Investment Commentary – Q4 2021
PRW14 January, 2022
We welcome 2022 with some uneasiness and frustration but much hope and resolve. The reopening of the world may have hit the pause button, but we will persevere. It is the only path forward.
Earlier in the year, we discussed the new generation of graduates heading into the world and the uneven landscape ahead. We normally ask our children to think big and to reach for the stars. We believe this is still the right message and are confident that the new generation of graduates will go on to tackle the challenges ahead. The last two years have given us lessons in resilience and challenged us and our children to adapt to what we once thought was just something out of science fiction.
While taking a big picture view makes sense, we were intrigued by a passage in Ian McEwan’s fictional novel “Saturday”. In the book, a father recounts a recent evening when his teenage son Theo shares the following aphorism: the bigger you think, the crappier it looks. Asked to explain, the son said *When we go on about the big things, the political situation, global warming, world poverty, it all looks terrible, with nothing getting better, nothing to look forward to. But when I think small, closer in – you know, a girl I’ve just met, or this song we’re going to do with Chas, or snowboarding next month, then it looks great. So, this is going to be my motto- think small.” From the mouth of teens- Small victories in the year ahead, we’ll take those too.
Fourth Quarter Market Review
• US equities continued their winning streak driven by ongoing economic recovery and strong corporate earnings. Despite some late-year volatility caused by the emergence of the Omicron variant and elevated inflation, US equities, measured by the S&P 500, gained 28.7% with 70 new all-time record highs’, second most on record after 1955’s 77 record highs?. Notably, 2021 marked the third consecutive year of double-digit gains. 2021 was also defined by relatively muted index-level volatility, with the biggest pull back of just -5.1% during the year, compared to the historical average of -14.3%*. Looking beneath the surface, however, shows that 13% of stocks within the S&P 500° ended the year with flat or negative returns, highlighting uneven performance across US equities.
• US equities beat international once again and emerging markets fell modestly for the year.
International developed markets outside the US had a strong year in local currency, up 19.2%. However, the strength of US dollar reduced the gains to 11.8% in dollar terms. Emerging market equities, on the other hand, fell 2.2% for the year following a correction in the Chinese stock market in the second half of 2021, led by fears of regulatory crackdowns and ongoing COVID disruptions. This caused US equities to outperform emerging markets by the highest amount in 23 years.
• Within US equities, all sectors were positive with double digit gains for the first time since 19957, despite wide gaps in performance. The energy sector was the best-performing sector for the year, up to 54.6%, led bya rally in crude oil prices. Real estate, financials and technology rounded out the other top sectors for the year. In a risk on’ environment, defensive sectors like Utilities and Consumer Staples underperformed in comparison with gains of 17.7% and 18.6% respectively for the year.
• Outside of mega-caps, economically sensitive value segments outperformed growth in 2021 in the US. Small and mid-cap value stocks outperformed large-cap value for the year driven by the ongoing economic recovery. Small and mid-value stocks also handily outpaced their growth counterparts. The outperformance of mega technology names led large growth to outperform large value for the year.
• Bonds went from hero to zero. US bonds fell 1.5% in 2021, the third worst annual performance since 1976 as interest rates rose for the year. While US bonds struggled, TIPS returned 6.0% as inflation rose faster than expected and lower quality bonds like high yield gained 5.3% as investors stretched to find income. Developed international bonds struggled and fell 7.1% for the year with losses magnified by a stronger dollar.
• US REIT’s and commodities posted strong gains for the year driven by inflation concerns while gold lost its luster. Gold was the top performing investment in 2020, living up to its reputation as a safe haven during the market crisis. However, in 2021, gold fell 4.3% despite rising inflationary concerns as investors favored other investments, including real estate and commodities. Commodities gained 27.1% for the year driven by supply chain disruptions and a surge in energy prices, all contributing to rising inflation. US REITs were one of the best performing investments in 2021, up 41.3%.
