The final quarter of another unforgettable year was filled with volatility, as investors reacted to yet more news about virus variants, spending programs, and inflation readings. Unlike the previous period, however, investors largely shook off those concerns and drove stock values higher. The S&P 500 index finished the quarter with gains of about 11%, which carried the full-year 2021 return spectacularly to over 28%.
Stocks shook off all headwinds last year. Markets reacted favorably to the typically milder impacts from the omicron virus variant and absorbed the increased likelihood that the Federal Reserve will begin to increase the short-term lending rate. The futures market is currently projecting four rate increases for 2022. This is a welcome change, as 2021 saw consistently above-average inflation readings, including the highest number in almost 40 years in November. These inflation increases, along with ongoing supply chain issues, continue to directly impact consumers, but so far purchasing strength remains on solid footing. This is crucial to ongoing growth in our consumer-based economy. Looking forward, we do not expect inflation to remain this elevated ongoing, but will be closely watching the impact of rent increases, since that measure accounts for about 1/3 of the Headline CPI calculation.
Bond markets had a fairly benign reaction to record highs in S&P 500 index values and the likely onset of interest rate increases, with the 10-year Treasury effective yield ending the year right near 1.5%. Bonds have largely shaken off the spike in inflation measures, but as the Fed completes the tapering of its quantitative easing program and begins to increase the short-term lending rate, we may see yields rise. While Treasuries remain a safe credit, and often yield more than many foreign issuers, this asset class does remain quite overvalued by typical metrics. Our philosophy remains to maintain a relatively short bond duration and take some measured credit risk. While very few bond strategies showed upside in 2021, we believe that this positioning is prudent for current market conditions.
Looking forward a myriad factors will impact markets, but consumer confidence and buying strength will remain paramount. After all, economic growth is ultimately what drives equity returns. With the sizable Build Back Better spending program being sidelined (for now at least), the chances of further government stimulus goosing growth, as it has in recent quarters, is unlikely. There are still massive levels of cash available, and how consumers can and will use that cash will be a key factor in how future growth is allocated. Growth expectations must also factor in tax policy. Expectations for significant disruptions have thus far proven to be overstated as more radical proposed changes are unlikely. Given the mid-term elections this year, where the party holding the presidency has historically lost seats, significant tax reform does not seem a political priority.
We have identified key data points in recent market commentaries. While these metrics may vary widely by quarter as we continue to deal with this Pandemic period, here is where they currently stand:
- Valuations. Valuations remain fairly high by historical standards, but solid earnings and low bond yields help rationalize those levels. The S&P 500 index ended the quarter at roughly 21 times earnings, lower than the level 12-months prior (source: JPMorgan). Continued earnings growth will remain key here, especially as bond interest rates begin to steadily climb over time.
- Economic growth. GDP readings for Q3 were dragged by delta variant economic restrictions, but so far Q4 looks good to rally up off those levels. The GDPNow Q4 2021 estimate is just over 7.5% growth (source: Atlanta Fed) (1), with the Wall Street average estimates modestly below that level. This level of growth still leaves us below the long-term trendlines prior to Covid, but these strong readings are good news for investors.
- Interest rates. The Federal Open Markets Committee finally changed their stance on inflation by dropping the word “transitory”. They have already begun tapering the bond purchase program, and futures markets now expect to see four rate rises in 2022. This is good news for investors, as cash and short-term bonds will likely begin to have material yields this year.
Asset Class Review
- Currency. The trend of modest softening was reversed in this period, with the dollar seeing a very slight uptick in relative strength. This had some light impact on the returns of non-U.S. securities for domestic holders.
The fourth quarter saw sizable gains in domestic stocks, driving the S&P index to an annual gain of over 28% as noted above. Gains for the full year were led by the Energy, Real Estate and Financials sectors, which are all considered Value style. However, the Growth style of stocks had the larger aggregate gains for the year as the lowest volatility sectors like Utilities and Consumer Staples provided solid- though not spectacular- upside for the year as a whole.
The aggregate taxable Bond market was roughly even for the quarter and finished the year with a modest loss in total return. The High Yield sector finished the quarter just modestly positive and provided some decent upside for the year as a whole- though credit spreads do remain near all-time lows as that class trades very rich. Commodities finished the year with significant gains, with the rally in oil and some specific precious metals and food-related goods offsetting the mediocre year for gold- which continues to show it does not provide the inflation hedge its reputation would imply. Meanwhile, Bitcoin- which has been anointed by some as the actual inflation hedge- finished the quarter “violently sideways” with a very volatile modest loss.
Foreign developed stocks finished the year with solid gains that only look disappointing relative to more outsized gains in big domestic stocks. Developed markets were yet again impacted by lockdown measures, but unlike the previous period this time, investors were undeterred from buying quality stocks in those countries. Emerging Markets had a disappointing year, as the most inexpensive broad stock class became even cheaper by relative comparison after a year with slight collective losses in value. These markets continue to trade at much lower valuations than domestic stocks, but comes with risks. We continue to advocate for the potential upside in these classes, with their lower valuations, higher yields, and strong internal population growth, but as noted in previous quarters many investors have favored the relative security of domestic markets- even as those trade quite rich.
Past performance is not indicative of future results.
Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be profitable or suitable for a particular investor's financial situation or risk tolerance. Investing involves risk, including loss of principal. You cannot invest directly in an index. Asset allocation and portfolio diversification cannot assure or guarantee better performance and cannot eliminate the risk of investment losses. Source: Morningstar
The S&P 500 Index (Developed Markets)
is widely regarded as the best single gauge of large-cap U.S. equities. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.
The Barclay's Aggregate Bond Index (Taxable Bond) is a broad base, market capitalization weighted bond market index
representing intermediate term investment grade bonds traded in the United States.
Headline Inflation (CPI) is the raw inflation figure reported through the Consumer Price Index (CPI) that is released monthly by the Bureau of Labor Statistics.
The Bloomberg Commodity Index (Commodities) is an index of the prices of items such as wheat, corn, soybeans, coffee, sugar, cocoa, hogs, cotton, cattle, oil, natural gas, aluminum, copper, lead, nickel, zinc, gold and silver.
The index is calculated on an excess return basis and reflects commodity futures price movements.
The MSCI EAFE Index (Foreign Developed Index) is designed to represent the performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the U.S. and Canada.
The MSCI Emerging Markets Index
captures large and mid-cap representation across 27 Emerging Markets (EM) countries. With 1,392 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
Bitcoin - Each crypto index is made up of a selection of cryptocurrencies, grouped together and weighted by market capitalization (market cap). The market cap of a cryptocurrency is calculated by multiplying the number of units of a specific coin by its current market value against the US dollar.
All opinions and data included in this commentary are as of December 31
, 2021 and are subject to change. The opinions and views expressed herein are of Cutler Investment Counsel, LLC and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This report is provided for informational purposes only and should not be considered a recommendation or solicitation to purchase securities. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither Cutler Investment Counsel, LLC nor its information providers are responsible for any damages or losses arising from any use of this information.