“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness.” So begins Charles Dickens’s novel, A Tale of Two Cities. It is fair to say that each of these lines, clichés notwithstanding, resonate as we focus on different aspects of current circumstances. In terms of stock markets and the economy, indices continue to repeatedly surpass previous highs, but so do COVID case numbers, echoing last year’s conclusion.
The hope, based on initial data, is that this latest virus surge will not translate into significantly higher hospitalizations and deaths, thanks to milder characteristics and the uptake of vaccines and booster shots. Still, in the final week of 2021 new daily cases in the U.S. were coming close to half a million, and globally the number soared to almost 1.73 million. Increased testing capacity, including at-home options, contributes to these numbers, but the bottom line is that COVID remains an overarching theme as we enter 2022 and markets remain susceptible to the trajectory of the pandemic and the societal constraints leaders impose in response to it. The hope of containment or eradication now appears slim and we await a transition to an endemic situation with a greater focus on treatment and management of outcomes rather than case tallies.
Despite some rockiness in the last month of trading mainly brought on by the emergence of this Omicron coronavirus variant, the S&P 500 closed on December 31st at 4,766 representing a return of 11.03% for the final quarter of 2021 and an impressive 28.72% for the year. The Dow Jones Industrial Average also fared well, although continued to lag the S&P 500 in the latter half of the year. The DJIA ended December at 36,338 for a return of 7.88% in the past three months and 20.95% for 2021. The markets have now experienced three years in a row of large gains with the S&P 500 hitting 70 closing highs in 2021, the most since the record 77 set in 1995.
These results indicate that investor sentiment remains positive even as the markets remain poised to react to the economic impact of the fast-spreading, but thankfully less virulent, Omicron variant, a more entrenched higher inflation environment, a phasing out of stimulus measures, and central banks starting to pivot away from extremely accommodative policies. Supply chain bottlenecks, which feed into inflation pressures, could be exacerbated if China decides that lockdowns at ports are once again necessary. There is also the question of how much steam this roaring bull market that began 21 months ago has left in it. No runs continue in perpetuity and our strategy remains focused on identifying investment opportunities that we believe are trading within reasonable valuation parameters regardless of the broader market momentum.
There were disparities between regions and countries, but world GDP (Gross Domestic Product) grew at the fastest pace since 1973 and marked the strongest turnaround in economic growth between two consecutive years. The rollout of vaccines correlated with a rebound in retail sales in the U.S. as consumer confidence recovered and regular activities resumed. Year-on-year, second quarter earnings growth for the S&P 500 was a record-breaking 92% and the third quarter was a substantial 40%. Reopenings favored the cyclical sectors over defensive ones this year, with Energy, Real Estate, and Financials leading the pack in terms of returns and Industrials, Consumer Staples, and Utilities bringing up the rear.
Energy really was the standout with close to a 50% sector return over the past 12 months and is set to set to finish out its best year since 2009 with WTI crude oil ending the year over $75 / barrel. This is down from the high close to $85 / barrel towards the end of October but a big jump from below $50 at the start of the year. These numbers are reflective of restored demand as economies reopened worldwide. Large Cap Value and Growth Strategies posted largely comparable overall returns for the year, with the more economically-sensitive value stocks making an early surge through the first six months before growth made a comeback.
As a further indication of the robust economic rebound from the havoc wrought by initial pandemic shutdowns, continuing jobless claims are down to 1.7 million, the lowest since pre-lockdown in March 2020. According to the Bureau of Labor Statistics, the unemployment rate for November came in at 4.2%. These figures, combined with stubbornly high inflation figures have put pressure on the Federal Reserve to not delay plans to go ahead with tightening initiatives.
Fed Chair Jerome Powell, who was reappointed to his post for a another four years by President Biden in November, conceded at the start of this month that current U.S. inflation trends could no longer be characterized as “transitory”. Treasury Secretary Janet Yellen also admitted the same. Chair Powell noted that “while the drivers of higher inflation have been predominantly connected to the dislocations caused by the pandemic, price increases have now spread to a broader range of goods and services.”
In its December meeting, The Federal Open Market Committee (FOMC) moved its final inflation outlook for 2021 up sharply to 5.3% for all items and to 4.4% excluding food and energy. For 2022, these same figures are now expected by the FOMC to be 2.6% and 2.7% respectively. Based on industry participant forecasts, food prices, in particular, may rise steeply in the first half of next year as companies are forced to pass on to customers the rising costs of wages, products, and transportation. Other businesses face the same issues but the timing of when the end consumer feels the impact may not be as immediate.
