12 January 2022 | Simon King
Thoughts on 2022: One Step Beyond
As a precursor to our outlook for 2022 we should state that we were surprised by the strength of most asset classes in 2021. Looking back, the record levels of global liquidity made this strength inevitable, and it was our expectation that these would recede that slightly wrongfooted us.
So, we are once again in a position where valuations have risen, neither short-term nor long-term risks have abated, everyone is nervous, and markets continue to climb. The world waits with bated breath for a fundamental change in macroeconomic policies, which is both anticipated by the market and promised by the powers that be, but never materialises. Is there any difference as we enter 2022 compared to every New Year since 2010? In our view yes, in short - inflation. It will finally allow us, in the words of Madness, to go “One Step Beyond”.
We have thought that inflation would be higher and more persistent for some time, and we take no delight in the fact we have been proven correct. We see no reason that it will cease to run at elevated levels for the majority of 2022. The various lags in economies mean it is baked in for the first half of the year eg energy prices and the impact the current iteration of Covid-19 is having on the supply side of the economy, will only intensify inflationary pressures. With people already poorer and with tight labour markets, wage growth will increase, and inflation expectations will start to get baked in to wage demands. The dreaded inflationary spiral will then loom large. This will force central banks into policy responses.
Our preferred route is to get on with unwinding the various quantitative easing (“QE”) programmes around the world and start weaning economies off the comfort blanket of cheap and limitless liquidity. You have to take a drug addict off their methadone at some point. Unfortunately, we do not believe this will be the option taken and instead we will see a combination of very gradual reduction in QE, and a series of interest rate rises. Market bulls suggest this is preferable since it gives central banks two levers to pull. Recent history suggests this is at least one too many. Our fear is that many parts of the economy simply cannot bear materially higher interest costs in the short-term eg UK mortgages, and that such a policy could result in a collapse in consumer demand that would necessitate a reversal. Markets would not react well, and we would be back to a worse position than when we started.
To be fair there is no guaranteed solution to the current problem and it is really a manifestation of all economies not dealing with the 20-year period of global over consumption which led to the Great Financial Crisis. Since then, the can has been kicked down the road as - rather than take a period of short-term pain - most governments have preferred to enact policies designed to let inflation deal with the problem over a longer period. This may have worked but Covid-19 has scuppered that plan. One could argue that the global economy is actually functioning as it should do in the long term ie that over-consumption and QE have led to inflation and increased savings. Individuals are now spending these excess savings, but once they are exhausted demand will reduce, inflation will abate, but people will become poorer over time. The problems that this poses are that it will take a very long time, it is not designed for periods of rapid change eg now, and the sections of society that will do worse are the poorest. They did not dine out on the bull markets of the past 10 years, and accumulate the savings that the higher strata of society will use to weather out the storm. Historically this scenario has never been politically or socially palatable.
We have to admit it has been difficult composing this piece in that uncertainty abounds. We have been helped by reading some of the missives sent out by various market commentators, which astonishingly still perpetuate some of the myths and reversion theses which, in our opinion are even more dangerous now than they have been. Many professional and casual investors like to look for patterns, reversion to means and historical norms which they believe will guide their investment decisions in the future. We would argue strongly against this. The majority are created and perpetuated by market participants who benefit from turnover and activity levels. The most common myth is to claim the current set of global market conditions are similar to year “such and such”. In our opinion they do not look, smell or taste like anything we have either witnessed directly or studied in detail. A combination of the prospect of a synchronised reduction in fiscal and monetary stimuli, high prices across all asset classes, elevated levels of inflation, global political uncertainty and an on-going pandemic is simply unprecedented. The relentless search for a “Rough Guide” to markets is a fruitless one.
Another issue that concerns us are the inexorable rise in the amount of assets supposedly run under some flavour of Environmental, Social and Governance (“ESG”) frameworks and the impact of this trend on valuations of certain assets. To be clear we take ESG factors into very careful consideration when assessing which assets to buy for our clients, but they are only a part of the process. There is no reason to believe that many of the companies who provide goods and services into the overall “greening” of the economy, will command superior returns in the long term - as their offerings simply become the norm. As their financial performance reverts to the average, then so will their share prices.
