Financial year wrap

Asset class performance

The past year was a good one for risky assets. The S&P 500 rose over 40%, the ASX 200 by almost 28%, and a fractionally stronger performance from the Small ordinaries and REIT sectors.

The key themes were “rotation” and “reflation” namely shifting from expensive, secular growth COVID beneficiaries (tech, healthcare, utilities and consumer staples) at the stock level, in those that benefit from a return to normal (banks, resources, consumer discretionary).

At the asset class level, this trade reflected a sell-off in treasuries, gold, and to a lesser extent credit.

Market drivers

The key drivers are worth reflecting on. We had multiple rounds of fiscal stimulus, multiple rounds of monetary accommodation (in Australia this took the form of the TFF (term funding facility) QE (quantitative easing) and YCC (yield curve control) and of course the eventual discovery of a vaccine, without which the recovery in asset prices would likely not have proved sustainable.

The Democratic election also paved the way for ongoing stimulus, long past the point at which it would have historically been provided, and, perhaps most stunning of all, a “regime change” for the US Federal Reserve (which as a monetary superpower influences interest rates around the world) which expressly shifted from inflation targeting to prioritising the unemployment rate.

The most important graph of 2021

This mix of highly aggressive monetary and fiscal policy led to the below graph, which we see as the most important graph since the Volcker years. Income and spending, normally cointegrated variables, diverged over the crisis, but, with incomes supported, the usual sticky-wage-debt-deflationary spirals associated with a collapse in spending that make recessions so toxic to health, wealth and income were prevented. And plausibly, there’s no reason a similar playbook couldn’t be enacted when the next recession, whatever its cause, comes along again.

The case for SAA

The end of recessions are a strange sentence to type, but the implication of such a change in policy are certainly supportive to risky assets. A world in which defaults from collapsed nominal spending are reduced, or less likely, lowers the risk premium demanded by investors for taking on equity market risk. The lower discount rate raises the net present value of future cashflows, and subsequently supports the equity market.

Now we don’t really expect policy to so forcefully offset aggregate demand shocks in the future, but the evolution of policy is certainly worth keeping in mind.

With a strong global economic recovery underway, we can feel reasonably confident about the outlook for the trajectory of corporate profits, which is also supportive to risky assets. Nominal GDP in the US is likely to be just shy of 10% for the remainder of the year, and will remain north of 7% over 2022. That’s a level of growth that we’ve not seen in decades.

We can also suggest that with bond yields at low levels, or in some instances outright negative, that assets with a material positive yield spread will continue to see flows, which supports equities, infrastructure, property and to a lesser extent credit within fixed income. This is a variation of the TINA argument (there is no alternative).

Pension funds, insurance companies, asset managers, all need to generate returns to meet future claims and liabilities are forced to search for yield, which means deploying away from safe assets and up the risk curve.

All of these reasons add up to support the case for an ongoing capital deployment inline with a strategic asset allocation (SAA). There are plenty of concerns at the margin, things to worry over, but, we reflect these concerns with tilts away from our SAA exposures, a process we refer to as dynamic asset allocation (DAA).

DAA is a process layer built atop SAA, and seeks to smoothen out the risk and return impacts of the economic cycle upon the portfolio. But all too often, a focus on prospective negatives (for example, the risk that the Federal Reserve begins to tighten policy unexpectedly, or, that the virus mutates in a way that renders vaccines less effective, or just a good old exogenous shock to risk appetites that triggers a fall) causes investors to exit asset classes in their entirety.

And so although we devote many pages in our research blog to discussions about such risks, it can make sense to periodically step back and remind ourselves of what the diversified investment portfolios are designed to do in the first place, namely protect and grow wealth inline with the associated return and risk objectives.

Stocks

The weakest stocks of the past year are a fairly unsurprising list, with travel, leisure, REIT, energy, oil and gas names featuring prominently. Looking ahead, we are quite constructive on energy names, viewing the current price of oil (~$75/bbl) as not reflected in current market valuations for Origin and Woodside, which remain deeply depressed.

We also think that REITs (Vicinity and Dexus) have been oversold due to concerns about the carrying values of Retail and Office commercial property. Sydney Airport, although not technically a REIT, suffers from the same overhang, namely the difficulty of collecting rent from tenants when the shops are shut (or in this case, the international airport closed). Insurance companies like QBE have been out of favour due to fears of business interruption (BI) related losses, and as such are similarly oversold, to our minds.

At the other end of the spectrum, some of the strongest performances are in stocks we are much less positive on. Many of the tech centric financials (APT, SZL), tech health (PME) and online consumer stocks (PBH) are very expensive, as are the more general/traditional consumer discretionary names (ARB, APE, HVN, JBH).

The Software-as-a-Service (SAAS) stocks like XRO, whilst being genuinely excellent businesses, are likewise over extrapolating growth rates that, historically speaking, are very challenging to maintain for long enough to justify the market cap.

Commodities, with the exception of alumina and oil, are overearning, and as such we remain underweight presently high yielding steel and iron ore stocks like FMG, RIO, MIN, SGM, BSL.

Despite that, there are several other commodity derivative plays that remain quite cheap, stocks like Incitec Pivot, Nufarm, and Orica, which whilst not in the portfolio at present are nonetheless looking quite interesting given cyclical tailwinds.