Where are we now with…
…Covid-19? As we have with all our quarterly writings over the last two years, we must talk about Covid-19. For one, we are now entering year three of this global pandemic. From a health care perspective, so much has changed for the better (there are vaccines available, improved treatment methods, etc.).
At the same time, there are still new variants arriving (Omicron being the most recent) with unknown consequences and health concerns (how quickly it spreads, will it evade the vaccine, and/or booster). Much is different from an economic perspective as well. When Covid first hit, economies were negatively impacted by lockdowns and shutdowns. Now, while Covid is still impacting markets and the global economy (more on this later), the impacts from the new variants appear to be less than in the past. What we do know is that this pandemic has distorted many economic indicators, making it very difficult to compare current vs. past data. We are also entering a new phase, particularly in the US, where peak stimulus (both monetary and fiscal) appears to be behind us, creating a potential economic drag. Think about it this way: the economy was injected with a lot of stimuli when it was almost literally shut down, which was needed to avoid financial disaster. As we are nowhere near this point anymore, it is also time to remove and reverse at least some of the stimulus.
Where are we now with…
…Inflation? All the stimulus referenced has certainly been a factor behind the large increases in inflation we are witnessing (see Exhibit 1 for historical references).
SOURCE: LABOR DEPARTMENT
In October and November, the CPI jumped to 6.2% and 6.8% respectively, all of which are well over the 2% average target set by the Fed. Plus, November represented the seventh consecutive month in which inflation was at or above 5%. (Source: BLS.gov, CPI-U, shows the percent change from 12 months ago). The reasons for higher inflation have been well documented and include reasons such as tight supply chains, worker shortages, increased consumer spending, and rising energy prices. More recently, in what is now referred to as the “Powell Pivot” the Fed has moved away from referring to inflation as transitory, suggesting it might be more persistent, and setting in motion the potential for rate hikes in 2022.
Where are we now with...
…Monetary policy? As we have previously mentioned, inflation can become a self-fulfilling prophecy. One of the ways to reduce or at least slow inflation is through higher interest rates. Let’s remember that since March 2020 the FOMC’s target federal funds rate has been 0-0.25%, providing a very accommodative policy for markets. More recently, since the Powell Pivot mentioned above, The Fed is speeding up its pace of tapering, now on track to end by mid-March 2022, with the possibility the Fed will raise rates by June 2022 if not sooner.
Exhibit 2 shows the number of Federal Reserve hikes implied by the Federal Funds futures market. In September of 2021 (shown in red) when inflation was still being referred to as transitory, the market forecasted one rate hike occurring before the end of 2022. However, since the Powell Pivot in December 2021, the futures market priced in almost three interest rate hikes by the end of 2022.
SOURCE: BLOOMBERG, PAYDEN CALCULATIONS
While signs of inflation are being seen globally, central banks across the globe are each taking their approach to interest rates. For example, in November in the UK, inflation hit a 10-year high when consumer prices increased 4.2% through October 2021. In December, the Bank of England voted to increase the Bank Rate by 0.15% to 0.25%, becoming the first major central bank to raise interest rates since the beginning of the pandemic.
Exhibit 3 shows headline and core inflation in the Eurozone vs. the US. While inflation is also elevated in the Eurozone, the European Central Bank (ECB) decided in December to end its emergency bond-buying program but expects to keep interest rates unchanged in 2022, continuing with loose monetary policy.
SOURCE: ORIGINATION FOR ECONOMIC COOPERATION AND DEVEL.
Each of these central banks has its challenges and dilemmas. Move too slowly and inflationary pressures can take hold, move too quickly, and they risk slowing or even stopping the economic recoveries that have taken place since the global pandemic began.
All the recent increases in inflation along with the varied approaches to central bank policy show just how different pockets of the global economy are recovering, and how the pandemic continues to shape future economic scenarios.
There are still so many unknowns, it is understood that there may be continued changes to expectation and increases in volatility.
Exhibit 4 shows the survey results from several major banks and asset management firms regarding the predictions they made for 2021. The S&P 500 wound up ending the year at 4766.18.
These market predictions for 2021, in general, are close and a lot closer than they were last year. For example, last year (2020), BMO and Goldman Sachs were off target by 10.5%, Bank of America was off by 13.8% and Morgan Stanley was off by a whopping 25.2%. At the same time, we still wouldn’t recommend too closely following these predictions as some are still far off. Plus, there is simply no way to know what will take place in 2022. For example, will the Fed act too quickly or too slowly? Will new Covid-19 strains appear? Will Covid-19 become an endemic disease? These are only a small sampling of divergent outcomes that could occur.
US stocks, in general, had another strong quarter with the Russell 3000 Index gaining 9.3% with large-cap growth stocks, as represented by the Russell 1000 Growth Index, earning 11.6%. The year-to-date returns were extremely impressive with most benchmarks jumping into double digits, apart from small-cap growth (i.e., Russell 2000 Growth Index) which only grew by 2.8%. Interestingly, for the year, small-cap value (i.e., Russell 2000 Value Index) went up by 28.3%, highlighting the difference between small growth and small value. For what it’s worth, the difference was negligible in the large-cap space with the Russell 1000 Growth Index achieving a 27.6% return with the Russell 1000 Value Index not far behind at 25.2%. These massive returns continue to come on the heels of the extremely accommodative monetary and fiscal policy that started at the onset of the pandemic, as low rates make it easier for companies to borrow while the same low rates make equities arguably more attractive than low yielding fixed-income investments. As interest rates are expected to rise and equity investors may have more options where to invest, this could have an impact on future US equity returns.
With this being our year-end edition, we wanted to highlight some interesting aspects of the S&P500. Throughout 2021, the S&P 500 reached new highs on seventy different occasions. If you consider that there are only 252 trading days per year, that means the S&P500 hit a new high on just over 25% of trading days last year.
