Musings on investments - Q4 2021
Happy New Year!
It’s always an interesting endeavor at this time of the year to stroll back along memory lane to see just how we got to where we find ourselves. The passage of time tells us the story, punctuated by the passing of things held dear and the emergence of new challenges, opportunities and technologies.
Last year public opinion and consumer confidence barreled out of the gate and rose steadily through late summer when the Delta strain started to gain ground and concerns about inflation rose. After a sharp pullback in early fall, we’ve seen a bit of a rebound in opinion despite the new Omicron threat. Markets followed suit, buoyed through much of the year by abating restrictions, increases in corporate profits and a continued bright outlook for growth, easing off a bit in the fall and rising toward year end as folks started to concentrate on the potential for better times in 2022.
As is our tradition for this time of year, we will take a couple of pages to give you a blow-by-blow of the major asset classes in our clients' portfolios: what they have done, what we anticipate going forward, and how we have approached each. We hope you will find this helpful.
As was the case in 2020, the economy and markets in 2021 were focused on the path of the Covid pandemic. The year featured a strong recovery in economic growth, followed by the emergence of new variants. At the same time, the broader recovery also featured concerns over rising inflation, due to supply and transportation disruptions, and strong demand fueled by fiscal stimulus. The Federal Reserve continued to assert that inflationary pressures were ‘transitory’, although the timeline remained cloudy, which markets seemed to accept. In keeping with improvement in conditions, the Fed began a tapering off of treasury/mortgage bond purchases. Interest rates experienced less volatility than in the two prior years, with the 10-year treasury note yield beginning the year at 0.9%, moving in a general band of 1.2% to 1.7%, before ending the year at 1.5%.
The result was a negative year for most bond groups overall, with corporate bonds faring slightly better than U.S. government bonds. Foreign bond results were mixed in developed and emerging markets, with results being dependent on U.S. dollar exposure (as the dollar gained sharply in 2021—a headwind to foreign assets).
In general, combined bond portfolio holdings fared better than market indexes in 2021, with positive returns from floating rate bank loans, which benefitted from rising yields. Conventional fixed income holdings earned negative returns for the year, but outperformed index benchmarks slightly.
In March, we implemented an adjustment in foreign bonds. This was a move away from more flexible global macro exposure, with a focus on currencies and emerging markets, toward more diversified developed market bonds, including the larger universe of foreign corporate debt
U.S. equity markets continued their upward ascent in 2021, as a strong recovery in actual corporate earnings followed the gains of the prior year, which had been based merely on expectations for improvement. This included historical highs in profit margins, particularly in the technology and communications sectors, which have been far less affected (or even thrived) during the pandemic.
Foreign stocks also fared positively, albeit to a far lesser degree than U.S. equities. This appeared to be due to more challenged growth conditions abroad to begin with, higher Covid case counts later in the year, as well as sector composition. In contrast to U.S. stock holdings, which feature larger weightings to dominant technology-oriented companies, foreign developed markets as a whole feature higher exposure to the industrial and banking sectors, which have a closer relationship to business cycle dynamics.
In March, we moved portfolios from a focus solely on core U.S. equities towards a tilt of ‘value’ over ‘growth’ across all market cap sizes—U.S. large, medium and small company stocks. This was the result of stronger relative valuation metrics for sectors on the ‘value’ side, as well as richer valuations for ‘growth’ stocks, which lowers the potential for forward-looking return expectations.
Real estate experienced a strong recovery year in 2021, despite continued uncertainty and divergences in sector expectations. Overall, the asset class was one of the better-performing of any for the year—surpassing even the booming U.S. stock market. This reflected the on-off nature of the broader economy and risk-taking, with periods of recovery marked by strength in retail, regional malls, and industrial. Additionally, periods of greater Covid fears rewarded digital assets such as cell towers, data centers, and internet commerce hubs. Lodging continued to struggle with uncertainty about a return to normal travel conditions.
In May, we elected to consolidate a smaller position in foreign real estate back into existing U.S.-focused assets. This was done in a reevaluation of the higher volatility and lower returns by foreign REITs relative to U.S., as well as more attractive apparent prospects for U.S. real estate looking ahead.
