January 05, 2022

Market Summary – Year-End 2021

Low interest rates, liquidity injections from stimulus programs including the $1.9 trillion bill passed in March, COVID vaccine rollouts, and strong earnings growth overcame rising inflation, new COVID variant case surges, and a shift to a more hawkish tone from central banks to produce a generally strong year for financial market performance. There were periods of volatility. However, in the end, major stock indices around the world posted double-digit gains with the exception of the emerging markets index which was hurt by the drop in Chinese stocks due to the regulatory crackdown on certain industries. Commodity market returns were also generally strong as demand was robust and supplies tight. The U.S. dollar strengthened against most major currencies after weakening in the prior year. Bond yields generally moved higher, and prices moved lower, in reaction to inflation rates not seen in decades. The price of gold declined as the demand for safe haven assets faded.

Key Economic News:
Economic and earnings growth was strong in 2021. U.S. real gross domestic product (GDP) growth was 6.3%, 6.7%, and 2.3% in the first three quarters respectively and forecasts put fourth quarter GDP at about 7%.

The labor market was also strong and continued to recover from 2020 shutdown impacts. The unemployment rate dropped to 4.2% in November from 6.7% in January. The number of job openings rose to a record high of 11 million. A statistic that gained much attention was the quit rate, which rose to all-time highs in the second half of the year reflecting workers willingness to switch jobs in search of higher pay and better perks. The tight labor market has pushed up wages and contributed to the rise in inflation numbers.

With the rebound in business and social activity as pandemic restrictions were eased and vaccination rates rose, demand for goods and services surged but was met with supply shortages and logistical bottlenecks. The result was a sharp acceleration in inflation in the U.S. and other countries. High inflation rates began to be reported in the first half of the year. For example, the U.S. core consumer price index (CPI) rose 0.9% in May over the prior month. This was the highest monthly increase since 1981. The year-over-year CPI growth rate was over 5% for seven consecutive months. The most recent report showed a 6.8% growth rate in November, which is the highest level since 1982. Producer prices have risen sharply as well. The U.S. producer price index (PPI) in November increased 9.6% from the prior year, which is an all-time high growth rate. In October, China’s year-over-year PPI was 13.5%, a 26-year high. The high inflation rates around the world led to a shift by central banks to begin to tighten monetary policy and reduce or end emergency stimulus programs.

Asset Class Reviews:
It was another record setting year for various U.S. equity indices fueled by the massive increase in the money supply due to monetary and fiscal stimulus and to the release of pent-up demand as business and social activities returned to somewhat more normal levels. The S&P 500 hit 33 new record closing highs during 2020 but more than doubled that pace in 2021. The S&P 500 set 70 new closing highs during 2021 including a new high during the last week of the year. The Dow Jones Industrial Average had 45 new closing highs in 2021 up from 14 in 2020. The Russell 2000 index of small capitalization (cap) stocks had 21 record highs with the most recent record set in November. The S&P 500, Russell MidCap, and Russell 2000 indices each finished the year with a double-digit return. This was the third consecutive year of double-digit positive returns for each index.

Those double-digit 2021 gains for the broad indices mask significant return differences between sectors. In a rather unusual result, in the S&P 500 index growth stocks outperformed value stocks by a wide margin but value stocks outperformed growth stocks by a significant amount in both the mid and small-cap indices. Typically, growth vs. value trends tend to be similar across the market cap spectrum. The surge in inflation as the year progressed pushed prices up for materials, industrials, and financials stocks which are more heavily weighted in the value indices. Correspondingly, any move higher in bond yields or hints from the Federal Reserve (Fed) about potential rate hikes to address inflation concerns caused high growth rate stocks to sell off, especially in the mid and small-cap categories. In the S&P 500 index, various mega-cap growth stocks, such as Microsoft and Alphabet, had strong price gains throughout the year which helped growth to outperform value in that index since those mega-cap stocks have the largest weightings in the index. All 11 industry sectors in the S&P 500 and Russell MidCap indices posted a double-digit positive return for the year. In the Russell 2000 index of small-cap stocks, 10 of the 11 sectors had a double-digit gain. However, the healthcare sector, which is the highest weighted sector in the Russell 2000, ended the year down 18%. Weakness in biotechnology stocks as well as selloffs for healthcare services stocks after those stocks prospered from the shift to virtual services in 2020 were primary reasons for the negative return for the sector. Energy was the best or second-best performing sector in all three indices reflecting the steep rise in oil and natural gas prices in 2021. The sector had a return of 55%, 45%, and 38% in the S&P 500, Russell MidCap, and Russell 2000 respectively. Communication services had the highest return in the mid-cap index and the second-best return in the small-cap index. Interestingly, that sector was one of the weakest performers in the S&P 500 index. Real estate and financials were other top performing sectors across all market cap categories. As investors focused on growth from stimulus and economic reopening, more defensive sectors lagged. Therefore, the utilities and consumer staples sectors had some of the lowest sector returns in each market cap category. In the mid and small-cap indices, information technology was also a laggard. As mentioned, in the small-cap index, healthcare had the lowest sector return for the year.

