January 2022
Fourth Quarter and 2021 Recap
It’s been another remarkable year for the S&P 500 Index. Not only did the index of large-cap U.S. stocks return a stunning 28.7%, nearly triple its long-term historical average, but for only the second time in market history, the index reached a new high in each and every month.
The S&P 500 also dominated U.S. small-cap stocks, developed international stocks, and emerging-market (EM) stocks for the year. Much of this outperformance occurred in the fourth quarter, with the S&P 500 gaining 11.0%, compared to 2.1%, 2.7%, and -1.3% for small caps, developed international stocks, and EM stocks, respectively.
The renewed surge in COVID-19 infections late in the year (particularly in Europe and emerging markets) and China’s policy-induced economic slowdown and stock market decline were key drivers of this relative performance. The MSCI China Index plunged 21.7% for the year and lost 6.1% in the fourth quarter. Chinese stocks comprise roughly 35% of the MSCI EM Index. The MSCI EM ex-China Index gained 10.0% for the year.
Also contributing to the underperformance of international stocks for U.S.-based investors was the strength in the dollar. After falling early in the year, the U.S. dollar index appreciated sharply, ending the year with a 6.3% gain. A rising dollar is a negative when translating foreign market local-currency returns into U.S. dollar-based returns.
Turning to the bond markets, the core bond index lost 1.5% for the year, as interest rates rose moderately. The benchmark 10-year Treasury bond yield ended the year at 1.51%, compared to a 0.92% yield at the end of 2020.
Given the very sharp rise in inflation, most pundits would not likely have predicted such a mild increase in bond yields. Credit markets fared much better than core bonds in 2021. The U.S. high-yield bond index returned 5.4% and the floating-rate loan index gained 5.2% (S&P/LSTA Leveraged Loan Index). These returns were consistent with our expectations given a recovering and growing economy.
Portfolio Performance & Key Performance Drivers
For 2021, our balanced portfolios generated solid absolute and relative performance. More aggressive portfolios, while appreciating nicely, trailed their strategic benchmarks on a relative basis.
On the positive side, our tactical positions in flexible, actively managed bond funds and high yield funds added significant additional return over the core bond index. While the core bond index lost 1.5%, our non-core, credit-oriented bond funds gained anywhere from 2% to 6%. Our actively managed core bond funds also outperformed the core bond index by a material margin.
The main detractor in our more aggressive portfolio performance was EM stocks. After outperforming early in the year, the EM stock index suffered from a one-two-three punch of (1) China’s regulatory crackdown/property–market deleveraging, (2) rising inflation and tightening monetary policy across EMs, and (3) the renewed surge in the pandemic.
In our portfolios with actively managed funds, our active fixed-income and bond fund managers strongly outperformed, as noted above. But it was a different story on the equity side, with the majority of our active managers trailing their equity index benchmarks for the year.
We made two asset allocation changes to our portfolios during the quarter: (1) In October, we reduced Emerging Market equity, adding an increment back to U.S. stocks and developed international. (2) In December, reduced our overweight to high yield in favor of floating rate debt.
Our Macro and Market Outlooks for 2022 and Beyond
The Macro Backdrop
COVID-19:
As has been the case for the past 21 months, COVID-19 remains a key variable for the near-term (12-month) global economic and market outlook. We still believe the most likely medium-term (multiyear) base case is for continued progress in the fight against the virus and therefore a lessening of its economic impact over time. We do not expect the Omicron variant to derail the economic recovery in 2022, although it looks likely to have a negative impact early in the year.
If the pandemic recedes in 2022 as seems likely, the current pandemic-related supply chain disruptions, U.S. labor market anomalies, and consumer demand distortions should also recede. This should both support overall economic growth and mitigate at least some of the inflationary pressures the U.S. and global economies experienced in 2021 related to supply/demand mismatches.
However, as we said last quarter, we are not out of the COVID-19 woods by any means. Even as global vaccinations and immunity rise and societies adapt, the risk remains of new, more contagious and/or more deadly variants emerging. We are facing that now with Omicron, which is even more contagious than the Delta variant (but seemingly less virulent). And we’ll continue to see disparate virus impacts across countries, economies, and industries, along with differing government responses. For example, in the last weeks of December, several European countries and China enacted new lockdowns and other restrictions on activity as Omicron cases surged.
