Juxtaposing the beginning of 2021 with its end inspires wonder. A spectacularly fractured transition of government, combined with the continuing specter of pandemic, created the set piece for an annus horribilis. Despite the threats posed by viral variants, potentially punishing tax regimes, geopolitical ructions that could change the world order, an impressive and unsettling lift in prices, and a rattled central bank, investors ended the year in much better fettle than they began.
Most equity markets around the globe posted remarkable returns in 2021. The U.S. and Europe set themselves apart by producing solidly double-digit returns. The Japanese and Chinese markets struggled by comparison. For developed market investors, 2021 was a win. For emerging market investors, the year was mixed. Brazilian, Chilean, Peruvian, and Hong Kong markets were notable for the losses they produced.
Within the United States, stocks of all flavors performed well. Large-, mid-, and small-capitalization stocks all rewarded investors with double-digit returns. While value and growth stocks both produced positive returns, growth continued to best value. Through the lens of larger companies, the energy sector produced exceptional returns, beating the next best sector by 8.3 percentage points. Notably, the worst sector, utilities, rose 17.7%
Bond markets broadly declined last year. Rising interest rates produced a sea of losses across the investment grade landscape. High-yield bonds, which gained 5.3%, were the only refuge for investors. Within the high-yield sector, returns on lower-rated debt trounced higher-rated debt by more than two times.
Overall, despite the sturm und drang of pandemic, politics, and inflation, 2021 was a cracking good year for investors. Contemplating the year ahead is another matter.
GAZING INTO A VERY FOGGY CRYSTAL BALL
In the investing business, forecasting future events is a feature of this time of year. Most of these forecasts prove to be of little use, and some are fantastically off the mark. Many attempt to divine the future by extrapolating recent past. Predicting a higher stock market in the year ahead is hardly a revolution in forecasting. To wit, the S&P 500 Index has posted positive calendar-year returns 76% of the time since 1926.
The more useful, and dare I say profitable, exercise is to see things as they are and wonder what might unfold. The goal is to know the questions and plan for contingencies.
Will society move on from Covid-19 or will the virus be a part of future life? With more than 270 million cases worldwide and more than 5 million deaths reported, and more coming, it is an obvious question.1 Coming to terms with it is critically important. How society calibrates its interactions based on the presence of the virus will have an impact on how we conduct our commercial lives. Society might achieve herd immunity through vaccination, infection, viral competition, or some combination. Perhaps the virus becomes endemic, essentially an aggressive version of the flu or common cold. Either way it is highly probable that dealing with Covid-19 will be a feature of our future with the episodic disruptions that ensue as society struggles to deal with both the real and perceived risks. For now, and the near future, Covid is a given.
Will inflation be transitory or enduring? The problems relating to virology, monetary and fiscal policy, and labor market and supply line disruptions all seem to converge on inflation. The phenomenon investors loath, monetary chieftains are charged to subdue, politicians fear, and the populace inured of appears to be rising from its decades-long slumber. The 6.8% rise in consumer prices in November, the highest in 39 years, set teeth firmly on edge. Moreover, the three-, six-, and twelve-month moving averages are all sharply higher at 6.1%, 5.7%, and 4.2%, respectively. Transitory or not, inflation is present.
The extent to which prices are rising is apparent when examining a heat map of the sectors measured within the government’s monthly inflation survey (Exhibit B). The persistence and acceleration of price increases is widespread. The rising prices of goods and services in the inflation report foots with shortages seen across the U.S. economy. To be sure, the problem is not a domestic one. An attempt to measure shortages of labor and products across the G7 economies is especially troubling. Measured in Z-scores, or standard deviations away from their average wherein a larger number suggests greater dislocation, the data paints a picture that inflation is widespread and worsening. This bodes ill for a quick resolution to the pandemic-related market disruptions (Exhibit C).
Will employment continue to recover? Americans continued to find employment in 2021. Nonfarm payrolls grew every month during the year, albeit in fits and starts. On average, monthly payrolls grew 484,000 for the year through November.2 Despite the improvement in payrolls, overall employment in the U.S. remains more than three million workers lower than before the pandemic. Viewed from a different angle, currently there are almost 12 million jobs looking for people and only 6.9 million people unemployed.
The causes of the dearth of workers are the subject of much speculation. Has the rise in financial assets created a wealth effect that allowed older workers with savings to call time on their working lives? Are ongoing concerns about vaccine efficacy and viral variants giving workers pause when determining whether to return to the front lines? Have the serial efforts by Presidents Trump and Biden to supplement unemployment benefits for displaced workers lifted their “reservation wage,” forcing the private sector to increase pay to lure workers back? The answer to all these questions is mostly likely, “yes.”
An obvious fix is for worker compensation to rise and skills to be upgraded. The former seems to be in train while the latter is a perennial problem with no end in sight. Since a definitive resolution of the pandemic seems unlikely, rising wages may be the solution that clears the imbalances between business and labor. Sadly, it might also create feedback loops that perpetuate inflation and clip the profit margins of employers.
