Economic Update: 2021 Review
As we enter the new year, we would like to take the opportunity to provide you with a review of 2021 and our outlook for 2022.
Despite the continuing global pandemic, markets around the world ultimately posted healthy positive returns over the course of the year. The bellwether for U.S. stock returns, the S&P 500, hit 70 new all-time highs over the course of 2021 to finish the year up 28.71% on a total return basis. The S&P 500 returned more than 15% for the third year in a row, a historical streak of strong returns only bested by the period from 1995 to 1999, when the annual return for the index topped 15% for five years running. In a reversal of the trend from 2020, small-cap stocks, as represented by the Russell 2000, significantly underperformed their large-cap peers, with the index returning 14.82% for 2021. U.S. equity performance varied widely by style as well. Though value had a brief moment in the sun during the first half of 2021, for the full year growth ultimately triumphed over value yet again in the large-cap space, with the S&P 500 Growth Index returning 32.01% on a total return basis for the year versus the 24.90% return of the S&P 500 Value Index.
Performance was strong across sectors for the year, with all 11 sectors of the S&P 500 posting double-digit returns for the first time since 1995. After a period of perennial underperformance, Energy led the way in 2021 on the back of a strong rally in the price of oil and natural gas, with the sector finishing the year up 47.74%. Real Estate, which suffered significantly in 2020 as economies around the world locked down, also posted an exceptionally strong year, up 42.50%. Utilities were the laggard in 2021, but it still finished the year 13.99% higher.
Returns in most developed international markets were also strong on an absolute basis, with most finishing the year up double digits. Many of the leaders on the year were resource-heavy markets, which benefited from the broad-based rebound in commodity prices. Canada led the way, finishing the year up 22.3%, with Norway close behind at 21.3%. As a whole, Europe (ex. U.K.) had a strong year, returning 21.1%. The U.K. finished the year up a respectable 15.0%. Emerging markets were the outlier for the year, losing -2.54% over the course of 2021. Weakness in Chinese stocks was largely to blame for the poor showing in EM. China has the largest weight in the index by far at around 30%, and Chinese stocks fell 22.7% on the year as the Chinese Communist Party cracked down on several key industries at various points during the year. Despite a resource-intense economy, Brazilian stocks also performed poorly as the country struggled to keep the virus under control. The United Arab Emirates and India were two emerging market bright spots, returning 43.7% and 27.3%, respectively. Despite some strong international contributions, the decade-long trend of domestic outperformance remained intact, as the U.S. market was the clear leader for the year, responsible for 14.5% of the MSCI All Country World Index’s 18.54% return for 2021.
Compared to the broad-based strength across U.S. equity markets, U.S. bond market performance was largely a disappointment in 2021, as concerns over rising inflation and the threat of potential policy shifts led to widespread weakness across the fixed income landscape. The Bloomberg US Aggregate Bond Index, a broad measure of the performance of investment-grade fixed income markets in the U.S., lost -1.54% on the year. This represented the third worst calendar year for bonds since 1976. All sectors in the index lost ground for the year, led by long-term U.S. Treasuries, which were down -4.6%. Outside of the Aggregate, a few areas of the bond market did post relatively strong performance for the year, however. TIPS, which were bolstered by a historically strong CPI adjustment, returned 5.96%. Lower rated areas of the credit market also were a bright spot as default rates remained exceptionally low. High yield corporate bonds returned 5.28% on the year, and floating rate loans returned 5.20%.
Performance in the municipal space was also relatively strong due to the combination of a relatively limited supply of new issues, an uptick in demand sparked by the threat of potential tax hikes, and broadly improving tax revenue as the economy rebounded over the course of the year. The Bloomberg Municipal Index returned 1.52% in 2021. High yield municipal bonds were the standout performer for the year, finishing 2021 up a robust 7.77%.
Bond returns were extremely disappointing internationally, largely the result of dollar strength versus a broad basket of international currencies. The Bloomberg Global Aggregate Bond Index lost -4.71% for the year. Chinese bonds were the rare exception overseas, with the Bloomberg China Aggregate up 5.65% in 2021, largely driven by the yuan’s appreciation against the dollar. Other emerging markets did not fare as well, finishing the year down -1.65%.
