Investments

A bit of “déjà vu”


René Julien, MBA, CFA

Senior Director | Investment

rene.julien@bluebridge.ca

The title of my article a year ago was “Good riddance to 2020”. I don’t think I need to re-explain why I had chosen that particular title. Well, here we are, one year later, and we are still dealing with Covid, albeit a new variant, and more lock downs. Fortunately for investors, similar to last year, the stock market carried on to new heights despite it all. I was tempted to simply title this article “Good riddance 2021,” but I settled on the title above instead.

Global equity markets continued to surge in the 4th quarter (see Table 1), despite the emergence of the new highly contagious Omicron variant in late November, its rapid propagation, and the resulting new lock downs and restrictions implemented globally. However, initial indications that this new variant was less severe than Delta seemed to appease market participants. In addition, markets were well supported by better than expected Q3 corporate results, particularly in the US, where 81% of the S&P 500 companies posted earnings above expectations. Furthermore, expectations for earnings growth in Q4 remained strong , in excess of 20%. As a result, global equity markets concluded the year with an impressive return of 21.8% (in USD). The only disappointing region was emerging markets, which posted negative annual and quarterly returns, in both USD and local currencies. The main culprits for these sad returns were a strong US dollar, concerns over an economic slowdown and Covid in China, and extreme currency volatility in Turkey.

Table 1

Source: Morningstar

The fourth quarter saw large divergence in performances across global sectors. Technology, materials and utilities led the way with double-digit returns. On the flip side, the communication services sector was the only one in negative territory at -1.7%.  For the year, energy was the best performer with a return of 40.1%. The next best-performing sectors were technology and financials at 29.9% and  27.9%, respectively. The other sectors all returned between 10% and 20%.

Inflation remained a hot topic during Q4 with US CPI accelerating at an annual rate of 6.8% in November, the highest since June 1982. This marked the ninth consecutive month that inflation stayed above the US Federal Reserve (Fed) 2% target.  Strong demand, pandemic-induced supply chain disruptions, wage pressures, soaring energy costs, and a low base effect from last year can all be blamed for the spike in inflation. As such, comments from Fed members and Chairman Jay Powell became increasingly hawkish (aggressive), even suggesting that the tapering of the bond purchase program could be accelerated and that they may stop referring to inflation as transitory. This change in views was reflected in the Fed’s economic projections released in December when the outlook for the median Fed fund rate was 0.9% for 2022, 1.6% for 2023 and 2.1% for 2024, higher than the previous projections 0.3%, 1.0% and 1.8%, back in September. Meanwhile, inflation in the eurozone reached 4.9%, its highest level since 1991. While European Central Bank (ECB) President Christine Lagarde kept the message fairly muted, other ECB members were more hawkish. This is in clear contrast to the exceptional support central banks provided to the markets in 2020.

 While the impact of inflation pressure and higher expected central bank rates were not reflected in longer term 10-year government yields, which finished at similar levels as at the end of Q3 (Table 2), it could be seen on shorter-dated treasuries, as the yield on 2-year US treasuries jumped from  0.28% to 0.73% over the quarter.

 

Table 2

Source : Koyfin

In the US, government and corporate bond returns were quite subdued during the quarter (Table3). The US Aggregate index was led by the high yield sector, mostly due to the high carry (coupon rate), but held back by the Mortgage Back Securities (MBS) sector. Negative and slightly rising yields ensured another disappointing quarter for European bond performance. Once again this quarter, the Global Aggregate index, which is in USD, was negatively impacted by the currency effect of some of the non-US bonds included in the index. All in all, it was a difficult year for the bond market as a whole with yields having increased substantially during the year across the major economies. The high yield sector was the only saving grace, having delivered positive returns in the US and Europe, supported by a higher carry and by spreads continuing to narrow throughout the year.

 

Table 3

Source: Morningstar

On the subject of currencies, it was another strong quarter for the USD relative to the Euro (Table 4). The more aggressive tone by the Fed, compared to that of the ECB, in line with higher inflation figures in the US and widening interest rate differentials, on the shorter 2-year issues in particular, fuelled the USD. The USD was relatively stable versus the CAD and GBP as yields moved more in tandem.

 

Table 4

Source: Koyfin

A new year is upon us, but the same concerns remain for investors: the pandemic, economic growth, inflation, interest rates, earnings growth, and market valuation, just to name a few. There is no point in attempting to guess at what could happen in 2022, after all, who could have predicted how the past 2 years unfolded. So, let’s deal with the facts.

The world is once again dealing with a new wave of infections due to the Omicron variant. While much more contagious, indications are that its effects are less severe, and that this new wave may be short-lived. This wave has nonetheless disrupted the global economy, be it with continued supply chain issues, labour shortages, cancelled flights, etc. As such, the world economy is at a tipping point, one of the key economic indicators, the Composite Purchasing Managers’ Index (PMI) is pointing at a slow down across most major economies. Still, inflation remains, with the latest figures for December hitting 7% in the US and 5% in the Eurozone. The fear of persistent inflation has already forced central banks to take more hawkish stances, which should lead to even higher interest rates. This is clearly negative for the bond market and should put pressure on stock market valuations.

While higher interest rates can negatively affect market valuations, earnings growth can sometime compensate and help maintain stock values. Unfortunately, analysts have already started to revise down their earnings expectations for the final quarter of 2021 (to be announced over the coming weeks) and for 2022. As such, the market is vulnerable to both a derating of multiples and lower projected earnings. Lastly, the S&P 500 has returned 28.7% (annualized) over the past 3 years. According to Rosenberg Research, there have only been 6 periods, since 1945, when the market has increased at a 3-year annualized rate of over 20%. The average return in the fourth year in those 6 periods is -2%.

Let’s all hope that I will not have to consider the title “Déjà vu all over again” for my article next year. Except maybe if I’m talking about the stock market, where a fourth year of strong returns would certainly be welcomed.

Wishing you a healthy and happy 2022!

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By René Julien, MBA, CFA

24/01/2022

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