“It is when we are in transition that we are most completely alive.” -- William Bridges
We are ever in transition, moving from one stage of life to the next in the growth of the human condition. New birth, a lost friend, a new job, promotion or demotion, career change, marriage, retirement, an accident; all warrant a change of action plan that can be joyous or life changing, transcendent or benign. Living is nothing but a long transition and the best that we can do is embrace the change, push forward, and renew again.
In 2022, we will transition out of our pandemic-induced behaviors and return to a new normal. The new normal may look something like the old normal, but with some significant behavioral changes. You will not be surprised to see a person wearing a mask. You might work from home forever, replacing in-person business meetings and travel with Zoom calls. Office towers may be converted into residences with home offices. The move away from the cities towards rural and suburban areas for cost of living and peace of mind issues may continue. Those who are impoverished and non-connected may remain impoverished unless they get connected.
The point is that transitions are a normal part of living and must be embraced. Certainly, when looking at our investment decisions, we consider explicitly where we are on our life journey, what has changed recently, and how do we feel about that change. And we will do so again in 2022.
A Look at 2021
The U.S. stock market finished 2021 with a third consecutive year of double-digit positive returns. The major U.S. equity indices were all near all-time records. Despite recent turmoil from the Omicron coronavirus variant, the S&P 500 turned in a great performance in 2021, returning 26.9% for the year. The last three years have recorded an accumulated return of 90.1% and the best three-year performance since 1999, despite the pandemic and other crises. Much of this broad market rally was driven by a small group of massive stocks such as Apple, Tesla, Amazon, and Microsoft.
Still, the top performing sector in 2021 was the much-maligned energy sector, returning 54% for the year (S&P GSCI Energy). The technology sector, which has grown 180% in the last three years, was up 33.4% for the year (S&P 500 Information Technology Sector).
Growth stocks again outperformed value stocks (27.6% vs 25.1%) despite value significantly outperforming in the first quarter (Russell). A rotation into defensive stocks (consumer staples, health care, utilities) occurred during the fourth quarter as market participants looked to hold onto the gains of the last three years. Small cap indexes were lower than the broad market, returning 14.8% for 2021 (Russell 2000).
Global equities had a modest positive year, as measured by the MSCI ACWI index, returning 7.8% for the year. International markets were hurt by a strong dollar (up 6.4% for the year) as developed markets (MSCI EAFE + CA) returned 12.6% for the year.
Emerging markets (MSCI EM) returned (-2.5%) for the year, hurt by poor returns in China (-23%) and Turkey (-31%), which were somewhat offset by strong returns in India (25%) and Taiwan (24%) (MSCI). The volatility in overseas markets was strongly influenced by their reliance on the dollar, raw materials production, and level of impact on regional economies by the effects of the coronavirus, including shipping and trade constraints.
Major fixed income asset classes were modestly negative in 2021. U.S. Bonds, as measured by the Bloomberg Barclays U.S. Aggregate Bond Index, declined 1.5% with most of the loss coming in the first quarter of the year. Longer duration fixed income was hurt by rising interest rates; long-term treasuries shrank 4.8% while short treasuries declined 0.6%. Corporate and credit bonds did better, particularly at the low end of the credit spectrum: the highest yielding and riskiest bonds returned 10.4% (ICE CCC and lower). Inflation protected bonds outperformed the aggregate bond index, returning 6.0% for the year.
U.S. interest rates remain at generational lows. The Fed funds rate, which is the interest rate at which depository institutions trade federal funds with each other overnight, has been near zero since the end of 2009 except for a short period from April 2016 to March 2020 where the rate reached a ‘high’ of 2.45% in April 2019. The 10-year treasury, which is the bellwether of interest rates globally, ended the year at 1.55%, up 50% from the 0.93% yield at the beginning of 2021 but still at levels which would have been incomprehensible at any time in the last fifty years before 2020. The 30-year mortgage rate ranged from 3.0% to 3.3% for the year, spurring demand for housing and helping drive home prices up more than 17% from a year earlier.
Overseas interest rates remain low but have shown recent nominal increases. European ten-year government bond yields hover between (-0.2%) (Germany) and 1.0% (UK). Asian developed markets rates vary from 0.1% in Japan to 2.3% in S. Korea. China’s 10-year rate is 2.8%. These low overseas interest rates maintain downward pressure on the U.S. interest rate as funds flow between countries seeking the highest safe yield. This willingness to fund the U.S. Treasury on the part of foreign buyers may in part be why the longer-term U.S. rates remain so low, despite enormous deficits and debt load.