The global economy experienced a strong recovery in 2021 as activity normalized and demand surged. The virus remained a challenge throughout the year as new variants emerged, snarling supply chains and upending labor forces around the world. While an initial uptick in inflationary pressure as the global economy began to normalize was anticipated by policy makers and market participants alike, these challenges added additional inflationary pressure that caught policy makers largely off guard. The key economic driver in 2022 will be the path of global inflation and subsequently how policy makers around the world respond, with the fiscal and monetary policy boost that drove extraordinarily high economic growth in 2021 likely giving way to policy headwinds in 2022. Most G10 central banks have already begun to respond by tapering or ending asset purchase programs earlier than expected, and the interest rate normalization process has begun in many international markets. With so much policy in flux around the globe, there is heightened risk of a policy mistake. Our base case, however, sees 2022 as a year of moderation, with economic growth cooling off from the torrid pace seen in 2021 and with it an easing of inflationary pressure. Such an environment would continue to be supportive of risk assets like equities and credit, but fixed income will likely continue to struggle in the near term as rates continue to normalize back toward the long-term equilibrium.
The U.S. economy has recovered from the pandemic-induced recession at an astonishing pace. We are hopeful that 2022 will usher in a full economic recovery, as the omicron variant appears to have accelerated the virus’ transition from pandemic to endemic status. This transition is expected to generate an acute increase in mobility and consumer demand across the globe, with countries that have thus far lagged firmly entering the recovery stage of the economic cycle and many major economies reaching the expansion stage. While we expect the recovery to continue in 2022, overall economic growth is likely to decelerate from here as various sectors of the economy revert to norm after distortions caused by the virus and the subsequent policy response, especially in the United States. The economy produced many surprises over the past two years: the significant increase in demand for durable goods, productivity increases that appear likely to persist, early retirements distorting the labor force, and, most importantly, a sharp increase in inflationary pressure. Policy makers around the world will be navigating a balancing act between maintaining robust economic growth and the inherent inflationary pressure that comes with it.
While both the Federal Reserve and market participants anticipated this increase in inflation, most underestimated the extent of the current supply chain challenges and thus the duration of these price challenges. A sharp increase in the demand for durable goods coupled with supply chain challenges induced by the virus has driven inflation in the United States to the highest level in 40 years, and the path of inflation from here will be the key economic metric to watch in 2022. This sharp uptick in prices has largely been driven by supply-side challenges, an issue the Federal Reserve has limited tools to address. The numerous supply-side problems that have emerged will take time to work their way through the global supply chain; factory shutdowns, congestion and closures at ports, labor shortages, and significant disruptions to semiconductor production have combined to rankle global production and trade. The most important question going forward remains whether the current supply-demand imbalances across much of the durable goods sector will begin to diminish, which should in turn normalize prices. In the near term, inflationary pressure is likely to remain quite high, but over the course of the year we expect these supply chain challenges will be overcome as spending patterns shift away from goods and back to services. Given the extent of the current challenges, this normalization process is likely to extend into 2023, but recent numbers indicate the normalization process is underway.
A second, related question is whether wage growth will continue at the current rapid pace. Labor shortages have driven a significant uptick in wages, with increases averaging around 5-6% in 2021. History suggests inflation is unlikely to moderate toward the Fed’s 2% target with wage growth at these levels. Our expectation is that the labor market will continue to normalize over the course of 2022 as we continue to make progress in the fight against the virus, allowing workers who remain out of work for pandemic-induced reasons to return to the labor force. Inherent to this view, however, is a belief that the impact of the omicron variant on the labor force – while potentially large – will be short and globally synchronous. After this brief period of interruption, the subsequent expected increase in labor force participation should ameliorate the current labor shortage, reducing wage pressure later in the year . There is risk, however, that a significant number of people who left the labor force during the pandemic remain on the sidelines, however. In particular, a significant number of early retirements occurred over the past two years, and most will likely remain out of the labor force for good. Should labor force participation fail to improve, labor shortages will continue for longer, putting upward pressure on wages.
The final determinant of the path of inflation in 2022 will be shelter inflation. The housing market is currently the tightest it has been since the 1970s, driving significant increases in home prices, and there is little sign of a slowdown on the horizon. Current estimates suggest that we have a shortage of around 1.5 million homes based on underlying demographics, and this shortage will take years to fill. Combined, these factors are likely to keep inflation elevated through the early months of the year, with expectations that price pressure will begin to moderate in the back half of the year and continue into 2023.
