What can 2021 teach us about what to expect in the markets in 2022?
OPINION:
With Christmas over and done with, it is a good time to reflect on the year in markets, and the lessons we can take from 2021.
It's been another extraordinary 12 months and as we slowly adjust to living with Covid-19, inflation and supply chain disruptions have become the dominant investment themes.
First, though, the good news - inflation aside, there is lots to cheer about last year.
It was another strong year in global sharemarkets, with the US S&P 500 up 27 per cent and the MSCI World Index up 17 per cent, resulting in solid gains for many investors.
While global markets have rallied, a lot has gone on behind the scenes economically, domestically and around the globe.
New Zealand has been affected by ongoing lockdown measures, just as many countries have reopened their borders and returned to work.
Inflation went from being low and at the back of investors' minds, to high and very much front of mind.
Most recently, the Reserve Bank of New Zealand has started to hike interest rates, which will have economic impacts in 2022 and beyond.
Investors have been left grappling with different issues from what they may have expected at the start of 2021. What were the central themes from 2021 and what can investors learn from them?
If 2020 was the year that Covid hit the economy and financial markets, then 2021 has been defined by the pandemic's aftershocks. These aftershocks haven't been the economic stagnation and unemployment that people initially expected. Instead, the side effects of the Covid emergency measures have been supply chain bottlenecks and inflation.
Lockdowns resulted in consumers who were flush with savings from government stimulus programmes and depressed services spending, which led them to open the spigot for goods that were scarce in supply. Combined with fewer workers in the labour market, factory closures and port backlogs, the natural consequence has been inflation.
While inflation was running at below 1.5 per cent in New Zealand and the US at the end of 2020, in the most-recent quarter it has more than tripled to 4.9 per cent in New Zealand and 5.4 per cent in the US.
Inflation is now one of the most vexing problems facing central banks, investors, and government policymakers.
Investors haven't had to deal with inflation of this magnitude in over two decades, and it comes at a time when interest rates are near rock bottom. This has left investors watching their bank deposits lose value in real terms, while looking for new ways to invest.
Gold, an often-touted inflation hedge, hasn't lived up to its promises - falling 6.7 per cent in 2021 despite surging inflation expectations.
Global equity markets did a much better job last year protecting investors from inflation, with markets in the US and Europe outstripping inflation by well over 10 per cent.
While rising inflation can also provide a headwind to equity returns (particularly when inflation is above 5 per cent per annum), it can provide much better long-term protection than many other asset classes.
Companies should ultimately be able to pass increasing costs through to customers in the form of higher prices, offsetting any short-term impact inflation has on profit margins.
But inflation-beating returns aren't guaranteed and picking the right businesses becomes all the more important in an inflationary environment. Companies that have well-entrenched competitive advantages, pricing power, and wide profit margins typically fare better than the broader market.
A key factor that will affect markets in 2022 will be just how transitory this inflation proves to be.
For what it is worth, financial markets appear less confident that inflation will quickly settle back to low levels.
Rising inflation prospects have caused investors to bring forward their expectations of interest rate hikes by the RBNZ.
The New Zealand 10-year government bond yield has more than doubled in 2021, from under 1 per cent at the start of the year to 2.32 per cent as of December 31.
The trend has been similar globally, and rising interest rates have pushed bond prices lower and led to negative returns for many sovereign and investment-grade bonds indices.
In its most recent Monetary Policy Statement, the RBNZ projects the Official Cash Rate will be hiked from 0.75 per cent, to over 2.5 per cent by the end of 2023.
Some sharemarkets are more interest-rate sensitive than others and have been affected by rising rates. As a result, the New Zealand sharemarket, which has a high proportion of dividend-yielding stocks (such as our electricity generation companies and listed property trusts), has underperformed global markets this year.
The NZX 50 Index ended 2021 down nearly 0.5 per cent, compared with strong positive returns in most global markets.
The drop in bond prices and our domestic sharemarket shows the benefit of diversification for investors. A prudent allocation to global equities would have seen investors offset these losses and still achieve solid positive returns for the year.
Rising interest rates have been a theme of 2021, and one that is likely to continue in 2022. Interest-rate increases can be a good thing if they head off rising inflation, but if interest rates rise too far and too fast it could be problematic for consumers and markets more broadly.
A third defining theme of 2021 has been the pockets of excess in markets. Former US Federal Reserve Bank chairman Alan Greenspan coined the term "irrational exuberance" in a 1996 speech when addressing the burgeoning dotcom bubble.
It is a term that also fits behaviour in the current market – the boom in SPAC issuance and IPOs over the past 18 months, speculation in meme stocks (such as Gamestop) and the euphoria that seems to be driving cryptocurrencies.
Runaway share prices of early-stage companies in trendy areas like genomics, fintech, space exploration and electric vehicles are another example of excess, although the enthusiasm for some of these companies has already started to wane.
But the big gains that have at times been on offer have seen new investors flood into early-stage businesses – hoping they may be able to pick the next Amazon.
All of this has echoes of the 1990s dotcom bubble. While some of these high-flyers (such as Tesla) are still surging ahead, others have already fallen back to earth (such as Beyond Meat or Peloton).
The ARK Innovation ETF that invests in many of these themes and captured investor attention fell more than 20 per cent in 2021, compared with a 27 per cent gain in the broader US sharemarket.
In times like these, investors often forget that slow and steady often wins the race. Investors may end up wishing they had simply invested in a proven but lower-growth company such as search giant Alphabet, instead of a pre-profit concept stock that offers the potential of high returns, but also a probability of significant losses.
The lessons from 2021 are not new, but they are important.
Reflecting on the year, it is possible to draw out some lessons – which aren't necessarily new - but should hold investors in good stead for what may come in 2022.
First, expect the unexpected and have a plan you can stick to.
Most investors didn't predict the sharp increase in inflation and interest rates we have witnessed in 2021.
Nor did they predict the pandemic in 2020 and the near-miraculous recovery in markets.
There is nothing new here, markets are inherently volatile and unpredictable. The important thing is investors recognise that markets are volatile and have an investment strategy they can stick with through thick and thin. It is easy to become complacent when markets have been rallying strongly.
Second, diversify - 2021 provided important illustrations of the importance of diversification. A "conservative" portfolio of cash and bonds could have seen its value fall, even before the effects of inflation.
Likewise, a passive investment in the New Zealand sharemarket would have declined in value. On the other hand, a balanced portfolio of bonds and domestic and foreign shares would have delivered solid positive returns.
Growth assets such as shares are critical longer term if investors want to grow their wealth and protect against the impacts of inflation.
And finally, stick to a formula and don't follow the herd. Many successful investors have generated their track records by following seemingly simple approaches to investing.
Investing in high-quality businesses, holding them for the long term, and avoiding investing in the latest market fads or business they don't understand.
In the current market, we believe this means avoiding many of the market darlings – the electric vehicle stocks, cryptocurrencies and many yet-to-be-proven businesses in areas such as genomics, blockchain and space exploration.
This year is shaping up to be an interesting one in markets. We will get more clarity on just how transitory the current bout of inflation will be, and central banks are planning to gradually withdraw their support for markets and hike interest rates.
It is a good time to reflect on these lessons, and to make sure you are comfortable with your portfolio as we move into the new year.
• Ashley Gardyne is Fisher Funds chief investment officer
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