Q4 2021 - Market Review
ECONOMIC COMMENTARY
Unfazed by the prospect of near-term monetary policy tightening in the United States and the progressive wind down of emergency fiscal support measures, global equity markets posted strong results in the fourth quarter. Specifically, the MSCI All Countries World Index, S&P 500 Index and the S&P TSX 60 Index advanced 7.03%[1], 11.03% and 7.19%, respectively. For 2021, the above indices surged 20.90%, 28.71% and 28.05%, respectively.
Almost every equity market segment were positive for the quarter. Notable exception was the MSCI Emerging Markets Index which finished the quarter with a performance of -0.90% after having been disproportionally impacted by the news of the emergence of the Omicron variant in the South African province of Gauteng in late November.
Interestingly, the Omicron variant did not have much of an impact on fixed income markets either. In effect, the ICE Bank of America Merrill Lynch Global Government Bond Index was up a modest 0.18% during the 4th quarter. The index did appreciate temporarily following the announcement of the Omicron spread on the assumption that it might cause Central Banks to postpone the end of their quantitative easing programs. However, the Index reversed its gains during December when it became clear that Omicron was a milder strain than Delta despite being more contagious. For 2021, the ICE Bank of America Merrill Lynch Global Government Bond Index returned -2.29% due to a difficult first quarter as interest rates increased by 0.29% on average across countries and maturities[2].
Commodities, represented by the S&P GSCI Total Return Index, gained 1.51%. The asset class was particularly volatile intra-quarter due to large up and down movements in the price of Brent crude oil which temporarily jumped from 76$/barrel to nearly 84$/barrel before plunging below 69$/barrel when Omicron surfaced. For the year, S&P GSCI Total Return Index, gained 40.35%.
GREENWASHING IN GLASGOW?
Every year since the inaugural United Nations Climate Change Conference was held in Berlin in 1995, a long procession of diplomats, scientists, lobbyists, elected officials and corporate leaders meet to assess progress in dealing with climate change and establish frameworks towards global climate action. The 26th edition of the Conference of the Parties (“COP26”)[3], was held in Glasgow, Scotland, from October 31st to November 12th.
COPs are far from perfect. In effect, since all formal agreements must be unanimously ratified, the pace is set by the countries that are least willing to compromise. Those tend to be the ones that benefit from the status quo and whose strategic national interests collide the most with the world’s interests. Yet COPs are currently the only forum that the world has in its effort to mitigate and adapt to climate change, certainly the biggest threat that homo sapiens has faced since the dawn of the anthropocene. It is perhaps in recognition of this that since the parties officially recognized the IPCC[4] Fourth Assessment Report goal of a maximum 2 ° celsius global warming before 2100 at the COP16 in Cancún that alarmists see each of these meetings as the meeting of the last chance.
The stakes were particularly high at this year’s event for a couple of reasons. First, it welcomed back the United States to the negotiations as President Biden rejoined the UNFCCC shortly after his inauguration. Second, it was the deadline for countries to submit updated Nationally Determined Contributions (“NDCs”)[5]. These are the country-level emissions reduction plans first developed in 2015 by the parties to the Paris Agreement and which must be renewed every five years starting in 2020.
When the COP26 summit came to a close, significant advances had been made in a number of key areas. First and foremost, representatives finalized the rulebook of the Paris Agreement, thus making it operational[6]. Importantly, the implementation of Article 6 will eventually lead to the adoption of a global carbon trading market through linkages between existing national and regional schemes[7]. This will inevitably make those markets more liquid and tradable. Beyond that, COP26 also witnessed delegates make stronger pledges to reduce methane emissions, to stop and reverse forest loss and damage and accelerate the phase out of the thermal engine and coal mining. In parallel, a collective of large financial firms also committed to make their portfolio carbon neutral by 2030, thus recognizing the risks of carbon intensive assets and industries. Judging from these advances, the Glasgow summit was more than just… greenwashing.
