February 24, 2022
Dear Friends,
It’s hard to believe that it was 20 years ago that I moved back from London, where I had primarily focused on very large institutional clients, and started Polygon, which has tried to apply some of the same principles to individual, and smaller corporate, clients. While we have by no means gotten it all right, since inception our primary strategy, Global Growth, has outperformed its benchmark of 70% global equities (MSCI All Country index) and 30% US bonds (Barclay Aggregate bond index) by an average of over 2.0% per year. In 2021, though we were somewhat hindered by our relatively risk averse approach, the Global Growth composite matched its benchmark gaining 12% (net of fees).
It was a surprisingly robust year for stocks, with markets exceeding expectations under the impetus of huge fiscal stimulus, particularly in the US, and lax monetary policy across many major markets. With the S&P 500 up 28% for the year, the Dow gaining 20%, and global stock markets increasing by 19%, only emerging markets, dragged down by poor performance in China, showed a decline, falling by 3%. Interestingly, bond markets were negative for the year, with the 10-year US Government bond also falling by 3%.
As of Jan 1, total equity exposure in our model portfolio was 63%, with fixed income securities equivalent to 18%, and alternative assets representing 20%. Our largest equity exposure was to the US (44% of the portfolio), while Europe was 7%, and Japan and emerging markets were both 6%.
In the US, in addition to our indexed core, we had standout performance from a number of tech stocks like Google up 65%, and Apple which was up by 35%. Our private equity positions also did exceedingly well, with Carlyle gaining 78% and Blackstone up by 84%. Some of our other choices were less positive, with Verizon falling by 7.5% and Zimmer by 19.6%.
In Europe, returns were a mixed bag, with Telefonica and Roche up by 11.4% and 28% respectively, and Philips falling by 32%. In Japan, Fanuc (the robotics manufacturer) was down by 12.6% on fears of falling demand from China, while Sony climbed 25%.
In emerging markets, the position in Vietnam gained 22%. Like many Chinese tech stocks, Baidu fell by a disconcerting 31%, though our position constituted only a little more than 1% of the portfolio. For investors with a long-term view, we think that most of the political risk is already priced into the Chinese market, causing the tech sector, in particular, to be overly beaten down.
The fixed income portion of the portfolio generally did its job of providing downside protection. The roughly 11% in cash we held at year end clearly had an opportunity cost during 2021 but is looking more comforting in light of the market’s current volatility and vulnerability (see below).
Likewise, the alternatives segment was protective, while adding value. The convertibles position was up by 5.3%, while the inflation protected bond gained 5.5%. Gold was down by 4%, but our commodities ETF gained 27%. Both the MLP’s we own provided handsome returns.
Looking forward, I continue to believe that our defensive stance is justified. To start with, economic conditions in the US are a concern. In an effort to ward off the damaging effects of Covid (which remains a wild card), we have had fiscal stimulus equivalent to 25% of GDP. On top of that, the FED has kept interest rates extraordinarily low and engaged in a significant bond buying program. All of these factors have contributed to the current inflationary surge, which has been exacerbated by supply side bottlenecks. While they have served their purpose in terms of keeping the US economy moving forward at a robust pace, the effect of all the spending is starting to work its way through the economy and is unlikely to be replaced. Current projections are that government spending will be down by $1.2 trillion in fiscal 2022. Spending in January 2022 alone was down 37% from the previous year.
Similarly, the FED will be cutting back on its bond buying policy in March, and current market expectations are for numerous interest rate increases during the year, which may add as much as 2% to short term interest rates. For example, Goldman Sachs is forecasting as many as seven rate increases. This will likely take short term interest rates to over 3%, though, interestingly, it has not yet had much of an impact on longer term rates. As a result, the yield curve is flattening, which is often a harbinger of economic deterioration. While predictions of an economic slowdown later in the year may be premature, they are not unrealistic.
