Market Review of 2021
2021 saw the a challenging year where asset classes started to move in different directions in the face of 3 main themes: Rising inflation and fears of rising interest rates, a slow-down of China's economy and tightened regulations, and the rise of Delta and Omicron variants of the COVID-19 pandemic. These 3 themes will continue to drive the returns of the various markets in 2022 and it pays for the investors to understand how these themes will affect various market returns.
Rising Inflation and Interest Rates
The sudden shock of the COVID-19 pandemic shut down oil fears, put ships and airplanes out of work and shut down a lot of factories and mines as business owners prepared for a prolonged winter, trying to conserve precious cash in the face of a diminished demand. The swift economic recovery, thanks to a combination of decisive decisions from central banks and government payouts, meant that the supply chain is unable to react as it takes time for them to restart any operations once they are shut down. Borders lock-downs, sick workers and grounded passenger planes meant that there are not enough manpower and transport to move goods around, resulting in a spike of shipping prices, which is translated to the final product costing. These disruption led to a record 7% inflation in the US last quarter of 2021, and this firmed up the decisions by US central bank to decisively cut back on the QE, while signally the intention to raise interest rates in 2022. Companies which take large and cheap loans during this period are punished, while large stable companies which generate stable profits and dividends are rewarded with record stock market growth. This lead to some expensive smaller growth technological stock still incurring annual losses to be pummeled.
A rising interest rate will also affect the value of longer duration bonds which have been issued during the period of low interest rates, generally delivering a negative return for 2021. The shorter duration bonds which are able to capture the rising interest rates, are able to make some gains as investors wanted bonds, which can react better to the changing interest rates environment.
Portfolio Strategy to Counter Rising Inflation and Interest Rates
The current portfolio is already well positioned to ride the rising interest rates trend, though some tweaks can be done to optimize for this trend. On the equity end, I will re-allocate sectors which are less sensitive to interest rates such as banking, healthcare and large cap US stock.
Meanwhile, for the bonds, we are well positioned in US high yield short duration bond which returned 7% last year as compared to the negative returns seen in a general bond fund which holds longer dated investment grade bond. As for the extremely negative return for Asian High Yield Bond, this has got to do with the property developer crisis in China, which I will touch in the next section.
A Rapid Decline of China Economic Data
At the start of 2021, many analyst expect China's stock market to still be one of the better performing markets given a stellar return in 2020 due to their exceptional handling of the COVID-19 pandemic, which enable their economy to still remain active, while most of the other countries have to endure massive shut-downs. Fast forward to 2021, the Chinese stock market became the worst performing due to a combination of regulatory crackdown, fears of a contagion due to the default of property developer, Evergrade and periodical full lockdowns in various cities due to a zero COVID strategy. Combine these with the rumor that the Chinese government is looking to force all Chinese companies to de-list from the US stock market, saw a big exit from foreign investors in China related stocks. Fears of more defaults from Chinese property developers lead to a sharp decline in Asian high yield bonds.
Chinese leaders have pledged more support for the economy as a property downturn weighs on investment and strict COVID-19 curbs hit consumption, with the recent local spread of the highly-contagious Omicron variant posing a fresh challenge. In a divergence from US, the Chinese policy makers opted to lower interest rates and looking to maintain a looser lending policy, trying to curb property and debt risks which exacerbated the economic slowdown, while having to keep inflation in check, while having to fend off a sharper slowdown that could fuel job losses ahead of a key Communist Party Congress late this year.
I have already pared down our exposure to China by lowering the portfolio allocation from 30% to 10% and re-allocating the fund from an Asian fund to an Emerging Market fund which has a lesser China weightage. Having said that, it is still not possible to escape the influence of Chinese market as long as we are investing in the Emerging Market sphere as Chinese companies are just too big to be excluded by any fund houses.
