2021: What the heck just happened?

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At the start of 2021, many thought the COVID-19 pandemic would be a distant memory by 2022, given a fast rollout of vaccines. Not only is the coronavirus still mutating and affecting our daily lives, but there’s historical evidence that we could be dealing with the disease for years to come. Research on the pandemic of 1889 (also called the “Russian Flu”) points to resurgence of the disease in 1893, 1895, 1898, and 1899; and historians have noted that the pandemic of 1918 took several years to subside. This looks to be a similar story for the current pandemic.

What this means for the stock market is anyone’s guess, but it likely points to higher volatility. After an initial spike in volatility during the half of 2020 (as measured by the VIX Volatility Index), relative calm overtook the markets. The chart below shows the price of the VIX from 2007 through 2021. Volatility rose significantly in 2008 thanks to the Global Financial Crisis but was subdued for the next decade. Another peak in March of 2020, was also followed by relative calm. Volatility came back to the markets in the fall of 2021, with a spike in late November thanks to news of the Omicron variant of the virus.

VIX

Source: CBOE

Volatility has stayed elevated (from levels seen over the summer) through the end of the year. Given the uncertainty around Omicron and other, future variants coupled with questions over inflation, Federal Reserve policy, geopolitical tensions, and US mid-term elections, 2022 could bring heightened volatility to the stock markets. This is welcome news for investors waiting to put cash to work, but can be unnerving for those who have seen portfolios rise significantly (and with little interruption) since the March 2020 crash.

It’s transitory! Or is it?

The US Federal Reserve, which had been calling inflation “transitory” for much of 2021, changed course, noting that it would no longer use that term to describe price increases. While the Fed stopped short of labeling it as something more enduring, the change in language is meaningful.

The Fed finds itself in a more difficult spot than it’s been in for some time, after having scrapped their once dual mandate in order to focus more on employment at the expense of keeping inflation low. The prospect of the Fed moving faster than expected was higher at the end of the year compared to January 2021. In fact, in early December, the market was anticipating a quicker move by the Fed than what the Fed’s own dot plot implied at the time. During the mid-December meeting, the Fed raised its forecast to three rate hikes in 2022, matching the market’s previous assumptions. Rising rates in the US effects nearly every US-denominated bond (not just Treasuries), growth stocks, and the prospects for emerging markets.

The end of an era

The outlook for investment grade corporate and government bonds is bleak as the Fed tightens the reins. After several decades of falling interest rates (and subsequent price increases), bond investors face a concerning outlook—the decades-long bond bull market is over. As rates rise, core bond strategies that track the Aggregate Bond index face considerable headwinds given longer duration and lower credit quality than during past tightening regimes. And inflation will eat away at what returns bondholders do take home. The good news is that as rates rise, active bond managers can swap lower-yielding bonds for higher-yielding ones, which will amp up total return over the medium term.

Cash is a good alternative to short-term Treasury bonds in the near term because it’s likely that as the Fed raises short-term rates, the yield curve flattens (meaning short-term rates go up but long-term rates do not move up as much). Cash can be put to work as rates increase, with investors taking advantage of falling bond prices. For long term, retirement focused investors, however, it is not recommended to swap intermediate-term bond exposure for cash. Yields on intermediate term bonds are still better than cash, and buy and hold investors will receive all the promised coupon payments plus par value at maturity.

Floating rate bank loans, whose coupon payments change alongside interest rates, are popular during regimes of rising rates and can provide insulation from falling prices as rates rise, plus the increased coupon payments. The low credit quality of these bonds, however, does not make them a good substitute for high-quality bond exposure, so the use of these bonds must be carefully considered. High-yield bonds are also popular in the face of rising rates, given their lower sensitivity to rising interest rates, but the race to find yield anywhere has led to very tight spreads, making current prices not super attractive in the near run. Over the long term, however, high-yield bonds can provide a boost to yield compared to an Aggregate-bond alternative.

In the face in inflation, Treasury Inflation Protected Bonds (TIPs) seem like a great investment. TIPs had a fantastic run in 2021 and investors who positioned portfolios for faster-than-expected inflation have been rewarded. But, like most investment ideas that worked well in 2021, TIPs are not as attractively priced at the end of the year compared to the start of 2021. Other inflation-oriented alternatives that may be able to eke out decent returns in the face of rising rates and higher inflation would include “real return” strategies that focus on a diversified portfolio of assets aimed at outpacing inflation, not just holding TIPs. Flexibility is key for bond investments in the face of so many headwinds.

Domestic stocks

The domestic stock market looks reasonable, despite a run-up in prices, especially when considering alternatives (see below for more on non-US stocks). Low levels of debt on corporate balance sheets and robust consumer spending coupled with still-high savings point to good fundamentals. Many firms also reported exceptionally strong earnings last year and forward-looking valuations, while historically high, are actually lower than a year ago. According to the Wall Street Journal, “the S&P is trading at 21 times analysts’ projected earnings over the next 12 months, down from 22.8 times at the end of 2020.” GDP growth is expected to slow from 5% last year to 3.8%, though this is still above historical averages (roughly 3% on average for the last 60 years). 

