4Q2021 Market Summary
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As we enter 2022, inflation remains a key driver of market expectations, although the impact of higher inflation may differ between stocks and bonds.
A combination of continued economic strength, ongoing supply chain bottlenecks, and years of underinvestment in certain sectors are all factors driving inflation to levels not seen in the US in over 30 years. While possible that some of these inflation drivers may normalize in the near future, even the Federal Reserve recently removed the word “transitory” from its description of inflation, leading investors in all asset classes to reassess their outlook.
Higher inflation reduces the value of the future fixed income stream that bond investors receive and can result in higher interest rates, which leads to lower bond prices. That said, current interest rates remain low relative to current rates of inflation, suggesting that bond investors still view high inflation levels as temporary. It’s possible that other technical factors are keeping bond interest rates low, such as demographic trends and foreign investors flush with cash seeking a haven in US bonds given even lower rates overseas.
The impact of higher inflation on equities is less clear, and some companies may benefit from higher inflation, while others will struggle. High quality companies with strong pricing power and limited reinvestment needs should withstand higher prices better than companies that lack pricing power or require high reinvestment to continue growing. However, if inflation leads to higher interest rates, valuation multiples for stocks may compress as the market discounts future cash flows at a higher rate.
While ongoing inflation may pose a risk to returns, we also recognize the difficulty in accurately predicting macro-economic outcomes. Accordingly, we suggest investors remain cautious and avoid over-allocating their portfolios to any one potential economic outcome. For example, a heavily growth-oriented portfolio may struggle if rates rise and valuations shrink, but a sharp or unexpected economic slowdown may result in cyclical value stocks struggling. Similarly, bond investors seeking income generation may need to increase equity exposure to reduce the risk of rising interest rates, although bonds should still provide diversification benefits if the economy slows.
As always, we continue to believe that an appropriate asset allocation based on your individual goals, diversification, and long-term focus on fundamentals and valuations will serve clients well over time.
The S&P 500 Index returned 11% during the fourth quarter, resulting in a 28.7% return for the year. While more cyclical value stocks outperformed growth earlier in 2021, strong returns for mega-cap tech stocks helped growth outperform for the year.
Small-cap stocks were mixed, as many smaller growth companies saw their stock prices plunge from the speculative highs achieved earlier last year. For example, the Russell 2000 Value Index returned 28.3% over the last 12 months, but the Russell 2000 Growth Index returned only 2.8%.
Foreign developed and emerging market stocks both lagged domestic equity markets during the quarter and for the year. The MSCI EAFE Index returned 11.3% for the year, but would have returned a better 18.7% if excluding the impact of a stronger US Dollar. China’s ongoing regulatory scrutiny of publicly traded companies across many sectors resulted in sharp share-price declines. Chinese stocks make up more than 30% of the MSCI Emerging Markets Index, which declined 1.3% during the quarter and fell 2.3% for the year.
Rising interest rates created a challenging environment for bonds during both the quarter and the year. While rates increased across most maturities on the Treasury yield curve, shorter-term rates experienced a relatively sharper increase. For example, 5-year Treasury rates increased from 0.36% to 1.27% during the year, or a 0.91% increase, while 10-year Treasury rates only increased 0.59% to end the year at 1.5%.
The Bloomberg US Aggregate Bond Index was flat during the quarter, but fell 1.5% for the year. Lower quality bonds, like high-yield corporate bonds and bank loans, held up well, as these asset classes are typically less sensitive to changes in interest rates. The Bloomberg US Corporate High Yield Index returned a positive 5.3% in 2021.
Commodity prices benefited from higher demand and supply chain bottlenecks throughout 2021. The Bloomberg Commodity Index returned 27.1% for the year. Gold lost some of its luster in 2021, falling about 4% after a strong year in 2020.
The Standard & Poor’s 500 Index, often abbreviated as S&P 500, is an American stock exchange market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ. The S&P 500 index components and their weightings are determined by S&P Dow Jones Indices.
The Russell 1000 Growth Index is a broadly diversified index predominantly made up of growth stocks of large US companies.
The Russell 1000 Value Index is a broadly diversified index predominantly made up of value stocks of large US companies.
The Russell 2000 Index is a small-cap stock market index of the bottom 2,000 stocks in the Russell 3000 Index. The index is maintained by FTSE Russell, a subsidiary of the London Stock Exchange Group.
The Russell Microcap Index measures the performance of the microcap segment of the US equity market. It includes 1,000 of the smallest securities in the Russell 2000 Index based on a combination of their market cap and current index membership and it also includes up to the next 1,000 stocks.
The MSCI EAFE Index is a stock market index that is designed to measure the equity market performance of developed markets outside of the U.S. and Canada.
The MSCI Emerging Markets Index is an index designed to measure equity market performance in global emerging markets.
The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market.
The Bloomberg Barclays US Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD denominated securities publicly issued by US and non-US industrial, utility and financial issuers
The Bank of America Merrill Lynch High Yield Bond Index tracks the performance of below-investment-grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.
The Bloomberg Barclays U.S. Municipal Index covers the USD-denominated long-term tax exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds and prerefunded bonds.
The LBMA Gold Price Index is the global benchmark for unallocated gold and silver delivered in London.
The West Texas Intermediate (WTI) oil, also known as Texas light sweet, is a grade of crude oil used as a benchmark in oil pricing. This grade is described as light because of its relatively low density, and sweet because of its low sulfur content.
Bloomberg Commodity Index (BCOM) is calculated on an excess return basis and reflects commodity futures price movements.