Market commentary: 1 October 2021 to 31 December 2021

Dec 31, 2021

As we end 2021 and enter 2022 markets and asset proces will continue to be driven by the actions of major central banks and the Federal Reserve in particular.

Last year the powerful liquidity injections from the governments and central banks gave implicit assurances to investors and ensured what has been referred to as an “everything rally”. Pretty much every asset class rose in the glow of this largesse.

There are two major areas of concern that will ensure that the outcome for 2022 is likely to be far less amenable to investors and they suggest a policy of increasing caution.

Firstly there is the issue of liquidity. Since the financial crisis large scale purchases of assets by central banks boosted not just the assets they bought (sovereign debt) but every other asset class whether they were “real” assets (equities, property, gold), “financial” assets (sovereign and corporate debt, and even bitcoin/cryptocurrencies) and “physical” assets (art and other collectibles). Real interest rates (after inflation) have been negative for over a decade now. This injection reached its peak in 2021 with record monthly totals.

The Fed is now set to completely stop asset purchases by the end of Q1 and it is unclear how a system that has become conditioned to this unconditional support will cope with its withdrawel. It is certainly hard to reconcile this action with asset prices moving higher.

The second risk is in tension with and rebounds upon the first; this risk is inflation.

As 2021 progressed global inflation rose sharply, at rates not seen since the 1970’s. This is partially a reflection of the massive liquidity boost to the system provided by both fiscal and monetary firehosing as a consequence of COVID lockdowns, but also because retail banks have repaired their balance sheets and showed a bold ambition to lend. Their business models do not thrive when they have excess liquidity in a negative real interest rate environment. They have to lend to make a profit and the data shows that they are.

Adding to the inflationary pressures has been the various supply chain shortages and bottlenecks that have emerged over the last year along with energy price rises. The long held view of central banks is that these factors would be temporary or “transitional”. We did not believe this was credible at the time and the evidence supports that conclusion.

Firstly, many of the supply shortages were not caused by COVID lockdowns but revealed by them. For example, the shortgae of silicon chips is partially due to the lockdown but mostly because chip fabrication capacity has not grown since 2016.

Secondly, politics has entered an inflationary phase. There are three key trends that have emerged that are dominating global politics:

1) A “safety first” COVID authoritarianism suggests government involvement in the economy to a profiundly higher level that had been witnessed up to the financial crisis.

2) Climate change and ESG concerns are already shaping capital allocation and investment.

3) The more modern phenomena of equality and identity.

All of these trends are inflationary and will persist.

Raising interest rates would help to quell inflation (this is the point of tension) but central banks have proved reluctant to test the robustness of the economy in this way before and with the already planned reduction in liquidity next year their resolve will be weak.

We try to make our observations and analysis as clear as possible and while there is a tug of war between liquidity and inflation, when it comes to the performance of the economy, we do not wish to suggest that the outcome is uncertain.

On the evidence that we have today, it is no longer a question of if the Fed will be behind the curve when it comes to combating inflation. It is already clear that the Fed is too late and that this is deliberate.

The Fed is so scared of causing collapses in asset proces, and plunging the US economy into a recession that it will keep interest rates too low too late. By some calculations interest rates should be at 6% by June this year in order to combat inflation. At present the Fed is not expecting to raise interest rates at all by then. Businesses are already preparing for this; rising stock levels and working capital. Wage inflation is already rising.

Just over a year ago the Fed predicted inflation at the end of 2021 of 1.8%. The actual level of inflation was 6.8%. This is neither a trivial nor modest miscalculation; they were miles off. The UK inflation target is 2%, but CPI in November rose 5.1% and RPI reached 7.1% – a 30 year high. Not only is inflation no longer transitory, it is no longer within the Fed or the BoE’s control. Their credibility when it comes to their ability to predict and control inflation has been fatally undermined and investors should place no confidence in their statements.

We have been factoring our concerns about inflation into the construction of our portfolios throughout 2021. We have been increasing our defensive assets and moving away from investments that are likely to be eroded by both inflation and rising interest rates (which are inevitable but too little too late to prevent inflation) but they will be a feature of 2022.

Pockets of opportunity are always available to investors who are able to select from any asset class and any asset, as we are, but 2022 looks set to be a lot tougher to make money than in 2021.