06 Jan 2022
In time honoured tradition I thought I would have a quick look back at key themes of 2021 and set out some thoughts for 2022.
Bond yields moved higher over the year. Looking back, I am surprised to be reminded that 10-year gilt yields started 2021 below 0.2% before climbing to 1.2% in October, rallying to 0.75% in early December and closing at 1%. Gyrations in the US treasury market were a bit less extreme: starting below 1%, the peak was recorded in March at 1.7% before falling back to 1.2% by August and ending the year above 1.5%. German 10-year yields remained negative throughout the year, ending at -0.2%.
Concern about inflation was the economic theme of 2021. Again, the UK led the way in terms of market moves. If we look at implied inflation at a 20-year horizon, we can see that 2021 started with a rate just above 3%, before moving higher to 4% during the course of Q4. Movement at the short end of the implied UK inflation curve was more extreme, mirroring the sharp rise in the Retail Price Index. Other markets showed similar patterns, as their own inflation measures adjusted to higher energy costs, supply chain bottlenecks and labour shortages.
Global growth picked up through the first half of the year although expectations were pulled back in the second half, as new Covid variants and lockdown responses offset some of the good news about vaccines. Central bankers became more concerned about inflation and in the latter part of the year the US Federal Reserve and the Bank of England both signalled a tightening of monetary policy, despite some loss in economic momentum.
My outlook throughout the year was driven by real yields. Despite concerns about rising defaults in credit and margin pressures for corporates in general, the key to risk asset performance remained the amazingly low level of real yields. Yet again, investment credit outperformed government bonds with the higher initial yields contributing to this outcome. If we look at the sterling market, spreads over the year were not much changed at the index level, despite showing some tightening during the summer period. At a sector level, there was not significant divergence although it was pleasing to see the strong performance from asset backed and collateralised debt – a key driver of the outperformance seen in our strategies.
High yield was more interesting. The search for yield, combined with ultra-low refinancing costs, proved to be a positive mixture for higher yielding bonds. Over the year, high yield spreads ended comfortably tighter – although the Evergrande default and concern about emerging market debt temporarily derailed the trend in early Q4.
I remain cautious on government bonds. This reflects both the waning impact of QE and the bounce back in economic growth. There is scope for US treasuries to settle above 2%, with real yields moving higher and yield curves to steepen. However, on a secular basis we remain in a relatively low growth phase – despite the technology advancement all around us. We cannot buck the long-term impact of ageing societies, nor the bills that will need to be paid for Covid and preparing for the next pandemic. In the UK this means more of our national spending going to the NHS – and more issuance of government debt.
To reiterate comments made in previous journals I am not an inflation ‘bear’, as I see some of the present pressures as being temporary. Consequently, I see little value in long-dated index linked gilts and much prefer short duration strategies in those markets where inflation protection is not so expensive.
On credit, the usual question is being asked: will credit outperform government bonds? This is not a coin toss. The simple observation is that credit generally outperforms – with the caveat that when credit underperforms the magnitude can be meaningful. However, for long-term investors the balance of outcomes sits firmly in favour of credit if you can stomach the bad years. Consistently, long-term investors get paid well for taking default risk. Interestingly, despite concern about BBBs and ‘cuspy’ credit, it is these areas where compensation is higher than required for the probability of default. Of course, this is a general observation and individual credits going wrong can impact performance if the weighting is inappropriate. So, my approach is to run diversified credit portfolios, take the carry, live with issuer volatility, and prefer asset backed bonds where possible. In my opinion, the illiquidity premium available to long-term investors, due to market traders’ concern about issue size and complexity, is a great source of long-term performance.
Happy New Year to everyone.
Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.