Monthly Partner Memo - January 2022

December 30, 2022 | Paul Chapman


Take comfort in the knowledge that your capital is being managed the way your friends complain they wish theirs was managed.

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” – Peter Lynch

Disclaimer: Note that the contents of this memo are all my thoughts, and not that of RBC or RBCDS.

Friends & Partners,

I hope that you and your family have had a restful Holiday Season, even though Omicron has put a crimp in many of our respective holiday plans.

Before we look forward to 2022, let’s reflect on 2021, as difficult for many as it was. I greatly appreciate my clients, partners and firm, and I hope that you have enjoyed my monthly Partner Memo throughout the year and I sincerely thank you. Your partnership and attention is precious and inspires me, and I try to honor it by giving you my best – my clients are my family.

As we assess the future for our investments and planning, I would note that 2022 is truly unknown territory. Central Banks have signaled that they will begin to raise rates and tighten monetary conditions – they have essentially fueled all asset prices for years, and most of us have experienced this first hand through investment and real estate value gains, to name a few. 2022 onward will be a different investing environment than most have ever known.

Omicron has caused some market and economic turmoil, but appears to be relatively short-lived and should not require widespread economic shutdowns. That said, this market isn’t ‘cheap’ (over 20x next year’s earnings), and we are heading into a macroeconomic environment that is characterized by 1) stubbornly high inflation, and 2) global central banks aggressively removing accommodation in 2022 in a way that we haven’t seen in 30 years. Central banks will essentially be taking the training wheels off of this market (though they will still remain very accommodative by longer-term historical standards). The market has also been led for the last several years by the tech sector and high-tech growth companies, which have benefitted from the low yield environment that is ending.

This set up doesn’t mean that stocks can’t produce positive returns in 2022. Below I list a number of reasons we may actually see solid returns in equities in 2022. But it does not leave a lot of room for error. The recent market noise is likely a very clear warning that 2022 will be more volatile than 2021 and while the outlook for stocks is still positive, we need to re-calibrate our return expectations to something more historically ‘normal’.

Given this inevitable volatility that I expect to continue in 2022, I would caution investors about being complacent since returns have come ‘easy’ for some time. I would encourage most to look at risk managed portfolios and solutions and think about how to minimize volatility – this is where I can help.

Best wishes for a prosperous 2022!

Volatility will Reign in 2022, So How Can we Position and Prepare?

With fixed income no longer as effective for diversifying portfolios, half of global family offices (51%) confessed to researching possible “alternative diversifiers,” such as areas within hedge funds and private equity.

Below is a chart from the UBS Evidence Lab showing global family office strategic asset allocations. As you can see in the illustration, ~40% of assets are allocated to alternative asset classes, in line with many other similar charts I have highlighted here showing pension and endowment allocations.

Having exposure to asset classes outside of just stocks and bonds should continue to provide ballast and stability within a portfolio. Partner with an Advisor who has extensive experience in alternative assets and can help navigate those asset classes. That is a very short list in this country.

Strategic asset allocation for 2020 (individual families’ net worth averaging USD 1.2 bn across almost 200 families):

Source: UBS Evidence Lab


The following chart shows just how low individuals are in their allocation to alternatives – there is room for improvement for individual investors on this front:

"Friends don't let friends buy index funds."

A great quote from the great John Mauldin.

As most of you know, I am a staunch supporter of alternative assets as part of a sound portfolio given the current environment, and have shown that many of the world's leading institutions employ a significant allocation to alternative strategies.

But where does one start here? As you can see in the picture below, finding the best managers for equities certainly adds some value, but finding the best managers in alternatives is key as the return dispersions between managers can be massive.

We are entering a different investing environment than most of us have ever known. Alternative assets can provide uncorrelated returns and a ballast to portfolios in an environment where bonds may fail to. But partnering with the best managers on this front is paramount - so you need to navigate this landscape with someone who has very deep knowledge and relationships in that space.

(Note that the investment strategies mentioned here may only be suitable for certain investors or portfolios.)

Reasons to Remain Optimistic on Equities into 2022

Though we should expect a bumpier ride in 2022, corporate earnings remain strong, inflation pressures might finally be peaking (which should ease pressure on margins) while overall global economic growth remains robust and resilient. Covid should finally subside with broad immunity and therapeutics becoming widely available. This should result in a strong cyclical recovery, a return of global mobility, and a release of pent-up demand from consumers (e.g. travel, services) and corporates (inventory, capex, and buyback recovery).

