FundMonitors closed for the end-of-year break before we could release this edition of the regular missive from Equitable Investors. Read and enjoy - the next issue will follow soon!

Our final 10k Words for CY2021 kicks off with The Economist's first cut on what events captured audience attention in the media during the year. We then range across Morgan Stanley's chart on China property sector's importance to commodities, the surge in VC investment in cryptocurrency startups illustrated by The Economist and Bloomberg's ranking of countries through time based on their COVID-19 vaccine penetration. We get into equities with Bespoke showing ETFs don't necessarily fulfill the diversification function that is expected of them and finally Equitable Investors' analysis of what has worked and what hasn't worked in CY2021 for ASX-listed micro-to-mid caps.

Impact of 2021 global events as measured by media activity (an initial draft analysis)

Source: The Economist

China property sector's contribution to commodity demand

Source: Morgan Stanley

VC funds piling into cyrptocurrency startups

                                                Source: The Economist

COVID-19 vaccine doses per 100 people

Source: Bloomberg

Sector ETFs not so diversified

Source: Bespoke

Quarterly average returns & CY2020 YTD return for ASX micro-to-mid caps by size (market cap)

Source: Equitable Investors, Sentieo

Quarterly average returns & CY2020 YTD return for ASX micro-to-mid caps by sector

Source: Equitable Investors, Sentieo

Quarterly average returns & CY2020 YTD return for ASX micro-to-mid caps by valuation band

Source: Equitable Investors, Sentieo

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Since Holon's beginnings in 2018, the digital asset conversation has evolved rapidly. Back then, Bitcoin was a dirty word, and the scandals of Initial Coin Offerings only demonstrated the 'wild west' attitude of an immature crypto-world. Skepticism by the traditionalists was strong.

Now, with an estimated 100 million+ users (including leading payment companies and global corporates), and a market value of USD$1Trillion and growing, Bitcoin is no longer a dirty word, it's just a word.

Institutions are quickly seeing Bitcoin (and other digital assets) as a valuable hedge against the volatility of the modern world. Investors (especially younger investors) are seeing that they have access to a store of value (wealth creation) opportunities as an alternative to the current financial system that has, and is, failing them.

And to meet this demand, new banks are being established (for example Avanti Bank in Wyoming, USA) to specifically custody Bitcoin for customers - with this trend accelerating. It seems that cryptocurrencies and digital assets, more broadly, are becoming mainstreamed. How things have changed in just a few short years!

But where is Australia in all this?

Holon has worked with Australian governments to discuss the accelerating digital economy across the political divide, particularly as we believe that data generation and storage requirements, driving Web 3.0, are being vastly underestimated by the market. While there has always been interest and an acknowledgement of where things were heading, we saw little real action.

Indeed, the major banks, and particularly the Reserve Bank of Australia, have been active 'resistors' - either attempting to delegitimize digital assets or dismissing them altogether, and even going to the extent of de-banking digital businesses. With all of this, there was a sense that Australia needed to be dragged kicking and screaming into the digital age.

2021 was different.

In October, we were pleasantly surprised that the advice contained in Holon's submissions to the Australian Securities and Investments Commission's (ASIC) crypto-related financial products consultation paper and the Senate Select Committee on Australia as a Technology and Financial Centre was reflected in the Senate Select Committee's recommendations to the Australian Government enabling the Web 3.0 economy and ASIC's guidance to the financial services industry.

Digital assets, and their custody and handling as financial products, were now being taken seriously. There was also acknowledgment that greater legal, business and investment certainty was needed to drive dollars into the Australian economy, rather than away from it.

The underlying message was that we desperately needed to avoid the 'digital-desertion' that we had been seeing (not unlike the 'brain-drain') - where young, talented digital companies are forced to move off-shore because of the uncertainty (and hostility) they faced at home. However, this may just have come to an end.

We have to thank the Chair of the Senate Select Committee, Senator Andrew Bragg, who led the charge to begin pushing for much needed regulation of digital assets in Australia and, as a consequence, helping to publicly legitimize them. From being 'well behind the eight-ball', Australia may have a chance to be a unique player on the global scene.

As a bigger surprise, and a significant affirmation to the work of the Senate Select Committee, the Federal Treasurer announced on 8 December that the Australian Government has agreed in principle with several core tenets of Senator Andrew Bragg's report. The Treasurer said that the impending reforms would be 'fast-tracked' as they are the 'most significant' in 25 years and will progress in two phases - with the most urgent and immediately implementable changes being consulted upon in the first half of 2022, and the remainder by the end of 2022.

