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Asset class review and outlook

Senior Investment Manager George Lin takes a closer look at how the various asset classes fared this year and offers insight into what the future could hold for each sector in 2022.

       Written by George Lin
Senior Investment Manager | Colonial First State
   

Fixed Interest

Fixed interest investors had a difficult 2021. The main drivers of higher equity markets, vaccination rates and re-opening of economies, also mean a “normalisation” of macroeconomic conditions and higher interest rates. The upward pressures on bond yields were further aggravated by persistently higher than expected inflation in a number of developed economies, including the US, since mid-2021. The benchmark US 10 year bond yield started 2021 at 0.84%, rose sharply and reached a peak of 1.73% in early March before concerns about Delta drove the yield lower. It is currently trading at around 1.50%. The Australian 10 year bond yield followed a similar pattern with even greater volatility – reaching a peak of 2.08% after the RBA announced a tapering of its bond purchase program and abandoned its yield curve targeting for three year bonds. Corporate bonds outperformed as credit spreads stayed narrow and corporate fundamentals improved as economies re-opened.

Looking forward in 2022, further reductions in asset purchase programs by central banks will likely exert continuing upward pressures on bond yields. However, bond prices have already aggressively priced in a lot of policy tightening and bad news on inflation. Five year US breakeven traded as high as 3.03% before easing back due to Omicron. We believe sovereign bonds, despite their low yields, still have a legitimate role to play in a multi asset portfolio as a diversifier against equity. We have a more constructive outlook on corporate bonds as corporates, especially investment grade corporates, are entering 2022 with strong balance sheets and improving economic conditions.

Australian and Global Infrastructure

Global infrastructure posted positive returns for the year to date in 2021, fuelled initially by the COVID re-opening trade, then sustained by the inflation protection features of the asset class as inflationary concerns came to the fore during the second and third quarter of 2021.

The initial re-opening rally mostly benefitted passenger transport infrastructure (toll roads, airports and passenger rail) as lockdowns eased and mobility began to recover. The Delta wave in mid 2021 paused the recovery of these infrastructure sub-sectors, with these now close to flat and underperforming relative to other infrastructure assets for the year to date in 2021.

The inflationary concerns lifted infrastructure assets with strong inflation characteristics, making them the strongest performing infrastructure assets year to date in 2021. These assets includes midstream pipelines, as beneficiaries of recovering energy prices, marine ports from supply chain demands and telecommunication towers with their high rate of structural growth from data consumption which is expected to outpace inflation.

Infrastructure Merger & Acquisition activities featured prominently in 2021, as listed infrastructure assets which traded lower than their pre-COVID levels were bid for by private infrastructure capital. This was particularly true for Australian infrastructure assets such as Sydney Airport, Spark and AusNet.

Infrastructure remains long-term assets which are vital to the economy, often with earning increases directly or indirectly linked to inflation. In an environment of a recovering economy and increasing inflation, infrastructure assets with stable patronage and the ability to pass on increases in cost, should perform well.
 

Australian and Global Property

Both listed Australian and global property delivered positive returns for the year to date in 2021, driven primarily by a recovery of assets hardest hit by Coronavirus in 2020.

Globally, the U.S. led the property recovery in 2021. Its relatively relaxed Coronavirus restrictions supported retail mall assets as mobility recovered. The self-storage and residential subsectors benefitted from the traditionally high geographic mobility in the U.S., accelerated by a migration shift towards the Sunbelt states. Inner city apartments also advanced later in the year as workers return to urban offices.

In Australia, retail and offices gained ground in the first half of this year in line with global trends. Although the Sydney and Melbourne lockdowns dampened their recovery in the middle of 2021, positive signs are emerging for these subsectors since the lockdowns ended. At the sub sector level, fund managers has led year to date in 2021, driven by their sustained asset growth and positive property revaluations. Childcare centre and self-storage are also among the strongest performing subsectors.

The outlook for property remains positive in 2022, with tailwind of a continued recovery from the most severe Coronavirus restrictions. Recent unlisted property transaction yields suggesting further upside to assets values held by listed property trusts.

