Welcome to yet another AWML Quick Note. This time around, we have a slightly longer than usual note, as we will look back on 2021 and see how it affected global markets. Two years have now passed since Covid-19 shaped how families live, work, travel and how governments make their policy decisions. These have been two very eventful and volatile years, but how many of you would have guessed that a proxy for global stocks – iShares MSCI World Index Fund – would have risen by more than 37% in the last two years, with 19% of that gain coming in 2021 alone? 

Equities:

Those who read about investing will have undoubtedly heard that there is a positive relationship between risk and reward. Consequently, the only way to achieve a higher return is to accept more investment risk. This is true for allocating savings: bank deposits yields less than real estate, and real estate yields less than stocks. However, not all risk is “good risk”, as investors in Emerging Markets shares discovered in 2021 – this is why we preach the merits of diversification at Abacus Wealth Management.

In 2021, despite all the new variants (Alpha, Gamma, Delta, Omicron and the rest of the Greek alphabet), global equity markets mostly brushed them off as non-events. Instead, the market narrative was driven by the record recovery of corporate earnings and sales: MSCI estimates that global sales and profits grew by ~15% and ~52%, respectively, after having fallen by ~4% and ~12%, respectively in 2021. Still, not everything was rosy, and investors in Chinese companies (roughly 36% of the MSCI Asia ex-Japan Index) saw a ~20% loss from their March highs. An overleveraged real estate sector, regulatory crackdowns on foreign listed companies (with a focus on technological behemoths), a huge increase in commodity prices, and covid-related supply chain disruptions all lead to deteriorating investor sentiment and economic conditions.

All told, developed world equities saw gains in the 20% region, led by the US, and emerging market economies went down by roughly 5%. Currencies also played a major role, as the US Dollar strengthened significantly against the Euro (~8%) and Japanese Yen (~11%), adding further gains to investors’ pockets. Investors with portfolios denominated in Pound Sterling weren’t so lucky.

Fixed Income:

Returning to our topic of risk and return, we will now examine the movements in the bond market during 2021. Usually heralded as low-risk investments and the core of every medium-low risk portfolio, it’s safe to say bonds didn’t play out as many expected. The most volatile (risky) side of the bond market – high yield bonds and inflation-linked bonds – posted positive returns while investment-grade bonds and nominal bonds went down in value. Another point in favour of diversification - not only between asset classes and geographies but also between sectors and credit ratings.

What happened? Inflation and a general risk-on sentiment. Total assets held by major central banks (FED, ECB, BOJ and PBOC) now exceeds $31trillion, and roughly 30% of that money was printed in response to Covid-19. On top of this unprecedented rate of money printing, global factory and shipping output are still mostly below pre-Covid-19 levels. This is the perfect recipe for inflation: too much money chasing too few goods, and inflation is bad for bond investors. In addition, with corporate earnings recovering so rapidly, investors preferred to put their money in stocks. We address the topics of inflation expectations, debt and interest rates further below.

Bond and Equity Market Valuations:

As readers of our past Quick Notes will know, current valuations are highly correlated with future returns, and that’s why they’re so important to look at. Put simply: future outcomes are unknown, but the price you pay for any given asset is known today. If you overpay, most likely you’ll do poorly, but if you buy cheaply, you increase your likelihood of success. Easier said than done, and in the short term, what is expensive often gets even more expensive, boosted by market sentiment. In the two graphs above, courtesy of Crestmont Research and JP Morgan Asset Management, we look at where equities are trading today vs their historical average (left) and where bonds are trading today relative to their 15-year median (right).

Equity valuations are driven by growth in earnings per share, current dividend yield, and how much investors are willing to pay for tomorrow’s earnings, while bond valuations are driven by interest rates and their spread relative to risk-free government bonds – when interest rates go down bond prices go up. Both graphs tell the same story: both asset classes are currently trading above their long-term averages. Let us consider the following scenario:

An investor with a £500,000 portfolio, an annual income requirement of £30,000, and a medium-risk profile, by definition, needs to withdraw 6% per annum from her portfolio. If total fees are 1.5%, she needs the portfolio to grow by 7.5% annually. If she had half of her portfolio invested in equities and half in bonds in the last few years, that would have been no problem. But what if equities earn 6% annually instead of 12%, and bonds earn 3% annually instead of 6%, thus bringing both asset classes in line with their long-term average valuations? The investor mentioned above would be underfunded by 3% per year after fees. If this happens for 5 years straight, 15% of her portfolio would be depleted (not even accounting for the impact of inflation), hence severely reducing her chance to meet the desired annual income goal of £30,000. At Abacus Wealth Management, we advise our clients on avoiding, preparing, and managing scenarios like the one we just described.

Yield Curves and Bond Markets Implications:

Having covered the main topics of “what happened” last year, we didn’t want to finish this note without addressing “what may happen”. For that, we look at the bond market’s expectations. Namely: the evolution of yield curves and public debt levels (as a percentage of GDP) for the US, Germany and the UK. In sum, market participants have adapted to changes in central bank posture. They are now expecting interest rates to rise in the future, which usually doesn’t bode well with rising equity and bond markets. The unprecedented pace of money printing in response to the pandemic was critical, but it created a whole new set of challenges for the global economy: rising inflation and inflation expectations, which affects both the short end and the long end of the yield curve, which raises interest rates and the cost of servicing the debt. Rising debt servicing costs tend to reduce future growth prospects, as that debt must be paid or rolled over sometime in the future.

Joao Feliciano Martins, CMSA, ACSI

Wealth Manager

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