Faced with the highest inflation prints in 40 years, the Federal Reserve has signaled it is prepared to take action to help alleviate price pressures. The Fed is currently tapering asset purchases, which are expected to come to an end in the first half of 2022, and appears poised to start raising interest rates over the course of the year. The substantial recovery should enable the economy to tolerate this expected monetary policy tightening relatively well. Importantly, the recovery has significantly reduced labor market slack, and the Fed has indicated in recent communications that members are more concerned about upside risk to inflation than downside risk to economic growth . Current expectations put 2021 GDP growth at 5.6%, and while a deceleration in growth is expected in 2022, the current composite forecast places 2022 GDP at a still robust 3.9%. The market is currently pricing in four 25 basis point hikes for 2022, with the first most likely to occur during the March meeting, and the Fed could also concurrently begin to allow its balance sheet to run off in the back half of the year should inflation continue to come in at significantly elevated levels. While we expect rate hikes will have a relatively limited impact on the trajectory of economic growth given the health of the economy, rising rates will have a significant impact on asset returns.
2022 ushers in an environment not seen in years for investors. The last 30 years were predominantly marked by a secular decline in interest rates, which in turn led to higher margins for firms and increased valuations in equity markets. With the Federal Reserve poised to engage in a significant hiking cycle beginning in 2022, we expect an increase in real interest rates, which are currently deeply negative. Historically, increases in real rates have put a ceiling on equity valuations, and based on market moves to start the year, this cycle appears to be following this well-known pattern. With equity valuation multiples expected to continue to contract during the course of the year, earnings will be the driver of equity returns for the foreseeable future. The expected economic environment can still produce positive equity returns, however; in periods of decelerating economic growth and rising rates, the S&P 500 has still managed to average an annual return of 8% historically, which is in line with our expectations for 2022. Real rates are expected to remain negative for quite some time, which creates an environment that is supportive of equities relative to fixed income, and absent a growth shock, we expect equity returns to remain positive over the intermediate term.
This environment likely calls for a shift in strategy, however, based on historical patterns. Growth stocks have significantly outperformed value for years, with only a few short pockets of value outperformance. The environment as we begin 2022 suggests that we may be in one of these periods where value outperforms. One key factor is the difference in duration between the typical growth stock and value stock. Equity market duration is determined by how sensitive a stock’s value is to future cash flows. If most of the value is in cash flows expected in the near term, the equity duration is short, relatively speaking. If the majority of the current value is due to cash flows expected 20 to 30 years in the future, then equity duration is long. Equity duration is similar to its fixed income counterpart in that it measures the sensitivity of a given stock to changes in interest rates, which are used to discount future expected cash flows to present value. Given that the vast majority of the value for growth stocks is in cash flows expected significantly out into the future, rising rates serve to reduce the present value of these future cash flows and thus typically lead to a compression in valuation multiples. While in the long term the growth style is still likely to fare well given that economic growth is expected to decline to low single digits from 2023 forward, in the near term duration, quality and profitability will likely become increasingly important drivers of equity market returns. Cyclical stocks have historically performed the best during the initial stage of past Fed hiking cycles, and we expect this pattern to continue during this cycle as well. In particular, interest rate sensitive sectors, like Financials have historically performed well in periods of rising rates.
An examination of performance across asset classes in past Fed hiking cycles could shed light on the possible path markets may take from here. There have been nine Federal Reserve hiking cycles since the U.S. went off the gold standard in 1971, and returns were predominantly the strongest in risk assets like equities – and in particular for commodities – during these periods of rising rates. Bonds have historically tended to underperform during these cycles. The initial starting level of rates and the level at which the Fed halted increases have been highly important, however, broadly producing two distinct return patterns. When rates at the start of the hiking cycle were already high and the terminal rate was subsequently high as well, as was the case in the 1970s and 1980s, equities performed extremely well at the beginning of the hiking cycle but returns suffered later as higher rates became a drag on economic growth. Since the 1990s, Federal Reserve hiking cycles have been gradual and have been initiated off a relatively low starting base rate, the same conditions that predominate today. In this environment, equity returns have historically tended to suffer some short-term pain in the initial stages of a hiking cycle but ultimately produced solid returns over a 12- to 24-month horizon. At this stage, the historical pattern looks likely to repeat as equities have declined to start the year with the expectation of the first rate hike in March. With a starting rate at the zero bound and real rates still deeply negative, current market expectations are pricing a historically low terminal rate; 3-4% is most probable based on current market data. Should the next 24 months play out as expected, this should ultimately be supportive for equity returns over the intermediate horizon.