However, there were also setbacks. For instance, the United Nations estimates that NDCs submitted to date are not sufficient to keep the goal of limiting temperature rise to 2.5 ° celsius alive. To this point, the NDCs submitted by some of the major emitters are particularly weak and contradict their ambition. Fortunately, these countries have agreed to strengthen their 2030 emissions reduction targets. COP27, which will be held in November 2022 in Sharm El-Sheikh, Egypt, will be the occasion to do that.
While there is still very little visibility on the projects that will be prioritized and technologies that will be adopted, one conclusion that we can draw from an investment standpoint is that the long term outlook for an equity investor in fossil fuel related industries has gotten bleak, to say the least. In the short term, however, the portrait is unclear and we believe that the sector will be remain subject to significant upside price risk. In effect, as fewer market participants are willing to invest or lend to fossil fuel industries, this may lead to chronic supply shortages which may not be easily adressed if renewables sources or energy are not brought on line in time. Hopefully, elected officials do not use the next crisis as an excuse to delay or rollback commitments for short term political gain.
TIMING ISN’T EVERYTHING
In the first few days of January, many investors take the opportunity to reflect on recent market events and wonder whether their investment portfolio is adequately positioned for what lies ahead. During the past few years, as highlighted above, investing has been, for most, a relatively pleasant exercice. Judging from the capital funded ratio of the large institutional investors at least, recent performance has been above long-term expectations[8].
Some investors who like to define things in black or white fashion, may respond in diametrically opposed ways to the recent past, depending on their own set of circumstances. Take inflation as an example. The pessimists may conclude that high inflation will persist or even worsen due to on-going global trade tensions between the United States and China, lingering supply chain bottlenecks and chronic under investment in the energy sector. For them, the time has come to move everything to cash and other safe assets because inflation is about to spiral out of control. The optimists, on the other hand, may argue that the slowdown in the Chinese residential construction sector, coupled with ageing demographics, elevated nominal debt levels and the likelihood that we are going to run out of greek-letters before the covid-19 pandemic ends are powerful deflationary forces. For them, it may make sense to invest in shares of large capitalization technology and communication services companies arguing that this segment will continue to be the best performing equity market sector for the foreseeable future as inflation will recede and there will be no reason for central banks to hike discount rates.
Our view is that nothing is ever entirely black or white. As a product of multiple opposing forces, the investing landscape is rather grey. As such, portfolio positioning for black or white scenarios are not optimal decisions for two reasons. The first reason is that these decisions are designed to work superbly well for a very narrow range of future scenarios but work atrociously across all other scenarios. For instance, a cash and equivalents only portfolio will outperform if all assets depreciate but faces significant opportunity cost if they do not. Similarly, a portfolio comprised exclusively of publicly traded Silicon Valley leaders will provide exceptional rewards if the price that market participants are willing to pay for companies with strong secular growth outlook increases further but could dramatically underperform if that scenario does not materialize. The second reason is that large portfolio movements tend to bring forward a significant tax charge which would otherwise have been spread over many years in the future. We are cognizant that the payment of income and capital gains taxes are inevitable but the difference if a significant charge is incurred in the near future is that the present value of such taxes is going to be much higher and hence impact the present value of the portfolio negatively.
All investors understand these concepts but some nevertheless subscribe to the black or white approaches because they are confident they will be able to anticipate the development of conditions that negate their base scenario and reposition accordingly. This approach is often referred to as “market timing”. Market timing is the act of trading in and out of capital markets based on predictive methods. The idea is that if someone can accurately forecast market direction, he or she can trade to maximize profits or avoid losses. While the idea is appealing, in practice, very few have demonstrated the ability to do that repeatedly. In fact, we suspect that market timing has only gotten more difficult. The reason is that there are more financially literate individuals with free access to information and the tools to process it than there ever was. Gone are the days when a investment manager could send a taxi driver to La Guardia Airport at 2 in the morning to collect a copy of the Financial Times so that he could extract precious information and position his portfolio before everyone else. Gone are the days when public companies annual reports were delivered by mail to shareholders. Gone are the days when a professional manager could gain an edge with a superior model for trading a complex financial instrument. Information has become ubiquitous and is instantaneously commented by swarms of investment professionals.