Finally, a tense political environment and upcoming mid-term elections make it less likely that politicians will pursue large lockdowns in the US again, even in the face of fast moving coronavirus variants (this is in contrast to Europe, where many countries imposed travel restrictions and lockdowns in December due to Omicron).

Within the US stock market, certain sectors and stocks will fare better than others, putting the thumb on the scale for capable active portfolio managers. During the first part of any market recovery, almost everything goes up—fundamentals often don’t matter and the junkiest of the junk tends to soar. This was true from November 2020 into the summer of 2021. Then the tide started to turn as inflation remained stubbornly high and workforce participation remained low; stimulus checks were a thing of the past and extra unemployment benefits were receding. The market’s meteoric rise slowed and several asset classes posted losses in the third quarter. The fourth quarter brought increased uncertainty, but closed with robust gains for US stocks.

We have entered a new phase of the recovery during which not all stocks, sectors, or asset classes can thrive equally. For starters, inflation will hurt smaller companies more than larger ones that can absorb higher labor costs and raise prices on goods and services more easily. Consumer spending remains high, but the travel and leisure sectors face serious headwinds. Restaurants and other service-oriented sectors may experience a tough winter if customers again decide to stay home due to concerns around COVID. Banks will benefit from rising rates, but a flattening yield curve lowers the “carry” they can earn from deposits and loans (the difference between what banks pay customers on deposits and what customers pay banks for loans).

Non-US stocks

Rising rates in the US often spells trouble for emerging market economies, especially when the moves are deemed more “hawkish” than anticipated. According to a study from the International Monetary Fund, “each percentage point rise in US interest rates due to a ‘monetary policy surprise’ tends immediately to lift long-term interest rates by a third of a percentage point in the average emerging market country." Traditionally, this has sent capital flowing out of emerging markets which causes currencies to depreciate against the US dollar. That, in turn, can hurt emerging market stocks whose returns might be lower due to that currency deprecation. 

Additional issues facing emerging markets include slower vaccine rollouts and subsequently slower economic recoveries, and China’s recent clampdown on private companies which could slow growth there. Because China accounts for a third of the MSCI Emerging Markets Index, it is a powerful driver of returns for broad emerging markets strategies. High growth stocks like Tencent and Alibaba fueled strong returns for many emerging market investors for the last decade, but their future growth prospects are now dimmed. Passive investments may struggle to make headway if China continues to clamp down on corporate growth and profits of some of the world’s largest companies. Active managers have an opportunity to step away from the shadow of China, focusing instead on countries and companies with better growth prospects.

Finally, non-US developed market stock indexes have failed to keep pace with domestic stock indexes for over a decade and may continue to struggle thanks to a greater willingness to place tight COVID restrictions on its citizens despite the damage it could do to the economy. And closer proximity to under-vaccinated developing nations, which may continue to be originators of new COVID variants, means getting a handle on the disease may be tough.

In all, 2021 was a good year for developed stock markets, which was a surprise to most market prognosticators. While making forecasts about the stock market can be a fool’s errand, investors should brace for greater volatility ahead.

Market metrics

Last quarter encapsulated much of the seesaw in 2021—optimism around the “end” of the pandemic, soured by new, more transmissible variants and concerns over whether inflation is transitory or a more worrisome trend. In all, investors took this news in stride, with most major developed stock market indexes posting positive returns for the quarter and the year.

  Total Return (%)
  4Q2021 YTD 1 Yr 3 Yr 5 Yr 10 Yr
S&P 500 11.03 28.71 28.71 26.07 18.47 16.55
MSCI EAFE 2.69 11.26 11.26 13.54 9.55 8.03
MSCI Emerging Markets (1.31) (2.54) (2.54) 10.94 9.87 5.49
BBgBarc Aggregate Bond 0.01 (1.54) (1.54) 4.79 3.57 2.90

Source: Morningstar as of 12.31.21. Past performance is not indicative of future results.

Published 1.12.2022

Important Information:
The Bloomberg Barclay’s Aggregate Bond Index is a broad based, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the United States.
The MSCI EAFE 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 is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.
The S&P 500 Index is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies.
Treasury Inflation Protected Bonds (TIPS) are a type of Treasury security issued by the U.S. government. TIPS are indexed to inflation in order to protect investors from a decline in the purchasing power of their money. As inflation rises, TIPS adjust in price to maintain its real value.
VIX is the ticker symbol and the popular name for the Chicago Board Options Exchange’s CBOE Volatility Index, a popular measure of the stock market’s expectation of volatility based on S&P 500 index options.
The indices are unmanaged and does not incur management fees, transaction costs or other expenses associated with investable products. It is not possible to directly invest in an index.

Mesirow refers to Mesirow Financial Holdings, Inc. and its divisions, subsidiaries and affiliates. The Mesirow name and logo are registered service marks of Mesirow Financial Holdings, Inc. ©2022, Mesirow Financial Holdings, Inc. All rights reserved. Any opinions expressed are subject to change without notice. Past performance is not indicative of future results. Advisory Fees are described in Mesirow Financial Investment Management, Inc.’s Form ADV Part 2A. Advisory services offered through Mesirow Financial Investment Management, Inc. an SEC registered investment advisor. Securities offered by Mesirow Financial, Inc. member FINRA and SIPC.