As 2021 began, many expected this to be a decisive year on several fronts. For example, early on there seemed to be a strong belief that this would be the year which marked the end of the COVID-19 pandemic, and with it many of the associated disruptions to supply chains, employment, and global commerce. As we know today, this certainly was not the case. What’s more, though we are optimistic about the prospects for a return to some sense of normalcy in 2022, we also recognize that the very word “normalcy” has likely taken on a different, more fluid definition as of late. On that note, given what we have seen transpire in the economy and markets over the past year, we feel that it is safe to say that 2021 was a year that ultimately raised more questions than it answered.
One great example of this can be seen in what we will refer to as the “Great Inflation Debate of 2021”. The combination of subdued economic activity in 2020, a strong fiscal and monetary response to the COVID crisis and ongoing supply chain disruptions meant that prices in 2021 were all but assured to rise from the prior year. The debate, however, arose as to whether this was a “transitory” state of affairs or the beginning of a new era marked by levels of inflation higher than those encountered in recent decades. There was certainly no shortage of ink spilled by market pundits this year exploring the issue, with some very cogent arguments made by both sides (as well as an equal number of objectively bad takes, to be quite honest). As the year drew to a close, the Federal Reserve, long on the side of “Team Transitory”, appeared to have capitulated somewhat as it took a more hawkish tilt to policy, dialing back asset purchases and setting the table for raising interest rates in 2022, citing both a stronger economy and rising prices.
While this may have resolved the debate for some, we feel this shift in tone by the U.S. central bank simultaneously created more uncertainty about the road ahead. We question whether the actions currently expected from the Federal Reserve in 2022 will be sufficient to bring inflation down from its current 30-year high. In addition, we are unclear as to what “success” looks like: is it about reaching the Fed’s current long-run target of 2%, or is it simply about bringing it down to levels that, though higher than recent history, are simply more palatable than the recent 6.8% CPI YoY number seen in the November release? The ongoing pandemic further obscures the view, with little visibility on when supply chain snarls may abate or demand for certain goods and services may recover. While those calling for Weimar-style hyperinflation are most likely far off the mark, we do believe that markets in general remain quite complacent about the prospect of prices remaining at elevated levels longer than expected, and at the very least, greater volatility in inflation data going forward. We are also of the view there is a very distinct possibility markets will not know the true path of inflation for quite some time. Consider the case of the 1970s, an oft-invoked era during this year’s inflation debate. It wasn’t just that U.S. inflation averaged roughly 7% over that decade, it was also the fact that there were two clear multi-year “false dawns” in which inflation moderated, only to come back with a vengeance:
Source: Bloomberg
With this in mind, as we move into 2022, it is our intention to continue to seek out opportunities where there is an asymmetric risk/reward profile when it comes to further volatility in inflation. While some assets like Treasury Inflation Protected Securities (TIPS) or consumer staples businesses appear to have fully priced in higher inflation, we see further upside from other beneficiaries of such an environment. There are a number of well-run commodity businesses in the energy and metals spaces with low production costs and a focus on return of capital to shareholders which remain attractive, and we have recently added exposure to these businesses.
At the same time, we have also sought out businesses which possess a combination of pricing power and falling capital costs, as we feel these businesses should perform well in the face of greater inflation. Consider for example our recent investment in Western Union. Nearly one in every seven dollars in remittances is sent via Western Union, making it the largest player in the space. Though many believe digital-only solutions will obviate the need for the company’s network of third-party agents at over 500,000 locations in 200+ countries, we view this low-cost physical network as an important asset for many years to come. When combined with the company’s own digital initiatives, we believe Western Union will continue to offer maximum flexibility and competitive costs for both senders and receivers of remittances, allowing the business to continue generating both impressive returns on, and returns of, shareholder capital. What’s more, should inflation persist, we believe there is a distinct possibility that Western Union will enjoy further top line growth as recipients in the developing world seek larger remittance payments to help compensate for rising prices. Yet regardless of what the future may hold, we believe we have purchased a stake in a business that possesses a clear competitive advantage at a sensible valuation. What’s more, as of the end of 2021, Western Union offered a dividend yield of over 5%, a factor which we believe may be of increasing importance in the year ahead and likely beyond. Though investors have for quite some time been willing to pay a good deal of the promise of cash flows in the distant future, we believe this may be changing, as rising prices, likely higher interest rates, and even increased volatility may lead investors to place a greater premium on repayment in the nearer term. While this outcome is by no means guaranteed, the fact of the matter is that many of the businesses we invested in in 2021 offered outsized dividend yields. Should discount rates remain low, we believe the income offered by businesses like Western Union may help to compensate. Conversely, should these rates rise, we see these businesses offering lower “duration” to the portfolio, blunting some of the impact this may have on equity assets.
