2021 Year in Review — Lorica Partners

Key takeaways from 2021:

Stock markets continued to climb higher in 2021, with the US S&P 500 hitting a series of all-time closing highs and ending the year near a record.
While COVID-19 continued to dominate headlines, concerns also focused on inflation and its potential impact.
Market volatility since 1 January 2022 is within normal expectations for market behaviour.

It was a year of uncertainty and anticipation, of hopes for a return to a degree of normalcy following the onset of the COVID-19 pandemic in 2020. And it was a year that showed, again, the difficulty of making investment decisions based on predictions of where markets will go—as well as the enduring benefits of diversification.

Coming out of a volatile 2020, investors sought signals as to which way the global economy was headed. The distribution of vaccines and the easing of lockdowns were followed by an economic rebound, but the emergence of new variants would be a setback for the recovery. Despite these challenges, global gross domestic product (the value of goods and services produced by an economy) grew, completing the transition from recovery to expansion and eventually surpassing its pre-pandemic peak.

Still, the recovery would be accompanied by labour shortages, supply chain issues, and rising inflation. Prices increased especially rapidly in areas such as food and energy, and the US consumer price index jumped 6.81% from year-earlier levels in November, a rise unseen in nearly four decades. In Australia, inflation for the 12 months to 30 September 2021 was 3.0%.

The media was filled with debates about where inflation would go, what was causing it, how long it might last, and what could, or should, be done in response. (An investor pondering those questions might take comfort knowing that many assets in the past have outpaced even above-average inflation.)

Throughout the year, the stockmarket continued a relatively steady rise. The ASX 300 was up 13.4% over 2021, whilst the U.S S&P 500 Index generated even stronger returns of 28.7%. Global equities, as measured by the MSCI All Country World Index increased 18.5%.

The graph below tracks the performance of the MSCI All Country World Index over 2021 against the backdrop of media headlines.

In addition to the effective vaccines, markets were buoyed by several positive developments, including strong corporate earnings and increased consumer demand. In the third quarter, US corporations pulled in record profits—both in dollar terms and as a share of GDP (11%). That came as consumer spending generally trended higher throughout the year, rebounding from pandemic lows.

Emerging markets did not perform as well as developed markets, with the MSCI Emerging Markets Index down 2.5% for 2021.

Fixed income markets experienced more tepid returns than the equity markets, with the Bloomberg Global Aggregate Bond Index returning –1.39%.

Global yield curves finished the year generally higher and steeper than at the start. US Treasury yields, for example, rose across the board, with larger increases along the intermediate portions of the curve. Longer-dated bonds generally underperformed short-term bonds, with intermediate-term US Treasuries returning –1.72% and short-term US Treasuries returning 0.04%.

We wrote this article last year to explain that short-term negative returns in a bond portfolios do occur and are no cause to amend investment strategies – Understanding your fixed interest portfolio Part 2

A Focus on Inflation and Debt

For investors worried about the impact of inflation on their portfolios, it is important to remember that stockmarket performance in the past three decades does not show any reliable connection between periods of high (or low) inflation and market returns. The graph below compares inflation to US large stock returns over the past 30 years.

The weakest returns can occur when inflation is low, and 23 of the past 30 full years saw positive returns even after adjusting for the impact of inflation.

Like in equities, when it comes to fixed income there is no reason to assume inflation will bring dire effects. In the US from 1927 through 2020 (longest global data set available), median annual inflation was 2.68%, and in the 47 years when inflation exceeded that rate, it averaged 5.49%. Many types of bonds beat inflation over those 47 years, which included double-digit inflation in the 1940s and 1970s.

Bond investments should always be matched to an investor’s goals—they aren’t one-size-fits-all. But inflation concerns needn’t scare one away from fixed income.

