December 2021 – A great year, full of challenges

We end 2021 posting extraordinary returns:

• Sigma Fund Real Return: +12,22% YTD.
• Sigma Fund Prudent Growth:
 +21,38% YTD.
• Sigma Fund Quality Stocks:
 +29,83% YTD.

vs MSCI World Index in EUR +28,99%.

2021 was the year of post-Covid recovery. We can safely say that this tremendous threat to health and global economy has been neutralized thanks to the massive distribution of vaccines. The most recent variant, omicron, has proved that not all mutations of the virus are equally dangerous and by no means do they all require the same actions to be taken. Lockdown periods and mobility restrictions were gradually eased during 2021 and, will most probably continue lessening over 2022. Even though the road has been rough, humanity has proven that it is reasonably capable of surmounting a global problem unprecedented in recent history.

In the economic arena, in 2020 the pandemic translated into a demand shock in a wide range of economic sectors. While the consumption of products and services that were affected by mobility restrictions fell drastically, demand for products that could be bought and used from home increased considerably. At the same time, there was an offer shock, with stockouts and supply chain ruptures.

Central Banks, headed by the FED, treated economy with its own vaccine: Ultra-permissive easing policies– such as lowering of rates, liquidity injections, and purchase of financial assets to stimulate demand– prompted a V-shaped recovery in markets and several real economy sectors.

This dosing also had important side effects: throughout 2021 demand recovered and it was expected that supply (companies’ output, beyond central banks’ control) would gradually meet this increased demand. Unfortunately, semiconductor and other component shortages –caused by the high demand of electronic devices– affected the manufacture of household appliances, cars, and consumer durables. Mobility restrictions also impacted the international transport industry– diminished supply despite a higher demand– as was made evident by the number of ships that remained anchored off the main hub ports. Construction and renovation projects –both private and public– also generated mismatches in raw materials and related services. An increased use of renewable energy intensified price volatility –already climbing in 2021– as supply can only meet rising demand at higher prices. In previous newsletters, we discussed the difference between “good” and “bad” inflation. We still believe that current inflation levels should correct in 2022 and therefore should be considered temporary and beneficial for the reactivation of the expansive economic cycle. However, the risk that the supply side may be unable to dampen prices still remains and could eventually force the FED to adopt restrictive measures aimed at reducing demand. This would be bad news indeed.

What can be expected from 2022? Governments should continue decreasing mobility restriction measures; Covid should become another virus for which we are vaccinated yearly, just like the flu; tourism, mass leisure, and other sectors dragged by restrictions will return to normal levels. The FED will discontinue its asset purchases in March, will increase rates and will continue make clear it is determined to control inflation from the demand side, if supply fails to reach the necessary levels.

This unfolds two possible scenarios for 2022:

  1. Supply increases and prices are adjusted with no need of extraordinary intervention by the FED. Inflation begins to fall in the second semester, triggering a moderate rate increase against a backdrop of controlled growth, low –albeit positive– rates (around 1% by year end), and 2-year and 10-year bonds at 1.25%-1.75% and 2.5%-3.0%, respectively. Negative real rates with an inflation of around 3%-3.5%. Mid-year, growth shares will again beat cyclicals, while US and Global indices will continue to rally, with frequent market and style rotations, such as those experienced in 2021.
  2. Supply is unable to meet demand and prices hike above expectations. The FED prioritizes inflation control over growth and accelerates rate increases and balance reduction. The yield curve begins to rise and flattens. 2-year bond rates rise more than 10-year bond rates. With a persistent inflation above 5% up to year end, 2-year bonds will probably rise to 1.5%, while the 10 year bonds’ yield will initially climb to 2.5% and then fall to below 1.5%. The yield curve will be inverted, discounting a high probability of recession due to lower demand dragged by monetary policies. In this scenario, growth shares will continue to lose ground to cyclical shares, until signs of a future recession appear, reversing this trend amid falling markets and rising bonds, on the back of expected rate cuts.

We will adopt scenario 1 as our main stance. In financial markets, being pessimistic is usually unprofitable. All actors (companies, Governments, Central Banks, etc.) are working hard to achieve scenario 1. Although it is true that at times it can take a while to reach an equilibrium, for now we see no reason why the supply side won’t be able to adjust its production, and, furthermore, Central Banks –especially the FED– are now more willing to favour economic expansion. If in March 2020 –at the climax of the crisis– we were able to be creative and optimistic when the first news of the production of a vaccine were released, now that we are closer to the end of the pandemic and of the much yearned-for normalization we feel it is more profitable in the medium term to believe that prices will resume normal levels and that the pre-pandemic upward cycle of moderate growth and low rates will once again return.

Our preferred asset for 2022 continues to be stocks. Our equity strategies always have a Growth bias. We favour companies with above average growth, capable of increasing sales and profits when rates are at 0%, at 1% or even 2%. Companies that are not capital intensive and have low debt ratios. The growth perspectives of these companies will fare well in the two scenarios described above. These shares have very attractive price/profit ratios after peaking in 2021. Although market rotations, flows and other managers’ positioning do affect these shares, in the long run they recover faster thanks to their growth characteristics. Weighed down by inflation fears, this is probably the most undervalued asset in the exchanges, considering its growth.

On the other hand, indices continue to discount a benign scenario for economy. Rises in the energy and financials sectors have helped contain falls. We will continue to actively manage investments in derivatives in our hedged funds, given the wide dispersion among the underlying shares. For now, we do not anticipate sharp falls in indices, that limit their protective features in market rotations. We will continue to capture profits in options to favour market rebounds. We expect to see a gradual reduction of volatility as increased supply adjusts prices. We hope markets will continue to buy stocks as the only investment alternative for long term capital preservation against a backdrop of positive inflation and negative real rates. In a scenario of economic recovery and inflation, investments in cash or bonds are not advisable. It is worth while to tolerate a little more volatility from investments in equities rather than to settle for an almost certain loss from investments in fixed income in 2022.

Finally, an asset to which we have been gradually increasing exposure is USD. The FED will rise rates before Europe does, and we expect its growth to continue and that the demand for products and services in USD will also increase. It is a profitable asset and offers, as well, a moderate degree of protection as a safe haven asset.

Wishing you a happy and profitable 2022.