U.S. Economic Policy:
In addition to the evolution of the pandemic, U.S. monetary and fiscal policy will have important impacts on economic growth, inflation, and the financial markets in 2022. After unprecedented stimulus in 2020 and 2021, both policy levers in the United States are set to tighten in 2022. But they should not become so tight as to cause a recession.
Monetary Policy:
At its December Federal Open Market Committee (FOMC) meeting, the Federal Reserve expressed increasing concern about inflation and signaled it would accelerate its timeline and pace for interest rate hikes in 2022. Also, as expected, the Fed doubled the monthly pace of reducing (tapering) its quantitative easing asset purchases (QE); QE should end in March 2022, if not earlier. More hawkish than the accelerated taper, the updated Fed member “dot plot” now indicates a median of three rate hikes in 2022 (up from only one at the last FOMC meeting in September) and three more in 2023.
Of course, these are subject to change—and the track record of the dot plot in predicting the Fed’s actual behavior a year or two out is abysmal. But the dots indicate the Fed’s current collective mindset and expectations given the individual members’ reading of the economic tea leaves and where they expect the economy, unemployment, and inflation to be six to 12 months hence. And, financial markets pay a lot of attention to them.
With both its inflation and full employment mandates likely to be met, the Fed will be in position to start tightening monetary policy (raising rates and reducing their balance sheet assets) in 2022.
Outside the United States, nearly half of all global central banks have already started raising interest rates. Notable exceptions are the European Central Bank (ECB) and the Bank of Japan (BoJ), both of which have signaled no intention to tighten any time soon given the state of their economies.
Importantly, China’s central bank (PBoC) has begun to modestly loosen policy—cutting interest rates and banks’ reserve requirement ratio—in response to weak economic data. China’s recent economic slowdown is due to both the government’s regulatory clampdown on the speculative but very large property/housing sector and their extreme “zero-COVID” policy in response to new variant outbreaks. China’s policy easing/stimulus is likely to accelerate in 2022, although it’s unlikely to be of the magnitude seen in response to China’s previous cyclical slowdowns in 2008, 2012, 2015, and 2020.
Fiscal Policy
Fiscal policy is also set to turn from a tailwind to a headwind for U.S. GDP growth in 2022. This is not to say the United States won’t have another large budget deficit this year, but relative to the huge fiscal boost from 2020-2021, 2022 will see less stimulus. This will amount to a “fiscal drag”—a negative impact on GDP growth next year. For example, the Hutchins Center on Fiscal and Monetary Policy in Washington estimates the fiscal drag will be around 2.5 percentage points of GDP. Further, with the passage of the Build Back Better legislation now in doubt (as of late December), economists have started to factor in an even larger fiscal drag, reducing their forecasts for 2022 GDP growth.
Economic Outlook
The consensus forecasts for economic growth and inflation in 2022 are broadly consistent with our base case, which envisions decelerating growth and moderating inflation, but both still meaningfully above the economy’s longer-term trend. From an investment portfolio perspective, this macroeconomic backdrop should again be generally supportive for “risk asset” returns, such as global equity and credit markets, and a headwind for core bond returns in the face of rising government bond yields.
Most importantly, as we evaluate investment opportunities and manage client portfolios, we always consider a range of risks and alternative scenarios outside of our base case. Building a diversified portfolio that is resilient across a range of potential outcomes while positioned to particularly benefit in our base case is our objective.
We see the following key macro risks around our cautiously optimistic base case for 2022:
• A new highly infectious and deadly COVID-19 variant emerges. Omicron also poses a near-term risk to the global outlook. Because of its very high transmissibility (in spite of its apparent lower severity of infection), there is a risk of overwhelming hospital capacity, leading to renewed lockdowns with resultant economic and social impacts.
• A wage-price inflation spiral starts to emerge; longer-term inflation expectations rise beyond the Fed’s comfort zone.
• The Fed makes a policy mistake: Either (1) the Fed tightens too much/overreacts to inflation readings; or (2) the Fed allows inflation to become entrenched (wage-price inflation spiral).
• The Chinese economy has a sharp downturn (“hard landing”), for example, due to a policy mistake related to the property-market deleveraging.
• A geopolitical or exogenous shock impacts the global economy (always a possibility).