Rising government debt levels may also lead some investors to worry about an adverse impact on stock returns. The US debt held by the public topped $22 trillion, up more than $5 trillion from the end of 2019 and 123% of GDP. In a more extreme example, China’s overall debt was 263% of its GDP late in 2021, driven by massive government sponsored infrastructure and property investment, as evidenced by China’s beleaguered Evergrande Group, which defaulted on its debt in December. In Australia, government debt is expected to be $729 billion by mid-2022, or around 34% of GDP.

However, the relationship between country debt and stock markets is complex, in part because sovereign solvency is dependent upon many factors besides just debt levels. In addition, debt is generally a slow-moving variable whose expected value should be incorporated in market prices. Consistent with this belief, the evidence suggests there has not been a strong relation between country debt and equity market returns.

Emerging Asset Classes

Spiking inflation and the ups and downs tied to the COVID-19 pandemic weren’t the only types of volatility drawing attention in 2021. Bitcoin and many other cryptocurrencies continued rising, prompting many investors to wonder whether this new form of electronic money deserves a place in their portfolios. But in its relatively short existence, bitcoin has proved prone to extraordinary swings, sometimes gaining or losing more than 40% in price in a month or two. Any asset subject to such sharp volatility may be catnip for traders but of limited value as a reliable medium of exchange (to replace cash), as a risk-reducing or inflation-hedging asset (to replace bonds), or as a replacement for other assets in a diversified portfolio. Thus, while cryptocurrencies may hold some appeal for adventurous investors, it’s hard to make a case for a significant allocation of one’s overall assets to them in the current moment.

Lorica Partners is undertaking substantial research into emerging digital assets at present and will share our policy paper with clients during 2022. Digital assets cover a lot more than simply cryptocurrencies and will undoubtedly change the world over the next decade.

When breaking records sounds like a broken record

There may be a tendency to think markets reaching a new high is a signal stocks are overvalued or have approached a ceiling. Such concerns may be especially potent now, with the S&P 500 having notched 75 closing records in 2021 on a total-return basis. However, investors may be surprised to find that the average returns one, three, and five years after a new month-end market high are like the average returns over any one-, three-, or five-year period.

For instance, in looking at monthly returns between 1926 and 2021 for the S&P 500 Index (longest data set available), 30% of the monthly observations were new highs. After those highs, the average annualised compound returns ranged from over 14% one year later to more than 10% over the next five years. Those results were close to the average returns over any given period of the same length.

Put another way, reaching a new high doesn’t mean the market will retreat. Stocks, at any time, are priced to deliver a positive expected return for investors, so reaching record highs regularly is the outcome one would expect.

This is a good reminder of the power of markets. Investors can’t predict the nature or timing of the next crisis, or the end of any existing ones. But markets are forward-looking and reflect optimism. New challenges will await, but rather than guessing at what will happen, investors can choose to trust markets and their long-term prospects.

Market volatility since 1 January 2022

Hopefully you have been enjoying your summer break too much to notice global stockmarkets are down around 10% since the beginning of the year. No particular external shock has drive the fall, and company balance sheets are healthy. The drivers appear to be geopolitical tensions thanks to Russia and concerns rising inflation and borrowing costs may impact some heavily indebted households.

It is important to put this volatility in context. The graph below shows the performance of the ASX 200 Index (the 200 largest listed stocks in Australia) since 1994. The grey bar shows the calendar year performance of the ASX 200 - the red dot shows the largest intra-year fall in the index. For example, in 2012 and 2013, the calendar year return of the ASX 200 was +15%. However, during each year, the index fell 10% and 11% respectively at one point in time. In fact, most years record an intra-year fall of 10% or more. So the current volatility is well within expectations of the inherent volatility of investing in stockmarkets.

Summary

The year 2021 was one that emphasised the benefits of discipline and diversification, of planning and perseverance, in a market that was uncertain (like markets in all the years before it).

Client portfolio returns for 2021 delivered above average returns for 2021 due to the strong performance of equity markets and our approach of ensuring global diversification.

As we enter 2022, looking backward can help as investors look to the future.

Author: Rick Walker