While many investors were excited to put 2020 behind them, 2021 certainly presented its own set of challenges. Despite these challenges, 2021 produced strong results in most equity markets. The S&P 500 returned 28.7% for calendar year 2021 after posting gains of 11% during the fourth quarter. The stocks of smaller companies generally did not fare as well, but were positive by 2.1%.
Abroad, developed market stocks as measured by EAFE returned 2.7% during the quarter and 11.8% for full year 2021. Emerging market stocks declined 1.3% over the quarter to finish the year down 2.2% on the back of strong relative performance in 2020.
Bonds had a challenging year as the yield on the 10 year Treasury increased from 0.9% to 1.5%. This contributed to the Bloomberg Aggregate Bond index’s decline of 1.5% for the year.
As 2021 drew to a close, the omicron variant swept across the globe. While infections seem to be less severe than previous iterations of the virus, omicron appears to be more contagious. If omicron had an impact on consumer behavior, it was not nearly as pronounced as what we saw in 2020. In fact, omicron seems to have a far bigger impact on production than consumption, as employees are unable to go into work due to getting infected. This will likely create new issues for global supply chains that have been strained but seemed to be improving during the second half of 2021. With vaccine and booster distribution well under way in the majority of the developed world as well as newly approved treatment options still ramping up, it seems like the market is no longer concerned that COVID-19 is going to bring the global economy to a screeching halt.
The Federal Reserve (“The Fed”) began to pivot their policy guidance in the fourth quarter of 2021 (more on that later). Gone is the guidance that the current elevated inflation is “transitory”. The Fed is now acknowledging that inflation is here and that making monetary policy less accommodative in the face of strong labor markets and high levels of inflation is prudent.
It’s unclear that changing monetary policy will do much to alleviate inflationary tensions, since a great deal of the issue seems to be related to physical supply disruptions. However, simply acknowledging that inflation has run significantly above trend and suggesting that the Fed is willing to fight inflation by tightening monetary policy has calmed inflation concerns, as measured by the yield difference in nominal Treasury bonds and Treasury Inflation Protected Securities (TIPS). Inflation expectations rose throughout the year and peaked around the middle of November as the Fed’s tone changed, ending the year well off their mid-November highs. While we acknowledge that inflation will likely remain elevated in the near-term, the longer-term dynamics suggest inflation will return to levels seen pre-pandemic. As the labor market has changed dramatically over the past two years, the unemployment rate has descended below 4%. It seems more likely that making monetary policy less accommodative will hurt employment more than it will help slow inflation. Long time readers are likely aware that we follow labor market dynamics closely and therefore we view this as a risk in 2022 and 2023.
We wrote extensively during the previous market cycle about monetary policy and it looks like the Fed will be following a similar playbook in terms of normalizing (tightening) policy. Step one will be tapering their asset purchases followed quickly this time around by hiking the Fed Funds rate. The Fed has already begun tapering their balance sheet which is the process of reducing the pace of asset purchases through their Quantitative Easing (QE) program that was put into place to provide stability during the pandemic-driven recession of 2020. Once the Fed ceases adding assets to their balance sheet, they will begin the process of unwinding their balance sheet – a process they struggled with during the last cycle as they were only able to reduce their balance sheet by about $0.75T from January of 2015 through September of 2019.
The Fed has offered guidance that they will begin to hike the Fed Funds rate from zero which as early as March of 2022. At this point the majority of Fed members are forecasting three interest rate hikes in 2022 and a total of between 4 and 8 rate hikes by the end of 2023. Changes to the current highly accommodative policy certainly seem appropriate in today’s environment, but a misstep by the Fed, either tightening policy too quickly or not quickly enough, is a key concern as we begin to look for signs of the end of the current economic cycle.
Interest rates increased meaningfully during the first weeks of 2022. As a result, we are likely to increase the duration (interest rate sensitivity) of client bond portfolios closer to that of the Bloomberg Aggregate Bond index. Having less duration than the bond market was helpful in 2021, but even still there were periods when adding to duration when rates were high, and reducing duration when rates were low, added additional value to client portfolios. We believe opportunities like this will continue to present themselves and will likely be part of our fixed income strategy for some time.
As the Fed became more detailed in their plan to reduce the overall level of monetary stimulus, the slope of the yield curve, as measured by the yield on the 10 year Treasury note minus the yield on the 2 year Treasury note, declined. This presented us with questions as to whether cyclically oriented value stocks, which performed well in 2021, would continue to deliver strong results. Since the end of the year, the yield curve has steepened and maintaining our cyclical value positions (which continue to look attractive relative to the broad market on a valuation basis) has been helpful.
Despite strong performance in 2021, valuations (as measured by the price to earnings ratio of the S&P 500) actually declined during the year. Therefore, returns in 2021 were driven primarily by very strong corporate earnings instead of increasing valuations. Earnings expectations have increased as analysts transition from forecasting what an earnings recovery might look like to forecasting how earnings growth will look in a world where consumers and producers live with the pandemic. It is worth pointing out that earnings expectation going forward are modest compared to the strong earnings growth in the early phases of the global economic recovery. Over this same time, Treasury rates have increased more than the price to earnings ratio has decreased. So, on an interest rate adjusted basis, stocks look more expensive than they did at the beginning of 2021, which could weigh on equity market returns for the year. That said, we are maintaining our neutral allocation to stocks, which we think will outperform bonds for 2022. We hope you have an enjoyable and prosperous 2022. As always, we remain available to discuss your goals and portfolio.
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