Financial Markets Outlook
Over the next year at least, barring a global macro shock, we expect positive returns for global equity and credit markets (and risk assets in general), driven by continued corporate earnings growth that underlies these assets. In this base-case scenario, the 10-year Treasury yield is likely to moderately rise, which means another poor year for core bond returns, both in absolute terms and relative to other asset classes and alternative strategies.
Earnings-per-share (EPS) growth will sharply decelerate for the S&P 500 compared to 2021. But it should still be at least around or above its historical trend growth rate of roughly 6% and in line with the current consensus expectations of 8%–9% for 2022. We think this is reasonable because (1) corporate revenue (topline) growth should be consistent with nominal GDP growth (real GDP growth plus inflation) in the mid to upper single digits; (2) profit margins should remain near historically high levels but will depend on companies’ ability to pass through higher input and wage costs or increase productivity and profitability via capital investments; and (3) share buybacks are likely to boost the S&P 500 EPS by a few additional percentage points.
Monetary and fiscal policy in the United States will become less accommodative but is unlikely to tighten so much (yet) to trigger a bear market and economic recession.
As always, equity investors should expect market volatility and be prepared for 10%-plus drawdowns (“corrections”). But absent a recession, a 20%-plus bear market is unlikely.
We see the likelihood for better returns for foreign markets from both improving fundamentals (cyclical earnings rebound) and, as investor sentiment improves, higher valuations (price-to-earnings multiples) over the coming year(s).
Market Risk Scenarios Around Our Base Case
Consistent with our earlier list of the main macro risks for 2022, there are two broad market risk scenarios around our base case that we incorporate within our investment outlook and positioning:
•Earnings growth surprises on the downside
•Inflation surprises on the upside
Earnings growth could fall short of expectations next year for any number of reasons, but outside of an unpredictable global macro or geopolitical shock, we believe the most likely candidates are COVID-related, China policy tightening, or Fed policy tightening that sharply curtails business and consumer spending.
There is not a tight historical relationship between the start of Fed rate hikes and U.S. stock market performance. As this NDR chart shows, the S&P 500 has typically had solid returns in the first year of a tightening cycle. However, if the Fed initiates a “fast” rate hike cycle, where it raises the federal funds rate at nearly every FOMC meeting, the market has fared poorly. NDR concludes, “(a) more restrictive Fed is a leading candidate for the cause of corrections or a shallow bear market.”
In contrast, an earnings slump would likely be positive for core bonds as Treasuries and the U.S. dollar are still seen as investment safe havens.
But there is also risk in the other direction: that the current high inflation rate doesn’t meaningfully decline or even increases through the year. Again, to a large extent this depends on COVID-related developments. While the Fed is now talking a hawkish game, it remains to be seen if, when, and to what extent it will follow through with rate hikes in 2022. There is a risk that a wage-price inflationary spiral takes hold. And if it does, how would the Fed respond?
A sharply inflationary environment well above current consensus expectations would undoubtedly cause market havoc for both stocks and bonds, as interest rates rise and equity market valuations fall.
All these considerations (and more) factor into our asset class analysis and current tactical portfolio positioning.
Closing Thoughts
In sum, our portfolios are well-positioned to generate attractive returns in our base-case macro and market scenarios in which the pandemic recedes (but doesn’t disappear), the global economy slows but still grows above trend, corporate earnings growth slows but is still solid, the U.S. rate of inflation remains elevated but is falling, and U.S. interest rates rise moderately.
That would be somewhat of a “goldilocks” scenario for the economy and global equity and credit markets, although not for the core bond market. But even in the best case, it likely won’t be a smooth journey: The pandemic remains uncontained, domestic and global political and social tensions are elevated, the risks of an economic policy mistake have risen, and any number of other inevitable yet unpredictable bumps in the road may occur.
We are confident in our long-term investment process, discipline, and ability to navigate whatever comes our way, with the objective of achieving your investment and financial goals. We sincerely appreciate your confidence and trust as well.
From all of us at Argent Trust, we wish you and yours a healthy, happy, peaceful, and prosperous New Year.
Certain material in this work is proprietary to and copyrighted by Litman Gregory Analytics and is used by Argent Financial with permission. Reproduction or distribution of this material is prohibited, and all rights are reserved. Argent Financial Group is the parent company of Argent Trust, Heritage Trust and AmeriTrust.