With that in mind, we’ve concluded that market timing is not a valid approach to deliver value add to the families that have entrusted us with the discretionary management of their assets. In fact, we think that more often than not, capital markets accurately reflect all the information that is available and that more often than not, we will humbly not possess superior information.
If we believe that market timing isn’t everything, what are the sources of value add that we bring to our families. Well, we think a good alternative is to seek to gain a better understanding of how each type of asset behaves in different environments and how they respond to changes in consensus expectations based on a thorough examination of how they have done historically and in relation to each other. This allows us to produce more realistic expectations about how different combinations of assets may perform in the future over a broad range of scenarios, including black or white scenarios. This in turn leads us to construct portfolios whose objective is not to yield the best results under any given scenario but rather be resilient across a broad range of scenarios while avoiding outcomes that would compromise their ability to meet our families’ long-term financial objectives given their respective risk profile. Since we do not know which scenario will materialize, we think it is better to be prepared for many of them, black, white or grey. This is our value-add strategy.
That being said, it does not mean that we never trade. In fact, while we highly respect market consensus, we are also conscious that in some instances, economic agents whose actions ultimately influence valuations are not necessarily economically driven and that this may cause valuations to deviate from equilibrium. One example is Central banks massive purchases of government bonds. Another example would be the growing number of passive strategies which, by design, are simply buying and selling assets as a function of their market capitalization or issue size. These are circumstances that will cause us to articulate views that are not consensual and often contrarian. However, these circumstances are the exception, rather than the norm. That is also why the portfolio changes that we advocate tend to be infrequent and gradual. In a way, fewer trades and portfolio changes is a good indication of how robust we think the portfolio is going to be.
To this point, 2022 will not likely be different in terms of portfolio movements as we do not think our views differ materially from consensus. There are of course a few exceptions. One such exception is that interest rates on government bond rates with maturities ranging between 2 to 7 years appear too low relative to inflation expectations over such horizons. Either nominal rates move higher or inflation expectations recede. This is driving on-going efforts on our end to seek low risk investments with higher return potential than fixed income instruments. Another area where our views appear different than consensus is the value of the US dollar in relation to the currency of other developed markets. The US dollar has effectively enjoyed the status of the world’s reserve currency since the decline of the British Empire. This status is driven by a number of factors such as the United States economic footprint in global transactions for goods and services, its raw military power and foreigners trust in the governance of its institutions, including its Central Bank. We believe that this status is increasingly being challenged on all fronts and that contested 2022 midterm elections will paralyze domestic policy making further and almost certainly lead to a chaotic 2024 presidential election. A large minority of Americans have already lost faith in the electoral system and in their institutions. We believe that 2022 could be the year where other countries start to lose faith in United States institutions and that this could have an effect on the US Dollar. This is pushing us to reduce modestly the unhedged exposure to the US dollar in clients portfolios relative to the currency other developed markets such as the Euro and the Japanese Yen. This will likely occur in across a range of fixed income and equity strategies. And it is not going to be about timing.
[1] Unless specified otherwise, performance is denominated in local currency terms.
[2] Measured by the difference between the Yield to Maturity of the Index as of March 31, 2021 and the Yield to Maturity of the Index as of December 31, 2020.
[3] Countries which are signatories of the United Nations Framework Convention on Climate Change (UNFCCC), an international treaty which acknowledges the existence of anthropogenic climate change and provides the framework for climate change negotiations. The Convention was adopted in 1992 during the summit in Rio de Janeiro, with the treaty entering into force two years later.
[4] International Panel on Climate Change
[5] These are the country-level emissions reduction plans first developed in 2015 by the parties to the Paris Agreement and which must be renewed every five years starting in 2020.
[6] Source: Glasgow Climate Pact
[7] The main outstanding issue in Article 6 was to avoid situations in which more than one country could claim the same emissions reductions.
[8] See Willis Towers Watson, Pension Finance Watch, Q3 2021, which computes an index measuring the value of Defined Benefit Plans relative to the present value of their liabilities.