International equity index returns lagged returns for the major U.S. indices. The MSCI EAFE index of developed economy stocks ended the year in double-digit gain territory with a return of just over 11%. The Emerging Markets (EM) index, however, finished the year lower with a return of -2.5%. The U.S. dollar strengthened against many currencies during the year. As a result, local currency returns for both the EM and EAFE indices were higher than the dollar-based return. There was little difference between the returns for the growth and value components of the EAFE index reflecting that both growth (information technology) and value (energy) sectors were at the top of the performance rankings for the 11 industry sectors. In the EM index, value with a positive return, outperformed growth which had a negative return. Energy was the top performing sector in the EM index, just as in the EAFE and S&P 500 indices. The consumer discretionary and communication services sectors were at the bottom of the performance rankings reflecting the sell-off in various Chinese internet, gaming, and education stocks after the government imposed strict new regulations on those industries. Returns across countries varied widely. Among developed markets, various European markets posted double-digit gains and outperformed Asian and Pacific region countries that had low single-digit returns, such as Japan, or negative returns, such as New Zealand. Among emerging markets, India, Mexico, Russia, and Taiwan all posted a double-digit gain as these markets recovered from the pandemic shutdowns of 2020. Other countries including China, Brazil, Chile, and Turkey each had a double-digit negative return for the year hurt by slowing growth, interest rate hikes, and government policy decisions.

Since bond yields moved higher in 2021, most sectors of the U.S. bond market had negative returns for the calendar year. During the first quarter of 2021 optimism increased for economic growth fueled by the COVID vaccine rollout and passage of the $1.9 million stimulus bill. That optimism for growth sparked inflation concerns and drove bond yields higher (and prices lower). In January, the 10-year U.S. Treasury bond yield moved above 1% for the first time since March 2020 and reached a 14-month high of 1.77% in March. Yields retreated modestly during the middle of the year as strong demand for bonds kept a cap on yields and as the Fed continued to signal that the rising inflation rates were transitory as the economy works through supply chain issues as pandemic restrictions ease. Yields also dropped in reaction to new COVID variant outbreaks with the 10-year Treasury yield moving to as low as 1.36% in December on worries about the impact of the new Omicron variant. Yields moved slightly higher as Omicron fears eased and ended the year at 1.51%. The yield on the 2-year U.S. Treasury note had a similar pattern beginning the year with a yield of 0.13% and ending the year at 0.73%. Not surprisingly, in a year when the inflation rate rose significantly and reached levels not seen in 30 years, the Treasury Inflation Protected Securities index with a 6% gain had the best return among the major sectors of the bond market. Reflecting the “risk-on” sentiment in financial markets in 2021, the corporate high yield index was another top performer with a return of over 5%. The municipal bond index was the only other bond index we track to post a positive return. Municipal bond prices were boosted by demand from investors outstripping supply of new bonds.

The commodity index posted a double-digit positive return of 27% for the calendar year. Of the sub-indices we track, only precious metals had a negative return for the year as both gold and silver prices fell in a generally “risk-on” environment. The petroleum sub-index, with an almost 63% return, was the best performing sector we track. The price of West Texas Intermediate (WTI) crude oil started the year at $48 per barrel. The price rose through the first three quarters of the year as economies reopened and demand increased but supply remained tight. WTI reached a high of $86 in October, the highest price since 2014. The price turned lower late in the year on worries about declining demand from travel bans and shutdowns related to the Omicron outbreak. WTI ended the year at $75.33. Natural gas prices also moved higher peaking in September on limited production but increasing demand. Prices dropped in November and December due to unusually warm weather. The industrial metals sub-index was another top performer with a 30% return. Demand was strong throughout the year as industrial production and construction activity ramped up to meet the surge in demand from new orders and attempts to restock inventories. Various commodities hit multi-year price highs. For example, the price of copper hit a 10-year high and lumber futures prices hit new all-time highs.

Outlook:
Various economic data, such as low inventory levels, strong demand for labor, and the need for capital spending to offset labor shortages, point to continued growth potential. Therefore, we expect solid corporate earnings growth in 2022. However, the rate of growth will likely slow from the reopening rebound and stimulus fueled gains seen in 2021 as fiscal stimulus programs have ended and the Fed is working to end its bond buying program that has injected significant amounts of liquidity into financial markets. Other uncertainties remain including will there be more waves of COVID variants impacting economic and social activity, will the rate of inflation slow as economies work through supply chain issues and pent-up demand eases or continue at multi-year highs and slow consumer spending, and will the Fed actually raise interest rates and what will the impact of those rate hikes be on economic activity. With valuations generally high after the gains since the pandemic lows, periods of volatility in reaction to changing events are expected. Therefore, we continue to prefer to have a diversification of exposure to sectors benefiting from secular growth trends along with some exposure to cyclicality to participate in economic growth. With bonds looking expensive with yields at historic lows and the Fed forecasting interest rate hikes in 2022, we favor equities over bonds.

We have an overweight recommendation for U.S. equities and recommend an underweight for developed international equities. We maintain an equal weight recommendation for emerging market equities. Within our fixed income recommendation, we continue to favor short to intermediate maturities. We continue to recommend an underweight allocation to hedge funds. We recommend keeping at least a year of cash reserves to avoid having to raise cash during a period of market volatility.

The statistical information contained in this commentary has been compiled from publicly available sources and is presented to you for your review and for discussion purposes only. The information contained in this commentary represents the opinion of the author(s) as of its date and is subject to change at any time due to market or economic conditions. These comments do not constitute a recommendation to purchase, sell or hold any security, and should not be construed as investment advice or to predict future performance. Past performance does not guarantee future results.

The statistical information contained in this commentary was derived from sources that Vogel Consulting, LLC believes are reliable, and such information has not been independently verified by Vogel. Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of the Russell Investment Group. An index is not managed and is unavailable for direct investment.