Kicking off the reversal of its ultra-easy policies, the Fed has accelerated the pace at which it is reducing its monthly asset purchases, announcing it will buy $60 billion of bonds each month beginning in January, half the level prior to the November taper. The tapering will continue, wrapping up maybe by spring, at which juncture the Fed has signaled three 25 basis point rate hikes being considered for 2022, followed by three more the following year. Policymakers are also focused on the Fed’s massive $8.7 trillion balance sheet, although nothing has been decided going forward. None of these announcements came as a surprise to the bond market and the 10-year Treasury yield ended the year at 1.52%, still historically very low, although the 50 basis points rise over the course of the year dampened fixed income returns.
If the Fed Funds rate at the end of 2022 is 0.9% and inflation does come in at 2.6% that represents a negative real funds rate of 1.7%, which is more stimulative than restrictive for the coming year. The big question for many, however, is if the Fed has majorly undershot on its inflation prediction and will be placed in a position where faster or higher rate rises must be considered. It’s a delicate balancing act for an economy whose numbers appear strong but still has a certain wobbly feel to it as COVID uncertainties prevail for now.
Many central banks around the world are facing similar macro pressures. The European Central Bank (ECB) and the Bank of Japan (BOJ), two major players, are not telegraphing their intentions regarding rates in the manner the Fed has, while the Bank of England came out on December 16th with a surprise modest rake hike from 0.1% to 0.25%. In so doing, Britain became the first wealthy economy to experience a rate rise since the pandemic was declared.
President Joe Biden, alongside the rest of us, had no doubt hoped when he took office at the start of 2021 for some kind of “return to normalcy.” Indeed, as the oldest President elected his familiarity was likely a contributing factor to his win. As we end the year battling the Omicron variant, things are not ‘normal’, but government business beyond the pandemic must proceed.
After months of negotiations, President Biden signed the bipartisan Infrastructure Investment and Jobs Act in November. The legislation promises to provide $1.2 trillion in federal spending over the next five years. Some of the highlights include $110 billion for roads, bridges, and other major projects, $73 billion for power grid upgrades, $65 billion to be invested in providing high-speed internet access, and $50 billion to help communities fend off cyber-attacks and the effects of climate change including bolstering protection from droughts and floods.
At the end of December Democrats in Congress were, however, still not able to reach a consensus on Mr. Biden’s wide-ranging and ambitious social spending bill. Democratic Senator Joe Manchin from West Virginia was a ‘no’ vote on President Biden’s “Build Back Better” plan and invoked the ire of the more progressive wing of the party. Regardless of Mr. Manchin’s dissent, the bill was likely too expensive and radical to have passed in the Senate in the face of Republican opposition.
2022 is shaping up to be a major political barometer at home as midterm elections loom. Approval ratings for President Biden have drifted down to around 43% according to recent polls and Vice President Harris is below that figure at 40%. In a wake-up call for the Democratic Party, Glenn Youngkin secured the Governor-elect victory in Virginia in November 2021 becoming the first Republican to win statewide office in the commonwealth since 2009.
On the political front abroad, the U.S. is observing some areas of major tension and the world is watching to see if, and to what extent, America might choose to intervene. There is concern that China, a formidable economy and force, might attempt to seize Taiwan. The U.S. position on Taiwan has been one of strategic ambiguity, making it hard for all parties to predict the response should China make a definitive move. In addition, China’s property sector woes are continuing as big-name developers officially default on debt payments as they cannot cope with declining home sales, government curbs on borrowing, and a lack of investor appetite for new bonds.
Meanwhile, Russia continues a buildup of military forces, including around 100,000 troops, on its border with Ukraine. On a December 30th call between President Putin and President Biden, according to a Russian official talking to the press, Mr. Putin warned Mr. Biden that any economic sanctions imposed by the U.S. on Russia in retaliation against Russian military action in Ukraine would result in a “complete rupture” of relations between the two nuclear superpowers. White House officials, for their part, said President Biden “made clear that the United States and its allies and partners will respond decisively if Russia further invades Ukraine.” Despite strong words on both sides, the call was characterized as constructive and laid some groundwork ahead of talks in Geneva in January that will include NATO allies and then Ukraine.
We end the year somewhat cautious, due to continuing broad-scale uncertainties, but definitely optimistic. Resilience is prevailing and the recovery is marching on regardless of an ever-changing backdrop. As always, we focus on what we can know and do know, applying our knowledge, experience, and analysis to help identify what we believe to represent the best long-term opportunities. We hope you share in this optimism and we wish you and your loved ones a healthy, happy, and prosperous year ahead!