Commodities rebounded strongly after a weak 2020, as strong demand and tighter supply dynamics in several groups elevated prices—being both the recipient of and contributing to higher inflation generally, in keeping with higher correlations of commodities to CPI. Crude oil prices led this push higher, as improving global mobility drove demand, while a reluctance of OPEC to enhance low production levels skewed the usual balance of the two forces. Industrial metals, such as copper, and a variety of agricultural products also moved higher. Precious metals, including gold and silver, lost ground as investors appeared less interested in safe havens, especially with an anticipation of rising interest rates. Later in the year, commodities experienced greater volatility along with concerns over the new Covid Omicron variant, coupled with inflation being acknowledged as less ‘transitory’ by the Federal Reserve.
The economy is poised for a continuation of growth even as the pace of growth slows due to the maturing of the recovery from the Covid sparked recession of 2020. While GDP growth likely peaked mid-year 2021 the prospects for 2022 remain above trend according to the mainstream economic opinion. Risks as we move along seem sorted into several buckets; inflationary risks, pandemic concerns and the potential for actions by the Fed to tighten monetary policy.
Inflation will likely be higher than we would like for a bit longer. The Fed abandoned their early language describing this inflation as “transitory” but is still convinced it won’t be “persistent”. If we do see a continuing inflationary trend, we’ll also see the Fed lean a bit harder in the direction of slowing it with a faster pace of interest rate hikes and other measures. There is reason to believe that inflationary pressures will be reduced as supply chain issues wane, but that process could take some time. Expect to hear a lot more about this (and to spend a bit more at the store as well).
The pandemic remains a wild card as we move into this new year. So far, despite the Delta and Omicron variants, growth has continued here in the U.S. and around the world. Other countries have resorted to new lockdowns and those will have a dampening effect on growth in those areas. As more people around the world become vaccinated it should be easier for us all as the pandemic eases into a more permanent, lower level, endemic situation. All this will, however, take time and the virus itself is the leading character in this particular play.
The Fed has begun the process of tightening with a ‘tapering off’ of their bond buying program. In their latest meeting they quickened the pace of the taper and expectations is that this program will be ending in the middle of this year. They will also begin the process of easing interest rates upward with Fed watchers predicting at least three rate moves this year. This could result in a modest slowing of economic growth from all the factors associated with higher interest rates. It is important to remember that the Fed only controls rates at the short end of the curve, bond traders, influenced by their own views about the pace and timing of economic growth, drive longer term rates.
Markets take their cue from the economy and rising GDP and corporate profits, subject to the risks discussed above, could be supportive of further advances in stocks of all sorts. But, along with growth, valuations matter. Rising rates change market valuations and a given level of earnings and dividend growth means less in a higher interest rate world than in one with lower rates. U.S. stocks especially look modestly overvalued while most international equity holdings have much lower valuations.
At this stage the market has perhaps already anticipated some of the inevitable interest rate moves by the Fed. There is certainly room however for a pullback in equities and we would not be surprised to see some extra volatility this year as investors weigh inflation, interest rate increases and the future trajectory of the pandemic. In any case we would not expect to see a year as robust in terms of equity returns as this last one was!
The fixed income asset class will continue to be driven by the occurring and anticipated change in interest rates. Bond traders will keep their eyes on the economy in general and the trajectory of inflationary pressures specifically. With absolute yields very low the anticipated returns for bonds as a whole are very modest. Nonetheless there is value both in the relative stability of these holding and in the diversifying element they provide in a diversified portfolio.
Our crystal ball is just as foggy as everyone else’s. If anything, the last couple of years have shown us just how far off of expectations any particular year can be. Rather than try to predict the storms and periods of fine sailing we’re better served to make sure our ‘financial boats’ are in good order and able to withstand and take advantage of both the good and bad times ahead.
We wish the very best for you and your family in 2022.
We do not provide legal or tax advice. Readers should consult their own legal or tax advisor. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. There is always the risk that an investor may lose money. A long-term investment approach cannot guarantee a profit. Investors should talk to their financial advisor prior to making any investment decision. This information is intended for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.
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