The last twelve months has seen a sustained recovery in markets, with a notable absence of meaningful selling. Following on from the vaccine bounce in November 2020, equity markets have continued to rally, driven higher by strong earnings and greater than expected economic growth, supporting company prospects. While the current fears surrounding the newly discovered Omicron variant prove an exception, the year has seen a general improvement in the COVID outlook as populations have been increasingly vaccinated and methods for tracking and treating the virus are improved.
The market consensus has evolved from concern over COVID towards fear of an overheating economy, which has continued to be buoyed by loose fiscal and monetary policies, exacerbating supply shortages in goods and labour markets. Such shortages, as well as the unwinding of low prices seen during the depths of the pandemic, have stoked inflation globally, leading to expectations of higher interest rates. Resultingly, bond yields have generally risen, giving poor returns to fixed income investors over the year.
Geopolitical risks have also appeared to wane over the course of the year, with the Biden administration adopting a less confrontational approach and Brexit mostly being left in the past. More normalised G7 negotiations and an uneventful COP26 have allowed investors to place political risks lower down their list of concerns. The exception to this has been China, where the ruling Communist Party looked to make interventions into markets and practices that it feels are against their “common prosperity” agenda. The most extreme of these was the banning of profit making in after school tuition. While this was a minor component of equity markets, it illustrated the willingness of the regime to intervene. The speed and magnitude of this took the market by surprise. Interventions in technology companies as well as overseas listing had a more meaningful impact on international investors. Resultingly, Chinese equities have underperformed global peers, dragging down broader Asian and Emerging Market indices.
Looking forwards, we had been expecting to see COVID fall down the list of risks, however, the emergence of the Omicron variant challenged this view. Nevertheless, the initial concerns over the higher transmissibility of the variant have been tempered by the apparent lower risk of hospitalisation and mortality risks. In markets, investors initially questioned the pathway of monetary policy and potentially company earnings, causing a rally in bond markets and a sharp selloff in equities, however, this was quickly unwound, with many indices regaining highs.
If the result from Omicron is indeed more positive than previous variants, we expect that the existing movement towards tighter monetary policy will persist, reflecting concerns over inflation. While this has already been reflected in shorter dated bonds, the coming year may see volatility in longer dated issues become more common, as the outlook for economic growth over the longer term becomes clearer and quantitative easing is withdrawn or even reversed. Within equities, the tailwind of positive earnings upgrades is unlikely to persist, as the initial rebound from the depths of the pandemic has already been seen and analyst expectations have caught up with reality. This does not mean that gains from equities are doubtful, however, it does mean that a repeat of the last 12 months is unrealistic, and the market is potentially vulnerable to a correction.
Given the balance of these outlooks, we are likely to continue to favour shorter dated bonds over longer issues, dampening portfolios’ sensitivity to rising bond yields. This is also a positioning that does not demand a significant opportunity cost. Equities continue to offer a reasonable potential for return; however, we see the best value within alternatives, including infrastructure and precious metals. These should provide a reasonable hedge against the prospect of higher inflation but also broader selloff events.