One trend we have to comment on, is the incredible performance of the very largest US companies both operationally and in terms of share prices. We have been and remain keen supporters of many of these companies. Their performance has been largely justified by their excellent operational performance, their allocation of capital and their innovation. They have performed well in all economic conditions in the past 20 years. We have termed them the new Blue Chips, but we could equally label them the new conglomerates. Most have many strings to their bow eg Apple now sells more watches by value then the rest of the watch industry combined. The fact they are not considered conglomerates is a combination of operating under one brand, not divulging significant information on each business and historically conglomerate being a dirty word. We expect these companies to continue to grow at a faster pace than the economy, and this coupled with their immense cash resources mean the only discernible major threat remains regulation and/or political interference.
The biggest challenge we face in terms of looking at individual companies and sectors is what the world will look like once the impact of Covid-19 abates. We are of the view that everyone will have to learn to live with the virus and as such, it is very difficult to judge what demand patterns will look like eg travel, where demand will certainly recover, but will it be to previous levels? Many corporate travellers have realised they can manage with Zoom, or the like, and certain parts of the population may choose to travel less for a variety of reasons. This will have big knock-on effects in areas such as aeroplane manufacture, airport services and most areas of leisure, all of which are large employers. This is not all bad news, as expenditure will divert elsewhere and economies are incredibly adept at adjusting, so interesting investment opportunities will appear.
This time round we will not comment in detail on all of the main asset classes but suffice to say we have not really changed our opinion. Our views on inflation and interest rates obviously lead us to anything that provides effective inflation protection; most parts of the fixed interest market look expensive; equities remain the least-worse option; economies that have the capacity to generate their own growth eg China and India, appear attractive; and there are still undervalued companies in certain areas such as Japan.
China does warrant highlighting further. It has had a very difficult year as the Government has run a relatively tight policy and its trade flows have suffered due to the pandemic. We remain attracted to its unique ability to control its overall economy, its short-term demographic position, and the optionality that its huge financial reserves offer. We expect the Government to loosen its purse strings during 2022 as it looks to stimulate domestic demand, level up income distribution and increase overseas investment, particularly in the rest of Asia and Africa. We believe this will be generally good for markets and the challenge is to find investments that offer exposure to this upside, but that are at the same time safe and reputable. The quality of financial disclosure and the well-publicised tendency of the Chinese government to indirectly intervene in certain sectors, makes exposure to individual companies risky. Our preferred route remains funds and multinational companies with significant exposure to China.
One subject about which we have an increasing number of conversations with our clients is whether they should fund their regular cash requirements purely from income from their portfolios or from a combination of capital and income. It is an area that has received commentary from several industry leading figures in recent weeks. Our clients are all aware of the difficulty of finding any sort of high levels of income across most asset classes. This has been compounded during the pandemic due to outright dividend cuts and a move in the UK, in particular, for companies to have lower pay-out ratios moving forward, in a similar fashion to the US. This has led to many vehicles that look to create income artificially or are taking too much risk to achieve the income they are creating. We very much try to avoid the latter. We do believe our clients, over time, should be looking to increase the proportion of their cash requirements that they take from capital ie selling positions. If companies are choosing to retain more of their cash earnings by not paying as much in dividends, and these companies continue to be successful, then it makes sense for investors to sell some of their holding to extract this value. We do not advise our clients on matters of taxation, but we note current UK capital gains tax rates are below income tax rates.
Our views on markets in the past twelve months have undoubtedly been proven to be too cautious. We identified inflation as a serious issue very early on - and until very recently the market has chosen to sail through it. We also expected QE to have already been put into reverse and believe, until it is, that most asset classes will continue to drift higher. We certainly do not wish to be “The Boy Who Cried Wolf” but there does appear to be some inevitability to our thesis.
Fortunately, there is plenty we can do to mitigate this in terms of our client performance. We do not allow our macro views to be all pervading and instead choose to seek out quality assets, that can continue to grow performance and returns across all economic cycles. Such opportunities are not in abundant supply, but the long-term changes of issues like living with the pandemic, greater emphasis on the environment and shifting global demographics will present further candidates for investment. Now more than ever, it is essential to be humble with one’s view as an investor, accept that your short-term opinions may be wrong and retain balance within portfolios.