Stock markets were nothing if not interesting this past year. These were some of the most schizophrenic markets we can remember. Many macro focused hedge funds seeking to discern larger trends were flat to negative for the year as markets gyrated between risk on and risk off, re-opening trades and pandemic fear trades, and general concerns over tax policy, debt, inflation, and the myriad of other concerns factored into the markets daily.
While the S&P 500 Index hit all-time highs in 2021, the S&P 500 equal-weight Index did not match those returns on the same day. The difference is the S&P 500 Index gives weights to stocks based on market capitalization or total stock value while the equal weight index gives each company exactly 0.2% weighting.
When the S& 500 Index makes new all-time highs but the equal-weight index does not, it means the rally is being led by a few stocks or sectors. This is nothing new but telling.
More interesting to us and a better way of understanding some of the volatility in the markets this vear is data compiled by Alpine Macro that looks at the major indices and the declines of the members of those indices from their market highs during the year as of 12/20/21. Alpine noted that 20% of S&P 500 companies, 68% of NASDAQ companies, and 66% of Russell 2000 (small cap) companies fell 25% from their year-to-date highs. The numbers jump to 37%, 74%, and 78% when looking at 20% declines from the 8 NDR: Benchmark Review: Stocks climb ultimate wall of worry highs of these companies. The average percentage price decline from year-to-date highs were 19% (S&P 500), 43% (NASDAQ), and 39% (Russell 2000). While some of the constituents may have rebounded to some extent, the striking declines do suggest that there is vulnerability under the surface of the broader indices.
During the year, we saw Reddit investors pile into Meme stocks and ultimately put some well -funded hedge fund managers out of business. Crypto currencies continued their volatile ride and new currencies seemingly sprouted up daily like those pesky garden weeds. We also saw the emergence of NFTs (Nonfungible tokens). NFTs are like a digital stamp attached to a specific digital work of art, such as a photograph, video, or painting. The NFT proves the identity of the artist and the current owner, making it easy to securely buy and sell works of art. The market research firm DappRadar estimates that the global trade in NFTs topped $23 billion in 2021. Earlier in the year, we discussed the SPAC market and the rise of this avenue for private firms to go public. The year was kind to some and quite cruel to others.
The focus in 2022 will be on inflation and the Fed. On the plus side, it is possible that we will see some reversal in the inflationary pressures of this past year, perhaps moving towards a 4-5% annualized rate and lower thereafter once the combination of supply chain disruptions, direct to consumer government stimulus, and pent-up holiday spending wear off. Already, consumer sentiment is starting to rise on initial signs that Omicron, while very contagious, may be less harmful in terms of hospitalizations and deaths.
Cash levels on the sidelines remain high and companies are prepared to buy back more stock. Employment is tricky as firms continue to face a mismatch between needs and skillset but the overall trend in employment is positive. Importantly, S&P earnings’re expected to be solid in 2022.
Corporate and consumer balance sheets are strong. James Knightley, chief international economist at ING, shared thoughts on the Federal Reserves financial accounts of the U.S, published quarterly. The report discusses the assets and liabilities of households, businesses, and governments. Since Q1 2020, household wealth has surged by $35.5 trillion. Knightley commented that “further massive accumulation of wealth only
On the less cheery side, the unwind of the long bull market in bonds is upon us and the impact of higher rates on stocks should temper return expectation going forward. While history has shown that stocks can perform well during the first few rate increases (see chart below), will the pandemic driven issues of the last 2 years and ongoing mean that we cannot count on history as a great guide? The Fed will be raising rates in a high inflation, low growth environment and that is a tricky maneuver. In December, the Fed pledged to be careful (Chairman Powell noted that he has learned a lesson and will pivot as needed) but higher rates are intended to cool inflation and in turn pose a headwind, especially for firms with heavy debt loads.
