2021 Q4 Market Commentary
2021 Q4 Market Commentary
Over the Christmas break our family watched Don’t Look Up, a satirical Netflix movie that imagines the world’s reaction to the discovery that there is a comet headed to earth to wipe out all mankind. Whilst we won’t spoil it for those who haven’t seen it, one of the jokes in it, is that equity markets rise as technology and defence companies look to profit from the opportunities the comet brings. I was reminded of this when I looked at the three year returns for our main portfolios and saw that this has been one of the strongest rolling three-year periods we have ever had. When you think of the disruptions and dislocations caused by Covid I do find this remarkable.
One lesson is of course that the cliché of not letting a good crisis go to waste remains as true today as it has ever been. Newspaper headlines just don’t correlate that well with market returns. Another is that the many and varied government support programmes put in place (broadly) worked. There may be a price to pay for all this further down the line but sitting where we are today most consumers were financially protected from the worst aspects of the pandemic. This meant that when the lockdowns ended the economy rebounded strongly. We would expect a similar reaction from governments when the next crisis comes along. Today’s higher equity prices in part reflect the fact that investors think governments and central banks will do more than they have in the past to protect the economy from nasty surprises. Better protection from shocks makes equities look a more attractive investment proposition today.
However, if opportunity is greatest when the crisis is at its peak, then where are we at the start of 2022? As I write this, the US S&P Index is within 1% of its all-time high, having had 70 all-time high days in 2021. Why put new money into markets that are as expensive as they have ever been? Is all this good news priced in?
The first point to remember is that it is perfectly normal for equity markets to go up. Long term average equity market returns are around 7%-9% per annum. These returns are of course lumpy: a few years of larger gains are often followed by short sharp sell-offs that take a chunk of it back. But the point remains that markets that generally rise should be spending a good amount of time at or close to all-time highs. There is nothing unusual or scary about this. In fact it is the opposite – markets that generate good returns but that are somehow always below some level in the past – that would be odd.
The second point is linked to the lumpiness. When markets rise, they tend to rise strongly. As investors, it’s important we capture these returns to provide a cushion for when the next crisis turns up. As an example, research by JP Morgan shows that missing (only) the 10 best market days takes the annualised return on UK Equities from 5.1% to 1.7% between 1999 to 2018 (see Chart 1). Missing the best 30 days meant you would have lost money over this period.
The effect of good returns being clustered together is called Momentum in the investment jargon. Momentum is in fact your friend. As an illustration, Chart 2 shows the 1 year forward return from investing on the day the market hits an all-time high compared to investing on any other day. 1 year returns are in fact higher on all-time high days compared to investing on any other day. Why? Because markets that are rising tend to keep on rising (momentum) and can keep on rising for a lot longer and go a lot higher than many think possible.
So the fact that we are in a market that is rising is (i) pretty normal and (ii) has been a good thing as we have been able to build some buffer to protect against the next unpleasant surprise that is inevitably on its way.
But in case we start sounding like we are getting carried away with all the bull market frothiness that we also see today, it is probably worth talking a little about valuations. The first point to make here is that, in the short run (by which I mean the next couple of years) valuations don’t help much when forecasting returns. Markets were expensive at the end of 2020 but kept rising in 2021 as the earnings that justified those expensive valuations actually materialised. Markets were by most measures not expensive in 2007 but that provided no protection against the financial crisis that was about to hit markets in 2008.
Over longer time horizons, valuations do of course matter. The less you pay today the higher your returns tomorrow. Here, we can safely say that on most traditional measures of valuation (such as the price you are paying today as a percentage of corporate profits, sales or book value) then equities do look expensive. This means our own internal forward-looking expected portfolio returns are below what we have achieved for clients over the last few years. There are, however, a couple of important caveats:
- Today’s high prices are in fact an average of “winners” and “losers”. Winners have been able to grow their earnings fast over the last few years and are expected to keep doing so in the future. Losers are businesses (such as traditional retailers) that look to be on the wrong side of today’s technology software revolution and may not make it through the next decade at all. The gap between valuations for the winners (such as Apple, Microsoft or Google) and the losers (which include BP, Shell or HSBC which all happen to part of the FTSE 100) is as wide as it has ever been. Lloyds bank trades on only 6x earnings! It would not take much of a shift in sentiment or outlook for these companies to re-rate higher. We have allocations to several managers who focus on these sorts of unloved value opportunities and we are optimistic for their potential 2022 returns.
- Today’s equity valuations also look very attractive relative to cash. Chart 3 shows that at the end of 1999 it was possible to earn 5.5% on bank deposits in the UK compared to a then CPI inflation rate of 1.1%. As I am sure many of you will be painfully aware, today UK CPI sits at 5.1% and the UK bank base rate is 0.25%. Real (i.e. after inflation) returns on cash have fallen from plus 4.4% to minus 4.8% in just over 20 years! In contrast, UK’s unloved FTSE 100 index yields 4.1% with valuations (and yields) that are in line with where they were 20 years ago. We think equities have room to re-rate higher if today’s low interest rate environment continues for the next few years. Today’s interest markets (and the experience of Japan) suggests that low interest rates are very probably here to stay.
This means that if your aim is to beat inflation a combination of equities and our alternative investments (which also had a strong, inflation beating 2021) looks the best place to be. These two asset classes drove our performance last year and we continue to be optimistic our portfolios will be able to generate inflation beating returns for 2022 and the years ahead.
Chief Investment Officer