2021 Q4 Newsletter
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The Rear View and the Front View
2021 saw very strong equity markets, while bond markets were somewhat weak. In Canada, the S&P/TSX Composite Index rose 21.7% while the Canadian bond market1 fell 5.2%. In the U.S., the S&P 500 posted a 26.9% gain, while the U.S. investment grade bond market2 fell 3.4% and high yield market3 eked out a 0.1% gain. 2021 finished with uncertainty about the omicron variant, combined with an abrupt shift in Federal Reserve policy and persistently high inflation readings, causing some volatility in December in particular.
In our Q3 newsletter, we stated our belief that the Fed was behind the curve. It seems as though Fed Chair Jerome Powell got religion after he was reappointed on Nov 22, as he quickly moved to retire the word “transitory” to describe inflation, and accelerated the pace of the QE taper. Some Fed officials have recently suggested the first Fed rate hike could come as early as March 2022 – a sharp change in tune vs. three to six months prior. In short, the table has been set for tighter monetary policy in 2022.
In our Q3 newsletter, we also shared our view that the 10-year U.S. Treasury would push toward 2% by year-end as a result of persistently higher inflation and anticipated tighter monetary policy. While we were conceptually correct, our expectation of higher rates has been reflected in the shorter maturities (2-5 years) while 10-year+ maturities have remained anchored. In fact, the 10-year Treasury yield finished the year at 1.51%, marginally higher than its 1.49% yield at the end of Q3. Stubbornly low yields at the long end of the curve (10 years+) may portend slower economic growth and disinflation over the longer term. As the ultra-low interest rates of the past 12 years have taken a monstrosity of future demand/economic activity and pulled it forward, a long period of slow growth would not surprise us in the least, particularly if central bank policies “normalize”.
Is the flattening yield curve a precursor to curve inversion, and potentially recession? Given central bank interventions in bond markets over the past many years, we acknowledge the information value of the yield curve is diminished, but we highlight yields did very well in early 2020 to predict an economic (and market) tumble as COVID-19 was just emerging. We still respect the yield curve and its abilities as a leading indicator for the economy and equity markets, and we’ll continue to watch it closely.
While the Federal Reserve (and other central banks) are arguably behind the curve in fighting inflation, we seriously question their willingness to raise rates if the economy slows. Raising rates into a slowing economy takes a level of fortitude we have not seen from central bankers since Paul Volcker in the early 1980’s. The market is currently pricing in 2-3 Fed rate hikes next year, and that seems plausible to us. The key question is at what level does the economy run into trouble? By any measure, debt levels globally are at or near all-time highs, therefore the sensitivity of the economy to every 25bp increase in rates cannot be underestimated. The economy’s breaking point today, in terms of the Fed Funds rate, is likely a lot lower than the last Fed rate-hiking cycle, which peaked at a Fed Funds rate of 2.25-2.50%. We therefore believe negative real interest rates have no end in sight, continuing to fuel asset bubbles and exacerbating risks to the economy.
Our Model Portfolios
For those who aren’t aware, ATH manages multiple model portfolios for clients of all sizes. Our models include capital growth portfolios, income portfolios, and specialty equity portfolios.
In Q3, we maintained modest fixed income allocations in most of our model portfolios, and continued to hold only real return (inflation-protected) bonds through quarter-end. During Q4, we reduced the duration of these bond holdings even further.
We also increased our weighting to gold-linked securities across all our model portfolios, in order to further fortify our clients’ inflation protection. While gold has remained relatively flat in recent months, we believe it will shine as an inflation hedge over the longer term, particularly against the USD. We remained steadfast in our holdings of infrastructure and real estate, which continue to generate attractive yields and whose underlying assets are appreciating through this period of heightened inflation.
Our equity exposure remains significant across all our model portfolios. While significant exposure to U.S. equities served us well in Q4 and throughout 2021, we are contemplating an increasing equity allocation to other geographies. For example, European and Asia- Pac equities look quite attractive to us based on current valuation and recovery prospects out of the pandemic.
As was the case through much of 2021, our individual equity holdings continue to be tilted more toward value than growth. As always, we continue to look for undervalued companies with strong and sustainable proforma free cash flows, identifiable catalysts, and sound capital allocation plans.
In closing, we’d like to wish you and yours a very happy and prosperous 2022!
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1 As measured by the Bloomberg Global Aggregate Canadian Float Adjusted Bond Index.
2 As measured by the Bloomberg U.S. Aggregate Bond Index.
3 As measured by the Bloomberg Barclays High Yield Very Liquid Bond Index.