As 2021 became history, I cannot escape in my mind the opening words of Charles Dickens in his masterpiece “A Tale of Two Cities.”
“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, …”
Dickens wrote these words more than 150 years ago to depict a story of the conflict between London and Paris during the French revolution. A tale of contrasts between good and evil, between wisdom and folly. He wrote about a time of despair on one hand and excitement and promises on the other.
Perhaps 2021 did not quite compare to revolutionary times, but the force of conflict, the certainties turning into doubts, the losses turning into profits and vice versa colored our trading days in a crescendo of volatility.
We can blame COVID or the Federal Reserve, we can blame human nature or algorithms, but the fact remains that this is the life we chose; life in the markets spent divining the unknown, betting on the future, surviving the storms.
The past twelve months uncovered a successful vaccine that proved a strong warrior against the threat of a virus that continues to mutate leaving elements of uncertainty in the economic framework, but we also had to deal with a monetary policy pivot with possible long-term ramifications. 2021 also brought back the specter of old enemies such as inflation and energy shortages.
When the music stops…
In the classic movie “Margin Call,” Jeremy Irons, who plays the CEO of a large bank on the eve of the 2008 debacle, reveals that he is paid to know, before his antagonists, when the music stops. We sense that we might be at a similar turning point; less dramatic, less cathartic, but just as complex and more difficult to adjust.
Are we witnessing the end of the Great Moderation? The end of familiar elements such as low inflation, generally reliable growth, and the morphing of macro volatility could spur a totally different investing environment that would require not only tactical adjustments but most likely strategic shifts as well.
It is undeniable that fiscal policies seem to be rising fast as tools of preference for boosting growth. For once, because monetary policy might have hit its natural wall of effectiveness, but also because reversing inequality is a new priority around the world. This policy change increases the chances of entering a new universe of higher inflation, bigger deficits, different macro volatility and, as JP Morgan suggests intriguingly, faster business cycles.
Central banks’ game
Getting the inflation call right for the foreseeable future is probably the key event currently in portfolio management. Strong inflationary pressures would justify portfolios heavy in commodities, overweight in real estate, and skewed toward short duration in fixed income. Equities would require reducing exposure to high valuation stocks and momentum names in favor of more cyclical and value-oriented sectors.
Cyclical equities should continue to benefit from recovering fundamentals albeit subject to some volatility as we adjust to virus mutations and public health responses. Strong corporate liquidity underscores the economic recovery theme and provides fuel for M&A activity. In fact, we could see M&A action rise to the forefront in the pharmaceutical and biotech sector where the convergence of decent valuations, cash on the balance sheets and pressing needs for the renewal of patent pipelines might just light a fire.
The big uncertainty, of course, is the degree of change in monetary policy. The Fed has officially stepped up the pace to end its latest quantitative easing program and opened the door to three rate increases in 2022.
While draining liquidity in a market that has become addicted to it is certainly a headwind, one must realize that monetary policy is still very accommodative by all standards and that Powell is essentially trying to at least normalize the real yield curve where real yields (nominal rates – inflation rate) are negative. The ECB, conversely, seem to be willing to remain more dovish for next year as the Union faces much more restrictive anti-virus policies.
All in all, most signs still point to a still lackadaisical approach toward inflation as governments seem more concerned with growth and addressing financial gaps between the haves and the have-nots rather than executing hard on price stability.
China is in the center again
When discussing risk in 2022, I would be remiss if I didn’t mention China. The Middle Kingdom is in the midst of a major economic and political regime shift. New policy objectives are becoming predominant and while growth is still relevant, financial stability, climate change and affordable housing are taking center stage.
This shifting of priorities has significant implications for the economy and for global investors. It is reasonable to expect that economic growth will be volatile and generally lower than in the past.
Policy support might not always come to the rescue of macro slowdowns or specific issues as the Evergrande incident is showing. Committing long-term capital to China today, even though valuations may seem attractive, carries more geopolitical risk than we have experienced in the last twenty years.
Naturally, if US-China relationships were to take a turn for the better, more positive scenarios could develop, but at present, it is hard to expect quick resolutions or catalysts.
Alternatives are taking over
As I mentioned earlier, in a changing macroeconomic landscape, tactical adjustments may be necessary but strategic shifts may be required as well. If the days of mindlessly riding Beta (the passive risk premium one can gain by just being exposed to the traditional risky asset in a diversified portfolio) are possibly over, one must think about how to integrate Alpha into her/his investing paradigm.
Alpha is the kingdom of excess performance over passive benchmark returns; it is the essence of individual investing skills where uncorrelated returns can be created by exploiting anomalies not everyone can. Pension funds, financial institutions, and experienced investors seem to like the idea of diversifying their risk profiles into alternatives as Wall Street witnesses increasing interest in hedge funds, private equity, physical real estate, REITs and yes… digital assets. JP Morgan research reports that the universe of alternative asset classes expanded by 19.4% since the end of 2019 versus a 15.5% increase for the universe of traditional assets. Assets under management for hedge funds rose 10% since the pandemic while private equity real estate recorded similar advances.
Private debt funds, usually confined to the periphery of even institutional portfolios, are reported to have grown to a significant size of $1.2 trillion; no doubt because of the solutions they can provide to fixed income investors starved by unnaturally low yields for far too long.
Distinguished British economist John Maynard Keynes once said:
“When the facts change, I change my mind. What do you do sir?”
Are the facts changing for global investors?
A Year In Review: It Was the Best of Times; It Was the Worst of Times by Inna Rosputnia
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