The above notwithstanding, in terms of the capital markets, US stocks continue to look expensive. While corporate profits and earnings are high, the cost of both goods and labor are surging because of inflation. For the time being, corporate America will continue to generate attractive returns, but over time this will have the effect of compressing margins unless companies are able to pass price increases onto consumers.
Compounding the problem, US dividends are at their lowest level in decades. If rates continue to go up as we expect, this will partially remove one of the main underpinnings of the buoyant US equity market, TINA (there is no alternative) to stocks. It is also worth noting that US household wealth is at an all-time high in its allocation to stocks—a potential hostage to fortune if equity prices continue to decline. In a similar vein, America now comprises 65% percent of global equity market capitalization, a level not seen in over 40 years, and one which stands in stark contrast to its economic size, which, depending on exactly how you measure it, is equivalent to somewhere between 20% and 30% of global GDP.
Europe looks significantly better positioned in terms of its capital markets, though perhaps less so in terms of its real economy, especially with the specter of increased Russian intervention in the Ukraine hanging over it. While political risk is always hard to calculate, our view is that the risk reward for Putin does not favor further military action. Nonetheless, state actors are not always rational, and Putin seems to have harbored so many grudges that his current policy actions may not be well thought out, even from the perspective of Russia’s own self-interest. Consequently, the threat of a land war, and the concomitant fall out in energy markets in particular, cannot be discounted. It would, of course, have a depressive effect on European stock markets, not to mention the global economy. Still, European stocks remain cheap compared to the US, and appeared poised to benefit from their relative lack of tech exposure, and bias towards value –which ironically has hurt them in the past. Inflation is also running at a somewhat less torrid rate across the pond and labor markets are not as tight, giving central banks more latitude to keep rates lower for longer.
For several decades, Japan, the world’s third largest economy and second largest equity market, has performed underwhelmingly, both in terms of its economy and its stock market. Consequently, Japanese companies are relatively cheap, trading at an average price to earnings ratio of 15 compared to 22 in the US. Amazingly, more than half of Japanese companies trade at under 50% of book value and 40% have more than 20% of their balance sheet in cash. Given concerns about global capital markets, these defensive characteristics make Japanese stocks look appealing. Japan also has the advantage of being a good diversifier as it is the least correlated developed market compared to the US. With its history of deflation, it is one of the few economies in the world which is in a position to maintain fiscal stimulus and keep interest rates low. We are overweight Japanese equities.
Speaking of lower rates, China, which increasingly dominates the emerging markets space, has already begun to cut rates. While domestic politics and the local property slump are both pushing Beijing in that direction, it may be a little late, as economic growth has started to slow significantly. For example, in recent months the IMF has cut its forecast for GDP growth from 8% to 5.5%.
Hovering over China is the fraught question of its relationship with the US. Though in the short, term lack of cooperation and lower levels of economic integration will hurt both sides, over time it is more likely to damage the Chinese—or at least that is the wager the Biden administration seems to be making. Nonetheless, China remains a global economic powerhouse, and the largest trading partner of many nations, including the US. With many of its major tech companies, especially those listed in the US, having fallen significantly, maintaining a degree of market exposure seems a reasonable risk.
With interest rates rising in many countries, including the US, a degree of caution is warranted for bond investors. As was the case last year, so far in 2022 bond prices in the US are down, especially at the long end of the market, with the US index having lost close to 4% YTD. Our exposure is concentrated at the short end of the market, with half of our fixed income assets invested in what I sometimes call quasi cash, or very short-term bonds. In addition to some medium-term bonds, we have some floating rate instruments which carry less interest rate risk. Altogether, the fixed income portion of your portfolio equals 19%.
The allocation to alternatives is less at 18%. Ranging from long short equity positions to precious metals and master limited partnerships, these are primarily designed to lower overall portfolio volatility because of their relatively low correlation with US equities. Given our overall market view and the current bumpy conditions, they will continue to be a core component of our strategy.
I hope this brief review will help give you a sense of how we are positioned and where we see markets heading going forward. As always, comments and questions are welcome.
Best,
Philip Winder