The last week of 2021 was fairly uneventful with markets in the US, UK and Australia ending up flat for the week, behind Europe and emerging markets. Maybe Australian long-term bond rates were a little volatile but we will see what happens when decent trading volume returns.

The topic du jour though for most pundits this week is what happened last year, as in “WHAT HAPPENED LAST YEAR!” It turned out to be another banner year for markets, the third straight one in a row, taking most markets, and especially US markets, to all time highs. Early in the year value (industrial, cyclical and financials stocks) made a huge come back off the back of the Biden reflation trade and vaccine sponsored reopening theme. Inflation expectations picked up and bond rates followed suit leading to negative returns on government bonds.

Then the Delta variant reared its ugly head (followed by Omicron later in the year) putting markets on the back foot. This also exacerbated supply chain disruptions and made so-called transitory inflation pressures look much less temporary. The extent to which inflation is also being affected by demand pressure due to the high levels of fiscal stimulus is debatable (as discussed in detail in last week’s video) but the result is the same - real rates of interest (the return on capital after the effects of implied inflation) fell deeper into negative territory as bond markets bet that deflationary pressures will eventually force central banks to support economies and markets again with ultra low short-term rates. This has a perverse effect on stock valuations as future cash flows (growing with inflation) become exponentially more valuable if they are discounted by a negative real rate. The easiest way to internalise this is to think about how much a house is worth if you can fix a long term mortgage at negative real rates while you expect its rental receipts and/or capital value to increase in line with or above a higher inflation number. The longer you assume this to persist the greater impact it has on valuing cash flows further out in the future, so higher growth stocks benefit proportionately more. If you assumed this situation persisted forever there is no limit to the amount you would theoretically leverage up and how much you would pay for the house or other asset as the value of the debt is being eroded by inflation while the ‘real’ cash flows and asset values are growing. Or as one market commentator put it on the Seeking Alpha podcast over the weekend when talking about the outlook for stocks in the context of persistent negative real rates “…put what ever number you want on it, it's not reality anymore”.

This brings us to another dominant theme of 2021 - the increasing importance of retail investors, many of whom took up trading with much gusto during the lock-downs of 2020 and apparently continued to put at least some of the direct fiscal distributions (Job Keeper and its overseas counterparts) to work in the markets. Early in 2021 there were some eye-opening interactions by retail investors in so-called Meme stocks where a group investors on on-line forums would co-ordinate and pump small lightly traded (and often shorted) stocks to previously inconceivable levels (at least if valuation is still a thing). This was interesting to watch but had little impact on mainstream portfolios but later in the year retail flows shifted to the use of options to leverage into more mainstream stocks and by the end of the year traded volumes of options on individual stocks, mainly by retail investors, had risen 4 fold compared to pre-pandemic levels.

A disproportionate amount of this trading and leverage was focused on just one stock, Tesla, but also in other household names like Amazon, Apple and Google as well as Meme stocks like GameStop and AMC. We discuss the drivers of this in greater detail at a market level and amongst some of the bigger stocks in this weeks video. The overall effect was to increase volatility and, by and large, the most volatile bets of 2021 were the most successful. However, there were some important Asian exceptions, like Alibaba and Tencent, where the volatility was seen more on the downside due to a Chinese Communist party that has sought to prioritise domestic consumers over its corporate national champions. That left the US market on top with a return of over 35%, while Europe and Australia looked relative laggards returning a mere 24% and 17% respectively. Meanwhile Asia, Japan and most other emerging markets languished in single digits but at least remained in positive territory.

While the return for Australian equities in 2021 was nothing too sneeze at in absolute terms, it also came from a narrow set of constituents. In our case the banks, which were up on average 25% and contributed 7% to the overall return. This also came with considerable volatility, although not by as much as the next biggest contributor, the Materials sector, which was up on average 14% but with considerable volatility and not just due to the huge swings in the Iron Ore price. Pilbara, Mineral Resources and Lynas and a host of smaller Rare Earth/Lithium miners also made meaningful contributions, benefitting from the global shift to electric vehicles. The shift towards sustainable and other socially aware form of investing also came to greater prominence in 2021 and investors pockets were rewarded as much as their pockets as funds flooded into ESG (Environmental, Social and Governance) focus funds, raising the prices of the underlying stocks with better ESG credentials.

Lastly, and as one would expect in rising inflation environment, fixed income government bonds were the worst performing asset class. Although, again as discussed in this weeks video, they actually performed surprisingly well as the various central banks appeared to do an astonishingly good job of ‘talking down’ rates as well as through their various bond buying programs. Credit markets also benefited and spreads (the premium paid for corporate default risk) fell to all time lows earlier in the year and stayed more or less pinned to those levels for the rest of the year.

Well that was 2021. Next week we will turn our focus towards 2022, one of the main preoccupations for ourselves, and we suspect markets in 2022 will be influenced by how long this era of cheap money can be sustained.