The Treasurer stated that the Government will commence consultation on the feasibility of a retail Central Bank Digital Currency in Australia - a digital asset issued by a central bank and linked to a sovereign currency for better consumer protection and connection the global financial system - with advice to be provided by the end of 2022.

In relation to payments, cryptocurrencies and digital assets, the Treasurer stated that, by mid-2022, the Government will have:

• Set out a strategic longer-term plan for the payments system, developed with industry and reviewed annually.
• Settled the details of additional powers for the Treasurer to set payment system policy.
• Determined the changes necessary to modernize payments system legislation to accommodate new and emerging payment systems, including consideration of BNPL and digital wallets.
• Completed consultation on the establishment of a licensing framework for Digital Currency Exchanges to provide greater confidence in the trading of crypto assets.
• Finalized consultation on a custody or depository regime for businesses that hold crypto assets on behalf of consumers so that investors have greater confidence in the safe keeping of these assets.
• Received advice from the Council of Financial Regulators, working with other relevant agencies, on the underlying causes and policy responses to the complex issue of de-banking.

By end-2022, the Treasurer indicated that the Government will have:

• Settled the framework to replace the current one-size-fits-all payment licensing arrangements with a functionally based framework adopting graduated, risk-based regulatory requirements.
• Received a report from the Board of Taxation on an appropriate framework for the taxation of digital transactions and assets.
• Undertaken a mapping exercise of existing crypto currencies and tokens to better inform consumers and others of the risks and benefits that arise.
• Examined the potential of so-called Decentralized Autonomous Organizations (DAOs) that is a type of decentralized corporation used to co-ordinate financial contributors from around the world through automated (smart) contracts.

Overall, the Australian Government's commitment to these reforms, based on the recommendations of the Senate Select Committee, are welcomed as they are advantageous to the future of Holon's Web 3.0 cloud storage operations and digital asset management business.

However, there's still some way to go to enact any regulatory reforms, but this is the clearest signal from Government that Australia is now embracing digital assets and 'open for business' - and at Holon, we're proud that we were (and will continue to be) an active part of the policy making that is bringing it about!

Luke Behncke, Executive Chair

Key takeaways

• The relatively low yields provided by government and investment grade corporate bonds do not provide much cushion for the volatility that could occur in 2022.
• While we do not expect significant disruption to the economic recovery, we think investors should look to maximise the yield they can potentially receive relative to the risk required.
• We believe the risk/reward profile of the high yield asset class remains a bright spot in an otherwise low-yielding/tight-spread world for government and corporate bonds.

No pain, no gain. At least that's the old saying. But portfolio management is a well-developed science of managing risk, of finding large or small opportunities that - when combined in a diversified portfolio - may produce a little bit more return with the same risk as a passive benchmark, or the same return with a little less risk. Or, ideally, some combination of both. As such, portfolio management is the science of finding as much gain with as little pain as possible and, in our view, 2022 is likely to be a year where active portfolio management could shine.

If the second half of 2020 was an environment where a bond investor wanted as much corporate credit risk as possible (taking advantage of hugely dislocated valuations because of COVID-19), we think that opportunity largely ran its course in 2021. Investment-grade corporate bond spreads could tighten further by the end of next year. But if they do, it is more likely to be modest than not. And if they don't, the relatively small yield they offer does not provide much return for the risk tolerance such a position requires. When the Bloomberg US Aggregate Bond Index is offering a yield of just 1.7%,¹ it just doesn't take much of a rise in interest rates or a widening in corporate bond spreads to risk giving it all back.

Corporate fundamentals remain robust

This doesn't mean we aren't positive on the outlook for the US economy, and select pockets of the corporate bond universe. We are. Broadly speaking, corporate fundamentals are still strong in aggregate, with consensus earnings-per-share (EPS) growth estimates for the S&P 500® Index near 7.5% for the next 12 months.² And, historically, corporate bonds have performed well during the early part of a US Federal Reserve (Fed) tightening cycle. In 2016 and 2017, for example, the Bloomberg US Corporate Bond Index returned 6.1% and 6.4%, respectively.³ It wasn't until toward the end of the tightening cycle, in 2018, when performance suffered, and the index fell 2.8%.⁴ However, current valuations suggest this effect may already have been anticipated. Because, despite the recent uptick to near 1.0%, spreads of the Bloomberg US Corporate Bond Index remain near historical tights.⁵

But if investment grade corporate credit has, historically, performed well during the early part of tightening cycles, the high yield market has been even more impressive. In 2016, for example, the Bloomberg US High Yield Index returned 17.2%,⁶ which makes some intuitive sense. After borrowing substantial sums when official interest rates were relatively low (and they were 0% in 2020 and 2021), many companies' liquidity profiles improved significantly. Now, flush with cash and the expectations that income could potentially remain strong on the back of a still-recovering economy, more companies have begun a process of repairing their credit profiles.