We are skeptical that one historical pattern of past rate hiking cycles will repeat this time around, however, at least in the initial stages – the outperformance of international stocks over U.S. stocks. Historically, international equities have outperformed during Federal Reserve hiking cycles, but we remain cautious due to the geopolitical clouds that are currently darkening the horizon. The risk of a Russian invasion of Ukraine appears significant as of this writing, and it very well may happen before this piece reaches you. Should such an invasion occur, the potential ramifications will be global in nature. During the Cold War, much of the nuclear stockpile of the USSR was housed in Ukraine. After the fall of the Soviet Union, these weapons fell under the control of the Ukrainian government. Despite concerns about potential future Russian aggression, Ukraine gave up its nuclear stockpile in 1994 and joined the Nuclear Non-proliferation Treaty as a direct result of promises from the United States and NATO to protect Ukraine from future Russian incursion. Should a Russian incursion occur without a swift and strong response from the United States and other NATO allies, other state actors around the world may take that as a signal that the protection offered by the U.S. nuclear umbrella to its allies around the world is no longer absolute. Specifically, inaction in the face of Russian intervention in Ukraine would signal to China – more specifically to the military and civilian leadership of the Chinese Communist Party – that U.S. support for Taiwan in the face of Chinese military aggression would falter. Either of these events would likely produce a significant risk-off event, with the heaviest toll falling on the geographies involved. While international diversification remains important, these geopolitical risks temper our appetite to follow the historical trend and increase our allocation to international equities. These situations remain quite fluid, however, and with international equities currently significantly undervalued in comparison to their domestic counterparts, developments on the ground over the course of the year could alter our view.
The current geopolitical risks present as we start 2022 remind us of the value of the fixed income allocation in a well-balanced portfolio. While bond returns are expected to be muted from here, should any of the potential geopolitical events above play out, we expect bonds to continue to provide a ballast in choppy seas, repeating the return patterns we saw in markets during the initial stages of the pandemic. We have, however, begun preparing portfolios for the expected increase in rates during the year. In this environment, we expect the same sectors that outperformed in 2021 to continue that run in 2022. Specifically, we believe a shorter duration posture, healthy exposure to the higher yields that come from credit exposure, and an increased allocation to floating rate instruments, which all serve to reduce interest rate sensitivity, are appropriate in the near term.
The New Year
As we begin the new year, the economy remains strong and the global recovery remains intact, despite the surprises thrown our way in 2021. Progress against the virus remains important to monitor, as setbacks remain a possibility, but the impact of the virus on the global economy is likely to fade in 2022. The path of global inflation – in particular progress in the global supply chain pressures faced throughout much of 2021 – and the potential impact of geopolitical tensions will be the key main events to monitor in the year ahead. While 2022 faces some potentially significant potholes that could generate negative headlines – as does every year – the experience of market investors in 2020 and 2021 shows that markets can shrug off this noise and generate solid returns. It remains as important as ever to exercise sound investment principles and a high degree of diversification.
We remain committed to focusing on your long-term financial goals and priorities and constructing portfolios designed to reach those goals while minimizing risk. The volatility environment experienced over the last several years demonstrates the value of disciplined professional management. The ups and downs in the market, exacerbated by the constant stream of headlines disseminating from 24/7 news networks, naturally elicit an emotional response. We humans are prone to behavioral biases, often overreacting to both downturns like the sell-off experienced in March 2020 and the strong returns that followed. In times like these, when dramatic headlines flow like a fire hose, determining the facts that matter and filtering out the rest is vital.
Our clients’ interests always come first, and our goal for 2022 is to continue to separate the signal from the noise and focus on what truly matters to the economy and markets to help you achieve your investment goals.