Quarterly Commentary

4Q 2021

If you somehow knew that a pandemic was about to close borders, disrupt businesses, and transform everyday life, would you have predicted that US stocks would return 50% over the next two years? What if you also knew that support from governments and central banks would far surpass the response to the 2008-09 financial crisis, helping people to be fed and housed and helping businesses save jobs, and that some consumers would invest their newfound wealth in the stock market – often in surprising ways? Who could have predicted that the Consumer Price index would be inflating at an annual rate of more than 6%, with a barely a response from the stock and bond markets?

As the pandemic descended on us two years ago, the negative implications were pervasive and understandably blinded many of us to the potential effects of stimulus on asset prices. Intense fear of deflation dissipated quickly and is now giving way to increasing fears of persistent inflation. Media pundits try to reduce investing (and nearly everything else) to attention-grabbing imperatives. We are better served to acknowledge the inherent complexity of the markets and admit how difficult it is to see into the future. Understanding and analyzing where things stand today, with an appreciation for history, at least offers context for processing new developments and whether we need to take action.

2021 Recap

We entered the year hopeful that low interest rates, continuing government stimulus and a huge rebound in corporate earnings would sustain the two-month-old “vaccine rally.”  It wasn’t long before stocks were racing ahead, particularly small-caps, reopening plays, and alternative energy stocks. By mid-March the small cap index (Russell 2000) had gained 20% - a surprising 14 percentage points ahead of the large-cap S&P 500. The exuberance faded from there - by year-end the tables had turned – the S&P finished 14 points better than the Russell index.

A more cautious narrative emerged. Inflation surged past the Fed’s 2% comfort level, and the consensus is now that its governing body will vote to raise short-term rates several times in 2022. The BBB spending bill would have provided additional support for consumer spending – its demise, for now, is also a blow to renewable and other climate change-focused businesses. The arrival of the Omicron variant eroded consumer and business confidence at a time when government financial support is tailing off. 

Wary investors once again embraced the largest of the large US stocks as the year progressed. In fact, just five stocks accounted for more than half of 2021’s large-cap resurgence – Google (aka Alphabet), Apple, Microsoft, Tesla and Nvidia. It’s true that these companies have been growing at an above-average pace with expanding margins for years, yet there are many good reasons why that won’t go on forever. Investors attracted to their upward momentum and aura of safety have pushed their share prices to new heights relative to smaller and foreign company shares. We continue to focus on investing in areas that are less exposed to the risks of high expectations and high prices. 

Looking Ahead

The term that describes a market where a handful of stocks are propelling an index such as the S&P higher without help from most of the other 495 constituents is narrowing breadth. It historically has been viewed as a sign that the market may be running out of steam. There is another interpretation – as an indicator of increasing investor caution that precedes a rotation into better values to be found outside of the mega-caps, as we saw early last year.

Inflation and interest rates are top of mind – for good reason. At year-end, the real interest rate was negative five precent (calculated by subtracting current year-over-year inflation readings of 6.7% from the ten-year Treasury bond yield of 1.5%). This is way off the charts! The real rate was last in this territory in the 80’s when inflation was running 5% ahead of bond yields. Today’s situation is unique. As the massive government stimulus helped consumers and juiced the stock market, it sparked a rapid economic rebound that has contributed (along with the pandemic) to labor and production shortages around the globe. Today’s meager bond yields are explained in part by the significant presence of price-insensitive buyers, such as foreign banks investing US dollar reserves and pension funds attempting to match future liabilities. Low bond yields also reflect an expectation that the inflation spike will ultimately subside. How this is resolved will be an important part of the 2022 story.

The decision makers at the Federal Reserve may have let the economy and the markets run too hot for too long in 2021. History will likely judge their efforts for the entirety of the pandemic based on how well they tap the brakes in 2022 and beyond. The Fed is always walking a tightrope, balancing its mandate to promote full employment while keeping a lid on inflation, and misjudgments are inevitable. While it is reasonable to expect that many of the current supply issues should be transitory, inflation can beget expectations for more inflation, a dynamic that can be hard to undo. What would be concerning is higher inflation without corresponding higher economic growth – that would leave us all feeling lighter in the pockets. We think the most likely course is slightly higher inflation accompanied by slightly stronger economic growth, which should be agreeable to the markets.

In many respects, our expectation is for less of the same in 2022. Less inflation, less covid, less government stimulus (fiscal and monetary), less (though still above average) economic growth. January’s market action so far seems to be a reset that reflects similar expectations, which is probably a healthy development after 2021’s exuberance.

As always, there are other risks about that we need to keep an eye on. China continues to flex its muscles at home and abroad and is still pursuing a zero covid policy that can lead to serious supply chain disruptions. In the midst of demographic issues and a decelerating economy, China’s leadership is walking their own sort of tightrope. 

We begin 2022 with our usual guarded optimism, ever more mindful that many surprises await us. Inflation, interest rates and the Fed are in the spotlight now – and midterm elections will command attention before long. Investor sentiment will continue to swing up and down, creating opportunities as the year unfolds. If 2022 does in the end deliver less of the same, we’ll take it.