High yield bond spreads, like investment grade corporate bond spreads, may also be pricing in much of the good news. But high yield is different in that the significantly higher yield the index pays is meant to be compensation for defaults. And the outlook for defaults has rarely looked so good. The current "stress ratio" (that is, the number of bonds trading below 80 cents on the dollar), which can be a great indicator of default rates, has improved dramatically in recent quarters. Indeed, we believe corporate bond defaults peaked in early 2020 and expect they will decline further in 2022. Simply put, when defaults (pain) are expected to be low, the relatively high yields (gain) being offered deserve the attention of active portfolio managers. While it helps that the Fed, as recently as 2020, signalled it would support the high yield market should a major crisis occur, we think the asset class' risk/reward profile remains a bright spot in an otherwise low-yielding/tight-spread world for government and corporate bonds.

In our view, volatility in the high yield market is more likely to come from external, macro factors than from concern about any individual sector or company. The Fed is expected to begin an interest rate tightening cycle next year and while that is usually cause for caution, the recent surge in inflation and the uncertainty about how fast it may fade are likely to add to the uncertainty. Volatility should also be expected from both good and bad news regarding the COVID-19 virus. On the one hand, news like Pfizer's COVID pill is cause for celebration, while the emergence of the Omicron variant is more concerning. Most importantly, we expect volatility in 2022 - whatever the cause - may have an outsized impact on returns, given how low government and many corporate bond yields are today.

This is not to suggest that investors should rethink their overall allocation to bonds. On the contrary, we believe a core allocation to bonds can often play an important role in reducing the volatility of an investor's overall portfolio. But with yields as low as they are, more - and more active - portfolio management, in our view, is needed. As we do not believe the Fed beginning to raise interest rates or new variants of the COVID-19 virus will add enough uncertainty to derail an economic recovery of the magnitude we see across the globe, we think investors should stay invested in bonds. But some diversification would help, and - where fundamentally appropriate - favouring higher yielding securities may help thicken the yield cushion against future volatility.

¹Bloomberg, as of 3 December 2021.
²Bloomberg, as of 8 December 2021.
³Bloomberg, as of 8 December 2021.
⁴Bloomberg, as of 8 December 2021.
⁵Bloomberg, as of 3 December 2021.
⁶Bloomberg, as of 3 December 2021.

Credit spread/spread: The difference in yield between securities with similar maturity but different credit quality, eg, the difference in yield between a high yield corporate bond and a government bond of the same maturity. Widening spreads generally indicate deteriorating creditworthiness of corporate borrowers, and narrowing spreads indicate improving creditworthiness.

Default: When a bond issuer fails to meet their repayment obligations to bondholders. The default rate measures the percentage of defaulting bonds within the defined market over a set period.

Fundamentals: The information that contributes to the valuation of a security, such as a company's earnings, its financial strength or the evaluation of its management team, as well as wider economic factors.

High yield bond: A bond that has a lower credit rating than an investment grade bond. Sometimes known as a sub-investment grade or speculative grade bond. These bonds carry a higher risk of the issuer defaulting on their payments, so they are typically issued with a higher coupon to compensate for the additional risk.

Investment grade bond: A bond typically issued by governments or companies perceived to have a relatively low risk of defaulting on their payments. The higher quality of these bonds is reflected in their higher credit ratings when compared with bonds thought to have a higher risk of default, such as high yield bonds.

Monetary policy/stimulus/tightening: The policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money. Monetary stimulus refers to a central bank increasing the supply of money and lowering borrowing costs. Monetary tightening refers to central bank activity aimed at curbing inflation and slowing down growth in the economy by raising interest rates and reducing the supply of money.

Volatility: The rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility.

Yield: The level of income on a security, typically expressed as a percentage rate.

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