Another interesting fact for the S&P 500 is that its 3-year annualized return as of 12/31/2021 is an astounding 26.1%. Let’s use Exhibit 5, which looks at the S&P 500 going back to 1970 using 3-year rolling periods, to put that in perspective. Since 1970, there have been 52 annual periods, meaning there are 49 rolling 3-year periods or 588 monthly observations. In all, there were only 37 months, or just over 6% of observances, with a higher 3-year rolling return than the one ended December 2021. Almost all these months fall within two distinct periods: 1) the months leading up to Black Monday in October 1987 and 2) the dot-com era of the late 1990s.
SOURCE: MORNINGSTAR DIRECT, S&P 500
Now, we are not predicting a downturn in 2022, but we think it’s important to show how unusual these last 3 years have been compared to historical trends.
Another interesting fact for the S&P 500 in 2021 was that the energy sector was the top-performing sector in 2021, going up by 53.4%. Interestingly, the energy sector was the worst-performing sector in 2018, 2019, and 2020 (Source: www.statista.com).
For the quarter and on a YTD basis, developed large-cap (2.7%, 11.3%), developed small-cap (0.1%, 10.1%) and emerging market stocks (-1.3%, -2.5%) saw mixed results. At least some of non-U.S. equities’ underperformance versus their U.S. counterparts can be attributed to the dollar’s strength over the quarter, as we know a stronger dollar hurts international equity returns. On a YTD basis, only the Israeli new shekel and Canadian dollar appreciated vs. the USD.
From a country perspective, there were only six developed non-US and emerging market countries that outperformed the US quarterly (Egypt, Switzerland, Czech Republic, UAE, Peru, Israel) and these have a relatively small weighting within the irrespective indices (Source: MSCI All Country World IMI Index, Russell 3000).
In the emerging markets, while China remains the largest country exposure by far, its performance has caused it to fall from being 37.5% of the MSCI EM Index on 6/30/21 to 31.2% as of 1/5/2022. Chinese stocks overall fell by 21% in 2021. The challenges within China over 2021 were varied and include a slump in its property market, weakened consumer spending, and new regulations that negatively impacted technology companies and online tutoring companies among others.
Oftentimes in US markets, we will refer to large-cap vs. small-cap, or growth vs. value to distinguish between various types of stocks. And while we may tend to do that less in non-US developed markets and emerging markets, those categorizations still exist, and they can have meaningful differences.
Exhibit 6 shows how much a difference it made in 2021. As the table shows, emerging market stocks classified as large-cap growth underperformed those in other emerging markets style boxes by 12% to 30%. This means the performance of your emerging markets investment depended on how it was allocated among these various types of stocks.
SOURCE: FACTSET, AVANTIS INVESTORS, DATA AS OF 12/31/2021
In all, we currently still believe investing in emerging markets is an important aspect of an investor’s portfolio, even with the knowledge that greater amounts of volatility may exist.
Global Fixed Income
Fixed income indexes saw very mixed results for both the fourth quarter and on a YTD basis.
For 2021, only munis (across the yield curve), high yield, and inflation-protected securities experienced positive results with Treasuries, corporate bonds, and non-US bonds largely having negative returns.
Like last quarter, there was quite a bit of movement in the US yield curve, with the curve flattening overall except only at the very short end (see Exhibit 7). Overall, 3-month Treasuries and shorter experienced very little changes, Treasuries between 6 months and 7 years saw a large increase in yields while the longer part of the curve (10+ year Treasuries) saw their yields decline.
In all, the various parts of the yield curve are at odds with one another. With the expectation of more inflation and ultra-loose monetary policy going away, the short end of the yield curve is seeing yields increase in anticipation of the Fed increasing short-term rates. Remember, in September the Fed was only penciling in one interest rate increase in 2022, but as of the end of December it was up to three increases, showing how efficient the market is in pricing in expectations. However, on the long end of the curve, rates are dropping, which normally happens when slower growth is expected, highlighting the potential that rates may rise too quickly and dampen growth.
SOURCE: BLOOMBERG, DATA AS OF 12/31/2021
We believe that an allocation to non-US fixed income can be a benefit to many portfolios. While we don’t expect much change in absolute returns when adding non-US fixed income, we do believe the allocation can reduce the risk of the overall portfolio. One of the reasons we want to have this non-US exposure is to diversify interest rate risk, so investors aren’t 100% exposed to changes in US interest rates. With economies across the globe in different phases of recovery, and while central banks are making different decisions vs. one another, this should provide a diversification benefit, so our fixed-income investments are not solely focused on US interest rates.
As we discussed in previous quarters, to expect to generate more return, investors typically need to assume more risk. In fixed income, that means either extending duration or reducing credit quality. Some tradeoffs must be weighed very carefully before implementing either strategy. From a duration standpoint, extending duration too far out can be a risky move in a period of rising rates.
Similarly, lowering credit quality means investing in high yield, or junk bonds, which generally correlate much more with equities and therefore may not provide the diversification benefits we expect from fixed income.
Municipal performance was positive for the quarter with longer-dated munis outperforming their shorter-term counterparts. Similarly, while Treasuries and Corporates generally fell for the year, munis had positive performance across the yield curve.
We continue to view fixed income as a method of reducing overall portfolio risk (as measured by standard deviation), given that equities are expected to have much higher volatility. Our portfolio’s focus will continue to be on high-quality bonds with an emphasis on short to intermediate-duration government and corporate bonds, where default risk has historically been relatively low. For some investors, muni bonds are attractive for their tax-free income.
As always, please reach out to your advisor if you have any questions about your personalized Investment Plan.