However, the valuation of Chinese stocks are looking very attractive now. For example, Alibaba has a PE of 14 while Amazon has a PE of 63. This means that Alibaba is 4 times cheaper than Amazon and is now an amazing value buy. However, the biggest worries now is the unpredictability of the Chinese government if they will force Chinese tech companies to delist from US and if the collapse of Evergrade will lead to a 1980s Japan like property crash. Property is the largest asset class held by the average Chinese consumer and if property price tank, it is expected that personal consumption will also plummet. I will expect property prices will continue to slide downwards as high risk property developers, will have to lower the prices of their new launch, in an effort to raise cash as soon as possible to pay back all the loans, which will lead to a overall drop to the prices for property. Another major fear is the uncontrolled spread of Omicron virus which will lead to a country wide lock down in China, due to a population with low immunity to Omicron and a less Omicron effective vaccine. The Chinese stock market is expected to take another dip in the event any of the above mentioned take place.
Although, the Chinese stocks are cheap now, I will prefer to era on the safer side and wait for more development first, else we will risk buying into cheap stocks which have potential to turn cheaper. We can start to tranche some allocation in over the period of next 2 years as the Chinese market bottom out.
The Rise of Omicron
The battle of COVID-19 was predicted to end in 2021 when the vaccine was expected to return society to normal. Reality is that the COVID-19 variants evolved quickly to start evading the vaccine just when it is rolling out through out the world. Most of the countries have returned to some form of normalcy with restrictions being imposed now and than whenever hospital systems start to get overwhelmed. The optimism that the extremely infectious Omicron seems to have evolved to a less serious disease and if this is the trend going forward, Omicron might evolve to another less deadly variant allowing humans to live as normal like the flu. The markets have more or less factored in the new normal and unless a new variant appears that seem to be more infectious, more deadly and more evasive to our current generation of vaccine, than we will probably see new hiccups to the stock market.
Portfolio Strategy to Manage Omicron and Possible New Variants
Unlike China, where we can choose to omit from our portfolio to reduce the risk, there will be no escaping a new COVID-19 variant should it occur and the best thing to do is to buy some insurance in the form of bonds and stay-at-home related stocks like technology. Although Tech stock has underperformed the S&P500 in general for 2021, its performance is still excellent, as compared to returns from other regions and other industrial sector. We will still be holding on to our technology fund as it is still serves as both a useful hedge and a good source of returns thanks to its inherent growth nature, though I will switch to another Technology fund with more focus in the US based tech companies rather than a more global one with exposure to China's tech giants, which has severely underperformed in 2021.
What About Investing in 2021 Top Performer: Energy?
The conventional wisdom is to invest in commodities when inflation starts to run high but I am not convinced that this trend will persist. The reason why for the recent spike in commodity prices is due to lack of capacity due to mines and plantations shutting down in response to the pandemic, and not a sudden surge in demand like what we saw in 2003 when huge populations in China and India entered the middle income belt. It is easier to restart an oil rig which has been shut down, than to build a new one where you will need to build a whole host of accompanying industries like refineries and storage to process the new supply. With aggressive monetary policies by US, faster adaptation of green energy and restarting of various oil facilities around the world, we may even risk a situation where the world will see an oversupply of oil, like the period just before the pandemic. In fact, oil price might have another collapse as supply regain its previous volume while air travel is still restricted due to the pandemic. I will prefer to avoid Energy under this hypothesis.
Portfolio Performance for 2021
The cash portfolio returned 10.77% while the CPF portfolio has returned 6.86%. The CPF portfolio returned less than Cash is mainly due to the underperformance of Franklin Opportunity Fund which has a huge allocation into Technology, which helps it performance in 2020 but dulled its performance in 2021. The portfolio has been caught off guard by a series of negative events in China in the first half of the year with it's 30% allocation in Asia, but the impact has been minimized as the allocation has been shifted to 10% into Emerging Markets with less emphasis on China. The portfolio also lowered it's equity position from a 80/20 to a 70/30 in the later half of the year to create more buffer in case of a possible market shock, which may happen as a result of either a China property collapse or a too tight of a monetary policy. I may move more of the allocation towards long duration bonds as interest rates become higher, making them a more attractive investment and better hedge against market shocks.
Though the COVID situation has stabilized some what, new threats have emerged making 2022 another uncertain year to navigate. As usual, it pays to be nimble, in order to protect the capital and make a decent return in the financial markets!
Wishing everyone a Happy Chinese New Year and good health!
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