The natural question is what to expect for markets in 2022, particularly after a 27% gain in 2021. Fundstrat’s head of data science team pulled together some statistics on this front:

  • Equity markets return median 11% following a >27% year
  • Post-1938, returns are even higher
  • Median gain is 16%, average gain 12%

And though the market has been much more volatile than usual this December, there have been five prior years since 1953 (when we went to the 5-day trading week) that have seen December as the most volatile month: 1973, 1978, 1985, 1995, and 2018. The January following these five prior years was BIG positive four out of five times, with January 2019 seeing the biggest gain. ‘Seasonals’ and technicals are often self-fulfilling…

Source: Bespoke

On the corporate earnings front, current consensus forecast shows that research strategists across the street, on average, expect the S&P 500 to reach 5,225 in 12 months, representing a ~12% advance from current levels. But history suggests that actual results will be quite different from that. Fundamental research Analysts are currently predicting 9% earnings growth for 2022, indicating some analysts are expect a modest degree of multiple expansion to contribute to returns as well (even from current lofty levels). But it is also worth keeping in mind that analysts may still be underestimating corporate earnings power, which is what happened this year that helped to drive strong equity market gains despite moderate multiple contraction: Analysts started this year forecasting $167 EPS for the S&P 500, which is currently on course to print just above $200 EPS to close out the year, that’s one big ‘beat’ by corporates.

Finally, it is worth noting that there is a lot of buying power out there. Cash levels have built up strongly, suggesting there is more dry powder to support the market. This chart shows US money market funds and Fed funds rate:

Source: EPFR, GS

Omicron – What We Can Expect From Here

Recent news on Omicron confirmed what the market previously expected, namely that Omicron was much more transmissible, but it caused much less severe cases. As such, Omicron is seen as not a major threat to the healthcare system and won’t likely require lockdowns. Second, cases in South Africa, where the variant originated, fell precipitously and that implies that Omicron is so contagious that it essentially “burns itself out” quickly, and this latest COVID wave should pass relatively soon.

Latest forecasts I’ve seen on this front comes from our tireless research team who expect cases in the US to peak in the first half of January and begin rolling over fairly quickly.

Should We Fear Interest Rate Hikes? Not Necessarily

While the transition from easing to tightening is likely to create volatility, we shouldn’t necessarily fear the start of a rate hike cycle. Looking back at the 16 historical tightening cycles since 1917, we see that stocks, on average, tend to climb going into the first Fed rate hike and in both the 6 and 12 month time frames following the liftoff. The odds of generating positive returns in the 6-M and 12-M period following the first Fed rate hike are strong (81% and 69% for the S&P 500, and 93% and 80% for the TSX, respectively). As well, bonds tend to suffer from rising bond yields when tightening starts – something I’ve written about ad nauseam.

Inflation – Where Do We Stand Today and What Are The Risks?

Inflation remains front and center as an investor concern. The concern is how high, how long, and will it cause a recession. The good news is that although one-year consumer inflation expectations continue to surge, the three-year indicator seems to have peaked:

High inflation can be tough on equities during certain time periods (chiefly the late 60’s into the 70’s). The million dollar question is will inflation eventually cause a recession? Former Secretary of the US Treasury penned a recent column in the Washington Post that isn’t overly encouraging on this front. Here is an excerpt:

“There have been few, if any, instances in which inflation has been successfully stabilized without recession. Every U.S. economic expansion between the Korean War and Paul A. Volcker’s slaying of inflation after 1979 ended as the Federal Reserve tried to put the brakes on inflation and the economy skidded into recession. Since Volcker’s victory, there have been no major outbreaks of inflation until this year, and so no need for monetary policy to engineer a soft landing of the kind that the Fed hopes for over the next several years.

“The not-very-encouraging history of disinflation efforts suggests that the Fed will need to be both skillful and lucky as it seeks to apply sufficient restraint to cause inflation to come down to its 2 percent target without pushing the economy into recession. Unfortunately, several aspects of the Open Market Committee statement and Powell’s news conference suggest that the Fed may not yet fully grasp either the current economic situation or the implications of current monetary policy.”

But so far, the bond market doesn’t seem to feel that inflation is a problem at this point. And some smart folks believe that inflation will subside in 2022 and that the bond market already sniffed this out. Time will tell.

And in recent history, if there is a relationship between TSX profit margins and inflation in recent years, it would appear to be positive:

Regardless, we have to be prepared for the inevitable market noise that the evolution of the higher inflation outlook will create.

Disclaimer: Note that the contents of this memo are all my thoughts, and not the views of RBC Dominion Securities.


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