While inflation is up around the globe, inflation is now higher in the United States than in any other advanced economy by some distance. Comparing prices today and those of 24 months ago show that consumer prices are up by about 8%, twice as fast as in the Euro area. The U.S. government’s forceful pro-growth fiscal policies contribute to inflation, with fiscal deficits at 14% of GDP, the highest of any G7 country. The Federal Reserve’s ultra-loose monetary policies are also a factor driving inflationary pressures. Both governmental policies have been structured to foster increased demand and have largely succeeded. Spending on durable goods, roughly a third higher than in the final quarter of 2019, is far outpacing increases in other big economies. But this demand has outpaced the ability of the market to supply goods and services as labor shortages and business shutdowns contribute to supply chain limitations. These supply chain woes and shipping capacity constraints are leading to higher prices around the world, further contributing to inflationary pressures.
The U.S. GDP annual growth rate for the third quarter was 4.9%, following a 12.2% rate in the second quarter. This brought real GDP up 1.0% from the end of 2019 level, before the pandemic began. It is expected that the U.S. economy will expand at a faster pace in the just completed October-December quarter, putting it on track to record its best performance since 1984.
Oil prices (WTI) ended the year at $79 per barrel, up from $47 per barrel at the end of 2020 which caused gasoline prices to rise to $3.48/gallon on average from $2.17 last December. These price increases, higher prices in autos, housing, and other goods and services and the latest Covid variant have all contributed to a drop in consumer confidence, which declined to low 70s at the end of the year, plumbing depths not seen in more than a decade and down from a level of 100 pre-pandemic. But business confidence remained positive, according to the Measure of CEO Confidence, at 65 in the fourth quarter. (Note that a measure above 50 points reflects more positive than negative responses – Conference Board.)
Transition to 2022
For 2022, we remain generally optimistic about economic and investment prospects. The U.S. economy continues to be an engine of growth and innovation not replicated in any other country in the world. S&P forecast earnings per share (EPS) illustrate this point; consensus EPS forecasts are $223 for 2022 and $245 for 2023, up from $206 for 2021. Stated in growth terms, EPS forecasts indicate that the largest U.S. companies will grow earnings from 8 to 9% over the next two years. If equity price multiples hold constant, then equity prices should return in the same level, with some sectors such as financials could outperform. Overseas valuations remain attractive on a relative basis, but this has been the case for a number of years, and we have yet to see a catalyst that will signal a regime change and international stocks start to outperform the U.S. stocks in a sustained fashion.
We are less excited about the outlook for U.S. fixed income except as an insurance for declining equities and a shock absorber for portfolio volatility. Rising interest rates and tight credit spreads do not provide much protection or yield from fixed income. We may well look to non-traditional sources of income for yield including non-U.S. equities, high-dividend US equities, preferred and convertible instruments, REITs and lower quality high-yield instruments.
Some of the reasons for optimism beyond the spirit of the U.S. economy include the vast amounts of liquidity remaining available in the global economy. Despite the central banks starting to unwind bond purchases and reduce monetary supply, interest rates will remain extremely low for the foreseeable future and this will continue to drive private investment. Shortages of goods will likely continue to dissipate this year as companies increase production and fix supply chain woes. Low unemployment rates and increasing labor force participation will probably return in March after the worst effects of the recent variant of the Covid virus are behind us.
However, the possible return of U.S. inflation will remain an area of concern. Whether this bout of inflation is transitory or permanent is still to be determined. If inflation has returned indefinitely to the levels last seen in the early 1980s, this could become a significant detriment to the average consumer and broader economy.
Other items that could offset the general optimism include the worrying general economic pessimism of the consumer. Fears of inflation, extremism in politics, the third year of social restrictions and shortages of goods and services are all contributors to the general worry. Further, the prospect of a faster Federal Reserve response to inflation pressures, amidst expectation of three rate hikes in 2022, may act as a brake on growth. These uncertainties may lead to a higher prospect for volatility in 2022 as the markets react to news that influence behavior.
But in general, our overall forecast for the year is positive and we expect that we will return to economic normalcy. Once the latest Covid variant runs its course, potentially by the end of February, we expect to return to a world with low unemployment, rising real wages, modest inflation, and a policy-constrained central government.
As the markets transition to normalcy from our pandemic-induced aberrations, we are optimistic about prospects for 2022. Every new year offers a season of hope and potential; we think that the strength of the U.S. economy, the miracle of scientific discovery, and the inventiveness of the human community will bring positive change to the world. We believe this potential will translate into higher corporate earnings and opportunities for financial gain. Knowing that risks abound in both known and unknown varieties, we will maintain our tried-and-true method of diversified investing, looking for new growth opportunities, even as we try to protect against volatility and loss.
Data Sources: Bloomberg, Conference Board, Trading Economics, S&P Global, iShares, MSCI, YCharts, FRED.