Updated: Feb 8
It’s that time of year again and our chief strategist takes his usual whimsical look at what it could hold
Despite everything, given the virus-related fear and doom at the start of 2021, equity markets have done pretty well. The US led the way with India doing almost as well which we suspect will come as a surprise, both just sub 30% for the year in sterling terms. The UK and Europe were also prominent especially small caps. On the border between profit and loss were Global Emerging markets dragged down by China which was at the bottom of the pile along with Latin America; both circa minus 11%.
Bonds generally were in negative territory in nominal terms with the exception of high yield and index linkers. The former buoyed up by yield seekers that latter by those becoming increasingly concerned about inflation.
Commodities did very well, nearly matching the returns from US equities. Oil was in the vanguard whilst gold was pretty much flat for the year. May we see a rotation from one to the other this year?
Traditionally the New Year brings a raft of predictions, which are very rarely right or pan out in a distinctly different way to the anticipated course; such is life. We do find the “Outrageous Predictions” from Saxo Bank worth a look and not just for entertainment value. Here’s this year’s crop.
1. The plan to end fossil fuels gets a rain check
2. Facebook faceplants on youth exodus
3. The US mid-term election brings constitutional crisis
4. US inflation reaches above 15% on wage-price spiral
5. EU Superfund for climate, energy and defence announced, to be funded by private pensions
6. Women’s Reddit Army takes on the corporate patriarchy
7. India joins the Gulf Cooperation Council as a non-voting member
8. Spotify disrupted due to NFT-based digital rights platform
9. New hypersonic tech drives space race and new cold war
10. Medical breakthrough extends average life expectancy 25 years
Most of them aren’t that outrageous, are they? Although No.4 is a bit scary. More on that topic below.
We are faced with multiple known unknows all of which have the propensity to shock so we need to keep a careful eye upon them when thinking about our asset allocation. Here are our top 10.
· Energy – this rather chimes with no.1 on Saxo’s list. The rush towards greening the planet has relegated investment in mining exploration, coal, oil and nuclear to the investing equivalent of the naughty chair. If you do the maths, we can’t have a substantially green planet without burning fossil fuels, especially in the transition phase as we are currently finding out as cold weather, not uncommon is winter, increases demand for energy. Europe in particular is struggling with very high natural gas prices and there are concerns that lockdowns will be the least of our problems if industry grinds to a halt through a lack of power. This is a topic that needs much further debate, and we will return to it in future editions of this note.
· Inflation – an equally hot topic. Will it stay or will it go. We suspect in the short term we are seeing something of a peak as energy prices (ex-Europe natural gas) and commodities are well off their peaks. The rate of change of inflation (and GDP too) are keys drivers of markets in asset allocation, not so much the absolute numbers. Wage inflation contuse to be the metric to watch.
· Interest rates – this is the central banks dilemma. They should be raising rates, significantly, to combat inflation, but that then makes the servicing of existing debt a real issue. The likelihood is that we will get “yield curve control” keeping the curve as flat as the banks can manage. If long term rates get out of control – 3-4%% plus in the US – we have a problem Houston.
· The “pandemic” – It does seem that omicron may be the last throw of the dice for the virus, but don’t discount government and media fearmongering which will continue to weigh on the economy especially in Europe and to a lesser extent in the UK.
· Geopolitics - China – along with Russia (see below) is being blamed for all the world’s short comings, but this is not something new. Ever since China gained admittance to the World Trade Organisation, they have been planning the West’s downfall, Ie If you let us in, we will pretend to be good capitalists. They never had that intention at all. Xi is a Marxist from the Mao era and his belt and road policies together with a military that is now competing head-to-head with the US, especially in terms of technical competence, is indicative of a rising hegemon. Taiwan is the first goal and maybe sooner than is expected.
Russia – an invasion of Ukraine (which might provide the “cover” for China to invade Taiwan) is another distinct possibility. They are also being blamed for the European energy crisis, but it is the Europeans who are stalling on Nordstream 2, while the Russians and negotiating with Chine for a gas pipeline into northern China. And why not sell to the highest bidder? It’s not as if the US aren’t doing the same thing. Liquid natural gas carriers heading out of the US are being diverted from Asia Pacific routes back to Europe; follow the money.
· The Middle East – as ever, always a potential “battle ground” metaphorically or more often physically. The Israel, Iran, Saudi “triangle” is getting ever more complex.
· US Mid Term elections – In terms of credibility, whatever you thought of Trump, the present incumbent is no better and already a lame duck, before the mid-term elections, which look increasingly like delivering the Senate back to the GOP. If the Grand Old Party can break the Trumpian shackles and promote someone with a far better geopolitical understanding, then they will hold all the aces. This inevitably means someone with a military background which won’t make many of us very comfortable given Eisenhauer’s parting shot.
· French presidential election – Macron is up for re-election in April. Currently his main challenger is Marine Le Pen but coming up fast is Eric Zemmour to whom the left gives no chance, which is probably why he has such potential to get into the second-round ballot. The winner requires more than 50% of the votes and no one is likely to get that in the first round. The second round is decided by the top two from round one. Zemmour, and Le Pen, are very much nationalistic and anti-euro. A win by either would herald an uncomfortable sea change for the European Bunion.
· Central bank policy error – this point ties in with point on interest rates. If the CBs tighten too soon or too aggressively they will run the risk of killing off the economic recovery. The belief, the common narrative, is that they can control interest rates and will come to the rescue if the markets swoon. That has been made much, much harder by their desire to reduce their balance sheets by abandoning quantitative easing, which they know, but won’t openly admit, doesn’t solve the problem except for the very fortunate “1%”.
· And last but by no means least valuations. There is an argument that with bond yields so low equity valuations can go to even higher extremes. This is a fallacy. Low bond yields are a signal of low growth in the economy, which translates, eventually, into lower earnings and hence lower valuations. This is also part of the CBs dilemma; they don’t actually have as much control as they think they have.
What can we take away from all of this? The best we can do is look as far forward as the end of Q1. Like the man in the fog, we can only see the hand in front of our face. For the time being we may see a slowdown in the rate of change of inflation, which may well be temporary rather than transitory, although the meaning of both words seems to change on a daily basis.
GDP growth remains strong but may also be losing some impetus from the continuing supply chain issues, the duration of the latter being another known unknown. Some growth with slowing inflation is something of a Goldilocks scenario with most asset classes reacting positively. Sovereign bonds and defensives don’t do too well, but for risk mitigation they won’t hurt too much. Equities, commodities and credit will do much better.
Historically the month of January following three years of plus 20% returns, leads to a flat market at best. January also can be the bell weather for the whole year. The keys to watch for are surging wage inflation and the official end to the pandemic. We suspect the former may follow the latter.
And finally apropos nothing in particular, but a nod to the fact that working things out for oneself is more valuable than most people realise, here’s a quote from Mozart.
“A man asked Mozart how to write a symphony. Mozart replied, “You are too young to write a symphony.” The man said, “You were writing symphonies when you were 10, and I am 21.” Mozart said, “Yes, but I didn't run around asking people how to do it.”