DB Wood Team
7th January, 2022
Quarter 4 2021 Investment Review…
We entered the last quarter of 2021 with significant ongoing COVID uncertainty, rising inflation and with policymakers considering their hand, on interest rates. We finished it with slightly less COVID uncertainty, still high inflation levels and more restrictive policy with a tick up in interest rates. Importantly, markets took all that in their stride and finished the year on a positive footing.
On the COVID front, none of us had even heard of Omicron on 1st December, and yet just a month later, it’s dominant all over the globe. Positive news emerged suggesting that we are around 70% less likely to go to hospital when catching it compared to delta (Chris Whitty), and with the booster roll-out continuing apace here, only minor additional restrictions were brought in before Christmas. Cases have been making records across the globe, but as outlined, hospitalisations and deaths remain low compared to the past two years.
Perhaps the biggest aggregate impact will come from the sheer number of people isolating (more than 1m in the UK alone at the time of writing), and prior to that we were already noticing signs of the growth rebound slowing. That was why it was surprising to see policymakers in both the UK and US start to act. Here at home the Bank of England raised interest rates for the first time since 2018, from 0.1% to 0.25%, and in the US the Federal Reserve further reduced the pace of their monetary easing. The main rationale for the change is not a positive economic outlook, but more the level of inflation, which is above 5% in both countries. Central Banks felt compelled to do something to try to stem that tide, despite the economic outlook looking mixed.
Investment markets as a whole were volatile in Q4, but overall finished the year well. The UK and US markets were strong, with the FTSE 100 for example adding 4.74% in the last quarter of the year. However, it wasn’t all rosy, with other areas such as Japan and Emerging Markets in the negative. Bonds were flat, capping off a challenging 2021. The UK gilt sector as an example lost 5.4% on the year overall, a big challenge to lower risk investors who typically rely on bonds for a significant part of their portfolio. Thankfully, commercial property and other alternatives performed solidly to finish the year, providing nice steady income driven returns.
Overall, it was a reasonable quarter. Economic growth pointed to a short-term slowdown, inflation a continued threat, and fiscal policy tightened. Investors, however, appeared to take the view that the latest COVID trends would reduce the chance of further restrictions, not increase it, and that this would provide some light at the end of the tunnel. That seems a reasonable basis to approach 2022 on, which we will discuss further in our outlook.
When we set out to allocate the portfolios, our aim is to provide consistent and dependable returns, through diversifying our asset mix in line with how we see the forthcoming threats and opportunities. This requires careful consideration of a range of possible scenarios. We aim to create what we think is an optimal balance.
Throughout 2021, though particularly in Q4, it was hard to recall a time where there were more scenarios, be it the path of COVID, inflation, government policy and the impact on growth. 2021 was therefore a very challenging year to manage, though we are pleased overall to have navigated it successfully.
Zooming in on the fourth quarter, the portfolios returned between 1.06% and 1.59% depending on the risk profile selected. A bit like the first quarter, the market shifts were violent with a resurfacing of inflation fears. We had anticipated this to a large extent, though some of our core equity holdings still underperformed their peers slightly across Q4. This does not worry us moving forwards, as we expect policy makers reaction to inflation to be constructive, and therefore some of the themes which hurt our higher risk portfolios in Q4 such as technology and renewable energy will benefit as this plays out. Investing is about taking the rough with the smooth.
In the lower risk space, our reduced fixed income, and increased alternatives exposure, capped off a strong year. We hold very little exposure to UK bonds, and as we have stressed for some time, this market along with others in fixed income, appear to hold all the risk with little return potential, so there is no compelling reason to invest. The return on UK government bonds was -5.38% last year, so our decision to reduce our exposure to the fixed income sector to record underweights, comparative to our peers was well supported. Add to that our alternatives bucket (including UK commercial property, infrastructure, commodities, and absolute return) which added 5.73%, and you can see why the lower risk portfolios outperformed their benchmarks by a significant margin in 2021.
Overall, the annual returns for the year finish between 3.14% (Very Low Risk) and 9.32% (High Risk). As a whole it represents an excellent outcome, where all portfolios hit their targets. More importantly, we always try to remember that one quarter or year doesn’t make a financial plan work, and it’s absolutely about providing consistency in our returns. The long-term numbers on the chart below support this. It’s great to see that even a client who invested in our Low to Medium portfolio 3 years ago has seen their portfolio grow by 25%. This has been achieved whilst also trying to protect against a lot of headwinds over this period. Whilst we are pleased with our delivery, as you’d expect, our focus has already shifted to continue to build on this foundation across 2022.
We enter 2022 both optimistic and cautious. On the positive side we remain in an era of rapid technological innovation that is providing efficiencies and standard of living improvements, the pace of which has not been possible in the past. We haven’t even scratched the surface of artificial intelligence, or the required transformations to stem climate change. New industries are developing and old ones revolutionised. That provides exceptional investment opportunities if you can find the winners.
At the same time, we cannot ignore some of the short-term challenges. Inflation remains higher than we would like, and Central Bankers appear keen to increase interest rates. Both of those factors might constrain consumer spending, which is a centrepiece of developed economies. Here in the UK, we have a Conservative government who are increasing taxes on both individuals and business’, with an aim to recoup some of the money spent during the pandemic. At the same time people on aggregate remain cautious in their social lives, again resulting in lower spending. All of that suggests GDP growth will slow as we progress through 2022.
One of the key questions for markets is what do policymakers do when growth slows? Do they only worry about inflation and keep raising interest rates, or do they care more about the wider picture and remain accommodative? We can’t rule out the former, but it seems much more likely that they take a more pragmatic view. The reason is that we are all more connected to the performance of investments than ever before, both with respect to the ease of investing in them, and the confidence good markets create. Policymakers are therefore somewhat constrained by the impact of their decisions on markets, and if growth is slowing, they have the perfect cover to continue to support. We therefore think that despite all the talk about inflation and interest rates, when push comes to shove, they will continue to change things slower than is currently expected.
As such we remain slightly overweight in equities across the portfolio range. At the same time, we have taken some profits on a few positions that performed very well in 2021 and have increased the cash levels in the portfolios to an average of 5%. This is our liquidity buffer to deploy if we see market volatility, so we will remain active on your behalf. Regionally we continue to prefer the US and UK to other areas. The US is the technology leader, with much of the innovation in some of the newer industries happening there. The UK on the other hand seems likely to progress more speedily from a COVID perspective, given record vaccinations and high previous infection levels which should provide better protection going forwards.
Despite our view that interest rates will remain lower for longer, we are cautious on fixed income as valuations are still very expensive. We remain underweight here compared to our peers. Instead, a significant portion of our Low-Risk portfolios are invested in absolute return which aims to provide a positive return in any environment, giving us a good anchor if things play out differently to our expectations. Commercial property should continue to deliver 3-4% per annum as well, and therefore remains in our portfolios with a specific role, albeit at lower levels than we have held historically.
So we are cautiously optimistic heading into 2022. The opportunities are definitely there as innovation continues apace, though markets will continue to require supportive policy to grow at the rates they have in recent years. Should inflation stay higher for longer, that could provide significant challenges, though we are also somewhat positioned for that with cash levels higher, allowing us to use any market shifts to our advantage.