Investors will likely focus on policy this year as questions about monetary, fiscal, and regulatory policy feature prominently against the backdrop of a mid-term election year. The volte-face on the wind up of quantitative easing suggests that Powell & Co. are on the backs of their heels. Central bankers are a cautious lot. They fear inflation, deflation, and chaotic markets. Full employment, low and stable inflation, and of course orderly markets are their raison d’être. Despite considerable resources at their disposal, the Federal Open Market Committee members would win no awards for accuracy for their forecasting track records, a fact belied by the reassuring tones with which they communicate policy.
Will the Federal Reserve, European Central Bank, the Bank of England, et al. architect the correct policy—one that does not reinforce current inflationary trends yet deftly avoids tipping their economies into recession? That remains to be seen. What is certain is that each bank appears to be taking a different path. The Federal Reserve appears on the edge of policy normalization. The European Central Bank is sticking with its bond-buying program for now, and the Bank of England hiked interest rates last month. In all these economic blocs, inflation is rising (Exhibit D).
It is hard to imagine that policy normalization will be an orderly affair. Practice is messier than theory. We envision a set of narratives metronomically swinging from fears of too restrictive to too accommodating a policy. Like the rest of us, central bankers will have to find their way to the appropriate end place.
MARKETS: INTO THE UNKNOWN
Profits, one of the two propellants of stock prices, will likely rise just under 10% this year after jumping an estimated 45% in 2021.3 This drop in earnings growth is normal as the pandemic’s recessionary impact recedes and earnings growth attempts to normalize. How much labor and material shortages will impact profit margins is an open question. Businesses must make the decision either to pass on higher costs or to absorb them through lower profit margins. The willingness and ability to do so will vary by firm and sector. However, from a valuation perspective, inflation that runs above 6% is a problem for equity markets. At this level, equity multiples tend to contract, which dampens returns (Exhibit E).
Interest rate and growth differentials among economic blocs will have an important impact on international equity markets. Liquidity conditions and currency adjustments will act as relative tailwinds for U.S. equities and headwinds for international shares. Emerging markets tend to be the most sensitive to rising rates and currency swings. Indeed, the same set of circumstances impacts fixed income markets as well.
Equity valuations in developed foreign markets continue to be attractive relative to the U.S., but policies to address growth and inflation are likely to benefit U.S. equities at the expense of European and Japanese stocks. Implicit in this assertion is the likelihood that the dollar will rise against the Euro and Yen.
Equity market volatility as represented by intra-year drawdowns was remarkably subdued last year (Exhibit F). It will be unusual in the face of policy pivots, budding inflation, and questions about earnings, to have the year be unchallenged by a downdraft of more than 6% to 10%. Prolonged uncertainty in the form of the absence of a coherent economic/policy narrative eventually makes itself manifest in market turbulence. Trading these drawdowns is difficult and often without profit; however, preparing for their appearance and enduring their occurrence without acting rashly is the key to success.
Fixed Income Reset?
Data organized visually can convey volumes of information. Of the scores of charts we survey, the one that captures attention is the 10-year treasury inflation-adjusted yield (also known as the real yield) which, since 1961, has never been lower. If inflation is not transitory, then investors and policy makers alike have a problem (Exhibit G).
At -5.36% the real yield is significantly below the 2.14% average of the last 60 years. Perhaps the near uniform negative performance of U.S. fixed income markets prefigures a reset to interest rates. If this is the case, equities are due for a reset as well.
Negative real yields are not the sole province of the government bond market. Inflation-adjusted yields on bonds of both high and low quality are negative. One must venture into the exotic world of emerging market high-yield bonds to enjoy a return that is above the U.S. inflation rate.4
Navigating markets in an environment that appears to be breaking away from 40-year trends will make for challenging times. The forces of inflation, policy normalization, and virus-related disruptions will make passage through 2022 at times feel like transiting the intersection of two powerful bodies of water, releasing exceptional energy on the vessel that is an investor’s portfolio. This year investors will likely see frequent bouts of market turbulence. It could be another year of disappointing returns for fixed income investors. Equity investors, always a resilient and hopeful lot, will most likely find opportunities for profit in higher quality names both domestic and foreign, as a more market-determined price of money attempts to emerge.
1 Bloomberg data as of December 13, 2021
2 Nonfarm Payrolls total month over month net change, SA through November 2021. Bureau of Labor Statistics via Bloomberg
3 Factset Earnings Insight, December 10, 2021
4 Data based on yield to worst as of December 14, 2021 of the Bloomberg Barclays fixed income indexes
The opinions expressed in this article are as of the date issued and subject to change at any time. Nothing contained herein is intended to constitute investment, legal, tax or accounting advice, and clients should discuss any proposed arrangement or transaction with their investment, legal or tax advisers.