Key Takeaways
- Stocks surged and the economy was red hot as the world has mostly adapted to Covid-19
- Booming consumer demand coupled with supply chain disruptions caused inflation to hit a 40 year high
- Economic growth is likely to slow in 2022 without help from government stimulus
- Stretched asset valuations are likely to force investors to focus on profits
- We expect below average returns and increased volatility in both stocks and bonds
Fourth Quarter Commentary
2021 ended with yet another stock market rally, extending the already historic bull market to almost 13 years. The world has now mostly adapted to Covid-19 allowing the economy to fully recover from the pandemic recession. Following a weak third quarter, economic growth accelerated during the winter prompting a sharp fall in unemployment and a surge in corporate profits. However, it has also been accompanied by some of the strongest inflation in 40 years. Heading into 2022, we expect several headwinds to economic and earnings growth; meanwhile stocks appear to be priced for perfection.
2021 Market Review
Global stocks rallied for the third year in a row, boosted by massive government stimulus measures and pent-up consumer demand. U.S equities surged to record highs supported by strong corporate profits and accommodative fiscal and monetary policy. The S&P 500 finished the year up 28.7% and did not have a drawdown of more than 5.2% the entire year.
The top 10 companies in the S&P 500 now represent over 30% of the index (even though they only contribute 25% of the profits), the largest percentage in history. The previous record was 27% in 2000 just before the tech bubble burst. A majority of the top 10 companies are tech (Apple, Microsoft, Google, Amazon, Facebook, Tesla, Nvidia) which helped Growth stocks once again outpace Value/Dividend stocks.
U.S. small-caps almost kept up with their larger counterparts, with the S&P Small Cap 600 rising 26.8%. Overseas stocks trailed the U.S. for the 14th straight year, the longest streak in modern history. The MSCI EAFE (international index) gained 11.8% and the MSCI Emerging Markets Index fell 4.6%.
Our alternative investments in REITs and energy had particularly strong years, while emerging market debt struggled.
On the income front, core bonds fell 1.5% in the face of rising interest rates. However, a year ago we removed most core bonds from our portfolios in favor of shorter-term and nontraditional bonds funds and market neutral income focused equity funds. We are happy to report most of our strategic income portfolios had positive returns in 2021.
2021 Economic Summary
In 2021, the economy not only regained all pandemic-related GDP losses, but it surpassed pre-pandemic levels. Corporate earnings grew 45% year-over-year according to estimates by FactSet, the highest growth rate in the last 13 years. American’s disposable incomes were higher in 2021 than they were in 2019 and 2020, and debt payments as a percent of disposable income dropped to 9.0%, the lowest level in 40 years (highest was 13.2% in 2007 before the financial crisis).
The surge in GDP has been mirrored by a sharp rebound in the labor market. After shedding an astonishing 22.4 million jobs between February and April 2020, the economy has now recovered 18.4 million jobs or 83% of the total pandemic loss. The so called “Great Resignation” has seen millions of people leave their jobs to reassess their careers and work-life balance. Meanwhile wage growth has been rising at rates not seen since the early 1980s. Put together with surging labor demand, this suggests the employment shortfall is primarily an issue of labor supply, which has been constrained by enhanced unemployment benefits, lower immigration, higher costs of childcare and lingering pandemic fears.
Fiscal stimulus, a surge in consumer demand and global supply chain disruptions contributed to the highest inflation in 40 years. The CPI index rose 7.0% in December (5.5% without food and energy). Energy rose 29.3% in 2021, including a gain of 49.6% for gasoline. While the Fed has indicated it plans to let the economy run hot, it has already begun tapering its bond buying program.
Despite the hot economy and inflation, the Fed left the overnight rate unchanged between 0 and 0.25%. Longer-term rates rose in 2021 with the 10-year Treasury yield rising over 50% from 0.9% to 1.5%.
2022 Economic Outlook
We expect the U.S. economy to remain on a solid path, with GDP growth in the 2.5-3% range and earnings growth around 8%. So, while we do expect growth, it is likely to be slower than it was in 2021 for a variety of reasons.
Firstly, the days of government stimulus are behind us. The Fed announced on December 15th that it will move more quickly to end its support, doubling the rate at which it winds down its asset purchase program. That puts the Fed on track to stop buying bonds by March and clears a path for it to raise interest rates shortly thereafter. We expect them raise rates 3-4 times this year, and the overnight rate to reach 0.75-1% by year-end.
High inflation is likely to persist through much of 2022, likely retreating in 2023. However, our forecast for inflation for the remainder of this economic expansion is higher than the sub 2% we enjoyed pre-pandemic.
Labor markets are likely to continue to improve as participants in the Great Resignation burn through their savings and eventually return to the workforce. High demand and increased wages should cause unemployment to fall below 4% in the first half of 2022.
2022 Market Outlook
Stock markets often act differently than economies. For example, in 2020 the U.S. GDP and corporate earnings fell 3.5% and 20% respectively, yet the S&P 500 gained over 18%. The reason is that stock markets look forward and economic results look backward. So, while we expect the economy to be strong in 2022 (not as strong as last year), it is possible stocks may act differently.
To quote Rob Lovelace, the president of Capital Group, “you don’t have to figure out what’s going to start the fire, you just need to know the brush is dry.” And there are several signals suggesting the brush is dry, in particular high stock, real estate, and non-traditional asset valuations. Additionally, the unjustifiable prices of non-profitable tech and clean energy “disruptors,” cryptocurrencies, NFTs, and retail investor led meme stocks suggest many investors have stopped paying attention to fundamentals.
While these investments are interesting to discuss at a party, we believe in 2022 investors will focus on profits not stories. A revolutionary technology such as blockchain is only valuable to the extent it can increase profits, and a digital coin will never earn a profit. As we learned with the internet bubble, companies that embrace innovative technologies to increase profits such as Google and Amazon are those who succeed over time. Others become AOLs, Yahoos or Pets.com.
Our base case for is for 8% earnings growth and some P/E contraction leading to mid-single digit returns for stocks. We expect the headwinds discussed above coupled with the mid-term elections, geopolitical threats and possible new Covid variants to spur market volatility not seen since the pandemic began.
With investors focused on profits and valuations, we expect value/dividend stocks are likely to outpace growth stocks. Overseas stocks are also poised to outperform as their valuations are reasonable and they offer significantly higher dividends.
On the fixed income side, interest rates are likely to continue rising which means core intermediate bonds remain unattractive. We continue to favor short-term, non-traditional, and inflation protected bond funds and income focused market neutral equity funds which should perform well in a rising interest rate environment.
Final Thoughts
We are likely at the tail end of a remarkable bull market, but as a long-term investor you should not count it out. To quote Rob Lovelace again, “I am buying the raincoat, but I’m not putting it on yet. I just want to have that raincoat handy.”
As always, we are making changes to your portfolio that we believe will give you the best chance of achieving your goals. This may include rebalancing your account which maintains the level of risk we agreed upon, takes chips off the table when asset prices are high and adheres to a sell high, buy low strategy.
This year your mettle is likely to be tested as volatility increases. With low interest rates and high inflation, cash is not an attractive asset class to use on the defensive side. So, stay invested. And if you do get more conservative make sure the lower expected returns are supported by your financial plan.
Bottom line; maintain long-term thinking, do not try to time the market, revisit your financial plan, and always remember we are here to help.