3] Koyfin – EEM – ishares Emerging Market – ETF Total Returns – Year End Dashboard 2021
[4] Koyfin – MCHI – ishares China MSCI ETF – Total Returns – Year End Dashboard 2021
[5] Koyfin – EXMC – ishares MSCI Emerging Markets ex-China ETF – Total Returns – Year End Dashboard 2021
[6] Koyfin – BABA – Alibaba Group Holding Limited – Total Returns – Year End Dashboard 2021
[7] Koyfin –Total Returns – Year End Dashboard 2021
[8] Koyfin – DFCEX – DFA Emerging Market Core Equity – Total Returns – Year End Dashboard 2021
[9] Koyfin –DEMSX – DFA Emerging Markets Small Cap & DFEVX DFA Emerging Markets Value Cap – Total Returns – Year End Dashboard 2021
[10] Koyfin – ZM – Zoom Video Communications Inc , PTON- Peloton Interactive Inc and AMAZ Amazon.com Inc – Total Returns – Year End Dashboard 2021
[11] Koyfin – GOVT – IShares US Treasury Bond ETF, LQD – Ishares iBoxx $ Investment Grade Corporate Bond ETF TIP – Ishares TIPS Bond ETF & HYG – IShares iBoxx $ High Yield Bond ETF –- Total Returns – Year End Dashboard 2021
