Despite some recent market jitters caused by the Omicron variant, it has been another strong year in global share markets. The US S&P500 Index is up 22% and the MSCI World Index is up 17%, resulting in solid gains for many investors. While global markets have rallied, a lot has gone on behind the scenes economically, both domestically and around the globe. New Zealand has been impacted by ongoing lockdown measures, just as many countries have reopened their borders and returned to work. Inflation went from being low and at the being back of investors’ minds, to high and very much front of mind. The Reserve Bank of New Zealand has also started to hike interest rates, which will have economic impacts in 2022 and beyond. What were the central themes from 2021 and what can investors learn from them?
The Covid aftershocks
If 2020 was the year that Covid hit financial markets and the global economy, then 2021 has been defined by the pandemic’s aftershocks. These aftershocks haven’t been the economic stagnation and unemployment that people initially expected, but instead, the side-effects of Covid emergency measures have been supply chain bottlenecks and inflation. While inflation was running at less than 1.5% in both New Zealand and the US at the end of 2020, it has recently spiked to 4.9% in New Zealand and 6.2% in the US.
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 the hype this year - falling 6% despite surging inflation expectations.
Global equity markets have done a much better job this year protecting investors from inflation, with markets in the US and Europe both outstripping inflation by well over 10%. While rising inflation can also provide a headwind to equity returns (particularly when inflation is above 5% 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.
Interest rates on the rise
Rising inflation expectations have caused investors to bring forward their expectations of interest rate hikes. The New Zealand 10-year government bond yield has more than doubled this year, from less than 1% at the start of the year to almost 2.5% today. 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.
Some share markets are also more interest rate sensitive than others and have been impacted by rising rates. As a result, the New Zealand share market, which has a high proportion of dividend yielding stocks (like our electricity generation companies and listed property trusts) has underperformed global markets this year. The NZX 50 Index is down 3% so far this year, compared with strong positive returns in most global markets.
The drop in bond prices and our domestic share market 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.
New investors and irrational exuberance
A third defining theme of 2021 has been the pockets of excess in markets – from cryptocurrencies to electric vehicle and meme stocks. Former Fed chair 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 last 18 months, speculation in meme stocks (like 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 hot themes 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 that they may be able to pick the next Amazon. All of this has echoes of 1990s dotcom bubble. While some of these high-flyers are still surging ahead (like Tesla), others have already fallen back to earth (like Beyond Meat or Peloton).
In times like these investors can forget that slow and steady often wins the race. Investors may end up wishing they simply invested in proven but lower growth businesses, like search giant Alphabet (itself up 63% this year), instead of pre-profit concept stocks that offer the potential of high returns, but also the possibility of very 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 that 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 this year, even before the effects of inflation. Likewise, a passive investment in the New Zealand share market would have declined in value. On the other hand, a balanced portfolio of bonds, domestic and foreign shares would have delivered solid positive returns. Growth assets like 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 and things they don’t understand. In the current market we believe this means avoiding many of the current market darlings – the electric vehicle stocks, cryptocurrencies and many yet to be proven businesses in areas like space exploration and genomics.
2021 has been another rollercoaster year for New Zealanders. Markets also haven’t been plain sailing. I am proud of how the Fisher Funds team has adapted to the changing economic environment and put their energy into delivering good outcomes across our client portfolios.
For our clients, thank you for your support and engagement over the year. We look forward to working with you all again in the New Year.
I hope you enjoy a much-deserved break and are able to reconnect with friends and family. Let’s hope for more normality in 2022!
Merry Christmas and happy holidays,