Regardless of our views on what the future may have in store, the fact remains that 2021 was, in our eyes, another year where speculators were rewarded far more handsomely than fundamentals-oriented investors. Over the course of the year, the S&P 500 registered 70 record closes, resulting in a total return of 28.7% in 2021. Though this may be cause for celebration to some, we remain skeptical of the willingness of market participants to continue purchasing equities in the face of their lofty valuations:
Source: Bloomberg (as of 31 December 2021)
In last year’s “Year End Review and Outlook”, we wrote about the rising number of IPOs by Special Purpose Acquisition Companies (SPACs). At the time, our concern was around the size of the speculative pool of capital being raised and deployed into these “blank check” companies. As a follow-up to that commentary, we would like to share with you the performance of the largest SPACs who have actually closed a deal since the pandemic began, as measured by the De-SPAC Index:
Source: Bloomberg (as of 31 December 2021)
While this chart is interesting for a lot of reasons, one clear takeaway is that an investor in a basket of SPAC investments would have performed quite poorly over the past year versus the S&P 500. Using this De-SPAC Index as a proxy, our team has increasingly come to believe the most speculative of equity assets may have peaked back in late February 2021. Moving into the second half of the year, other similar proxies for “irrational exuberance” exhibited similar behaviors, further reinforcing this view. The recent weakness encountered so far in 2022 in large cap growth equities is, in our eyes, likely this recalibration of expectations spreading to wider swaths of the general market. While it is too early to make any major prognostications on this front, it is certainly a situation we expect to follow quite closely in the year ahead.
Even with these “cracks” becoming visible, the continued dominance of animal spirits (despite frequently shaky fundamentals) raised another series of questions for us in 2021, mainly around what could cause things to finally revert to some type of reasonable mean. Inflation, despite its persistence throughout the year, had only a minimal impact on risk assets, and only then on those whose value was predicated on the most distant of future cash flows. Though some central banks recognized that more proactive measures needed to be taken to counter this inflation, markets barely seemed to react. Some have questioned whether a policy mistake (either too hawkish or too dovish) by the Federal Reserve could precipitate a market rout, and while we certainly see this as a distinct possibility, we find it equally as possible as other reasonable market risks. Whether it is geopolitical turmoil, inflation running out of control or, on a related note, a major disruption to global energy supplies, there are no shortage of scenarios that could prove to be the catalyst for further volatility.
Given that we have been expressing these concerns for some time, and that we live in a world where alarmism is in no short supply, we want to emphasize that we are not eternal pessimists. Rather, we merely wish to express the fact that assets from equities to credit to possibly even rates, in our eyes, generally have not been providing adequate compensation for the risks we perceive as of late. While there are certainly exceptions, and we work quite hard to find them, complacency on the part of market participants has meant that genuinely good opportunities have been hard to find. As such, we have continued to maintain a reduced exposure to risk assets- not out of fear, but rather out of prudence. We recognize that this is not always an easy path, but we greatly appreciate your support and trust as we look to navigate what continues to be a difficult and bewildering environment.
On that note, we ask that you alert us promptly to any changes in your financial situation and/or investment objectives that may necessitate a change to how your portfolio is managed, or if you wish to impose any reasonable restrictions to your accounts. While in the past we have sought to emphasize the importance of communication during periods of market volatility, keeping dialogue with our clients is always a priority for our team. Even if you wish to receive further insights on portfolio positioning or our views on the market, we encourage you to set up a time to talk.
We wish you all a happy, healthy, and prosperous 2022, and look forward to continuing to work together in the year ahead.