Notes from the recent Fed meeting, released in January, suggested to market watchers that the Fed is turning more hawkish than first thought and that has unnerved investors to start the year. In a scene reminiscent of January 2021, growth stocks sold off and value stocks rose at the start of the year. We expe we may see more see sawing to come. We believe that Omicron fears have been accounted for by the market over the last few weeks, but the path of the virus and its global impact remains a wildcard. We are also mindful of geopolitical risks driven by Russia’s advance (again) into Ukraine, China’s continued pressure on Taiwan and general cooling of US relations (as discussed in our last letter), and Iran’s push for a nuclear capability.
We view the year ahead as one of transition, marked by a period of continued growth but with a falling rate of change as economies digest the pandemic’s extraordinary policy actions. Fed words and actions will be watched closely as will the impact of the virus, supply chains, and worker shortages. Volatility is likely to be elevated over the course of the year but may settle down some following a shoot now ask questions later start to the year. As we head into earnings season, we expect more uncertain outlooks. Companies that are executing, delivering on margins, and can pass on costs to consumers may find support for growth while unprofitable companies with high valuations may suffer.
There are few screaming bargains in the public and private markets and that makes for a difficult investment landscape in 2022. In a word, it will likely be a grind, full of fits and starts. We believe that equities should outperform fixed income and that we are likely to see a continuation of the see saw between growth and value assets. The push to higher rates does favor value stocks. The relative performance between growth and value is at an extreme and we see a potential for “mean reversion” to also favor value stocks. This does not mean a wholesale move out of growth stocks but more of a tilt to value.
We have been quite US focused in our equity portfolios over the last 5 years and have slowly been adding to our international exposure given the very wide valuation disparity. This disparity is particularly acute for the emerging markets. Higher rates would seem to favor a stronger dollar, a headwind to overseas stocks.
However, we think that the market is due for some mean reversion and the dollar may have potentially hit an inflection point. We will be looking to opportunistically add to overseas exposure.
On the fixed income side, we have focused on keeping duration low, maintaining our floating rate bond exposure, and adding in funds with latitude to find returns across areas of the market. We have also begun to incorporate structured notes into portfolios over the past few months and also adding exposure to private debt opportunities in some places. Finally, we have incorporated real assets such as real estate as well as some hedged exposures throughout our portfolios to account for the wide range of outcomes we may see this year.
Our headwinds/tailwinds summary is below:
• Federal Reserve set to tighten
• Inflation in a decelerating economy
• Supply chain issues and declining labor participation hampering economic growth
• Equity and fixed Income valuations are high on an historical basis
• Elevated corporate and government debt levels offset in part by healthier consumer balance sheets
• Government stimulus held up, still likely on the way, but winding down.
• Covid continues its disruptive and in some cases deadly path
• Higher tax rates expected in the coming year(s)
• More fiscal support on the way at some point
• Corporate buybacks likely to be supportive
• Significant cash on the sidelines
• Healthy consumer and corporate balance sheets
• Earnings expectations are still positive in 2022
• Vaccines are helping to reduce the severity of the virus and some suggest we could be turning a comer by mid-year.
We are excited to announce the addition of several new team members:
Debra (Deb) Burns joins us as Senior Support Advisor, adding depth to our growing team. Deb has over fifteen years of experience in financial services and currently holds a Series 65 Uniform Investment Advisor) License along with a Life & Health Insurance License. She is a 25-year resident of Cape Cod where she lives with her fiancé’ Tom, son Taylor, black lab Milo, and cat George. Deb enjoys off-road beaching, paddle boarding and hiking with her Lab, and dedicates a lot of her free time to volunteering for The Fresh Air Fund where she serves as the Fund Representative for Cape Cod & The Islands.
Marilyn Starbird joins us as Senior Executive Assistant. Marilyn has over 20 years of experience in the Executive Assistant role. Prior to joining PRW, she spent 15 years with Boston Private Bank. She has a B.S. from UMass Amherst and grew up in Dorchester. She currently resides in Abington with her two sons, Jared and Jake.
We wish you a very Happy and Healthy New Year and appreciate the trust and confidence you have placed in us. We look forward to serving you in the coming year. Thank you.