Australian Shares

In 2021, Australian Shares continued their strong performance from the tail end of 2020 despite ongoing macroeconomic uncertainty. The recovery has been supported by a positive recovery in earnings as the Australian economy, backed by government stimulus and positive sentiment with the vaccine rollout, continued to grow. Supply chain challenges and shortages remain common themes from companies and of particular importance in the lead up to the Christmas trading period ensuring there is sufficient inventory but also managing higher costs that will impact earnings and margins.

Australian small caps outperformed broad cap calendar year to date. Small caps benefitted from strong performance in the resources sector. Lithium and copper stocks outperformed, driven by a transition to a lower carbon economy. Ironically, coal stocks also performed strongly as coal prices surged following the energy crunch in China. As a result, small cap resources are currently trading at a premium to large caps whilst small cap industrials are trading at a discount.

The earnings outlook for 2022 remains positive but we have started to see some headwinds and downgrades for key sectors such as banks and resources, impacted by falling iron ore prices. The expectations of rising interest rates and the impact of higher inflation are key areas to watch with their impact on earnings a key driver for returns in 2022. Valuations remain elevated relative to history with a level of support given earnings expectations.

Global Shares

Developed market equities had a spectacular year as economies re-opened following mass vaccination programs. At the country level, the US continued to be the strongest performing equity market. The S&P 500 rose 21.6% as at 30 November 2021, while the technology dominated NASDAQ rose by a slightly lower 20.6%. Among the main developed equity market indices, the Hang Seng is by far the worst performer and fell 12.8% as investor sentiments towards China deteriorated through 2021.

Performance of Major Equity Indices (YTD 30th November 2021)
S&P 500 NASDAQ EuroSTOXX FTSE Hang Seng
21.6% 20.6% 14.8% 5.82% -13.8%

Source: Factset

The fluctuating fortunes between value and growth stocks also stood out in 2021. Value outperformed growth by 6.7% in the year to 30 September 2021, with the outperformance concentrated in the March quarter of the year. Despite the recovery in value as an investment style in 2021, the long term underperformance of value relative to growth since the Global Financial Crisis persisted.

We are cautious on the outlook for developed market equities in 2022. Expensive valuations, the prospect of higher inflation and interest rates are all potential headwinds. The prolonged underperformance of the value style and its attractive valuation, compared to its historical average, suggest that there is a slightly higher than average probability of a relative outperformance outcome for the value style.

In contrast to the stellar returns generated by developed market equities, emerging market (EM) equities had a positive but subdued year. China is a major factor in the relative lacklustre performance of EM equities given its large weight of around 34% in the benchmark. The heterogeneous nature of EM equities is again demonstrated by the large disparity in returns from different countries: India surged by 51.9%, despite the ravage of Delta, while Taiwan, driven by strong demand for semiconductors, rose 42.1% and China fell 8.1%.1

The attractive valuation of EM equities, relative to developed market equities, is a feature which should support its return in 2022. However, China will be a key driver of EM’s outcome, due to the size of the economy and its weight in the benchmark. This means Chinese domestic political and economic developments, as well as Sino-US relationship will be critical.

Liquid Alternatives

2021 has witnessed a largely supportive environment for liquid alternatives interspersed with some episodes of volatility, as the economic recovery from 2020 continued.

Strategies that benefitted primarily were equity-linked and those with exposure to commodities, such as trend-following, as inflation concerns continued to rise – for example tracking rising global energy prices. Global macro and asset allocation funds have needed to navigate some turbulent events in fixed income, interest rate and currency markets as the pace and timing of interest rate rises and the end of central bank asset purchases have remained a key focus. A largely benign credit market, with low levels of corporate defaults has been beneficial for managers investing in this space. In equity markets, long/short sector specialists have benefitted from continued dispersion in healthcare and technology.

Looking ahead in 2022, the macroeconomic environment is expected to present continued opportunities for investment managers operating in a variety of markets. Corporate activity in both equity and debt markets remains robust. We expect continued periodic volatility as the pandemic plays out and global central banks look to increase historically low interest rates amidst a backdrop of heightened inflation. The positive is this also provides potential opportunities for managers taking directional or relative value views in bond, equity, currency and commodity markets.

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