December 2021

“Inflation is the senility of democracies.” 

Sylvia Townsend Warner

Inflation and the Omicron COVID variant were the main drivers of markets in December as the former’s continuing rise finally compelled central bank action with the Fed formally announcing the beginning of the tapering process for bond purchases, while the Bank of England raised its benchmark rate to .25%.  These actions – auguring the arrival of the tightening cycle – were well received by a market that has grown increasingly worried about the disconnectedness of monetary policy and monetary reality.  On the other side, the rapid spread of Omicron led to the reintroductions of restrictions, including full lockdowns in several jurisdictions, which dampened activity in the more vulnerable sectors during what would have otherwise been a buoyant period of economic activity.  For the month, the SPX rose over 4%, while USTs traded in a fairly narrow range just below 1.5%.  In Europe financials recovered most of their November losses while credit markets tightened back, led by the larger beta names amid usual light year-end volumes.  Against this backdrop the fund’s A shares gained 1.3% to end the year up 9.3%.

Looking forward, 2022 promises to be a watershed year.  For the first time in four years both risk assets and the economy will face higher interest rates in most key markets, a challenge that takes on new meaning given compressed risk premiums, stretched tech valuations and the mountains of new government debt taken on to fund COVID relief.  The historical record suggests there will be rough times ahead; the only question is whether we see a major correction or a relative underperformance in certain sectors.  The key variable is the degree to which the inflationary cycle has taken hold and wage increases accelerate.  While policy makers have already signalled their intent to move slowly the risk remains that given conditions in the labour market the Fed will have to accelerate rather than pause.

It will be a very interesting year for European financials.  On the one hand higher rates will help reduce pressure on NIMs, even if the ECB doesn’t move official rates, which should be supportive of equities while creating challenges for credit markets.  On the other hand, a risk off environment would be destabilizing for all sectors.  In the wake of the dot com collapse 20 years ago banks generally outperformed but suffered nonetheless, driven by exposure to tech companies and fears of extended economic contraction.  The underlying fundamentals this time around are such that more extreme downside scenarios cannot be ruled out.

As a consequence, we enter the new year without long term convictions.  Our equity exposure remains fairly concentrated in deep value names with tangible catalysts for performance, typically driven by the ongoing twin themes of capital repatriation and consolidation.  On the credit side we will continue to use strength to reduce net exposure while monitoring the broader fixed income markets.  Our overall objective is to retain flexibility to react to what we believe could be a volatile year.