December has historically been known for two things: tax-loss selling and a holiday-induced boost to equity markets. Accordingly, 2021 proved to fall right in line with history. Stock markets seemed immune to the pressing wall of worry from a massive global surge in COVID-19 infections, inflation at 6.8% (the highest reading since June 1982), and backlogs still clogging supply chains.
This year’s Santa Claus Rally capped off a year where the S&P 500 Index hurtled through record highs 70 times, and the equity market has now doubled since New Year’s 2018. Happy Holidays, indeed.
Once again, COVID-19 caseloads are surging around the world. In the week of December 22 through 28, almost 900,000 cases were confirmed worldwide each day, with over one million in those final two days. In the U.S., we are averaging more than 260,000 new cases a day, surpassing prior highs made last winter.
The good news? Well, it appears the Omicron strain, while being more transmissible, is less severe than its Delta predecessor. Even if it is better at evading current vaccines, the hope is that Omicron does not trigger restrictive lockdowns. So far, despite growing case counts, states have opted not to impose business closures and other such measures.
Despite concerns about the economy and the pandemic, 2021 was one for the record books. The S&P 500 hit its 70th record close on December 29, the most in a year since 1995 (when the index hit new all-time highs 77 times). While the markets could have gone the other way given the global pandemic, looming Federal Reserve monetary policy tightening, and the inability to pass a $2 trillion Build Back Better bill, it turned out there was reason to be optimistic, instead.
After repeated government and Fed-supported stimulus, consumers are spending, and corporations are earning more than ever before.
Corporate profits rose 3.4% to a record $2.52 trillion in Q3 2021, and that pace is expected to have continued throughout the fourth quarter, with holiday sales jumping 8.5% from the prior year despite price increases.
Consumer demand appears strong, with this holiday spending marking the biggest increase in 17 years. While there will likely be a slowdown in January and February, this is constructive data for the economy, and it is showing up in equity performance. Over two-thirds of the economy depends on consumer spending, so optimism abounds when the consumer is strong.
One of the bigger headlines for December was the actions of the Federal Reserve. As signaled in November, in the face of rising inflation that is no longer ‘transitory,’ and a stronger economy, the Fed has elected to shift from its ultra-loose monetary policy to tame rising prices.
Government bond purchases are now set to end in March 2022, and Fed officials are expected to raise rates three times over the course of this year, a significantly more aggressive stance than a few months ago.
Why might this worry investors? First, rising interest rates could dampen the prospects of high-flying growth stocks, which tend to underperform during higher interest rate cycles. Secondly, several equity market crashes have been preceded by Fed policy missteps, such as hiking interest rates too fast or too slow.
The path of interest rates and tapering will be closely watched by market participants in 2022. The last time the Fed tried to taper too quickly, back in 2018, markets did not react well, dropping 20% from September to December 24 that year.
To prevent any surprises, the Fed tries to communicate their policy well in advance, which is what they’ve done now. As Fed Chair Jerome Powell noted, “The economy no longer needs increasing amounts of policy support,” a nod to the strength of the recovery.
The Great Moderation
As economist David Rosenberg put it, 2021 was a year of peak growth, peak inflation, peak stimulus, and peak valuations. In short, peak everything.
Similarly, many market participants believe that we will see a year of slower growth and inflation, and with greater volatility.
In our view, 2022 will continue to be a year of global recovery as the world tries to shake off the COVID-19 pandemic. We believe growth will continue, albeit at a likely slower pace as global stimulus is gradually pared back, and as we move on from comparisons to the depths of 2020.
Despite the headwinds of inflation and new COVID-19 variants, the macroeconomic picture continues to look healthy. For instance, the IMF projects the global economy will grow 4.9% in 2022. Job openings are at 1.5 times pre-pandemic levels, wages have grown, and consumer savings have shot up sharply during the past two years.
As we head into the moderating growth phase of the cycle, we remain optimistic about the growth opportunities in the markets. However, caution is warranted, given the elevated valuations of the markets.
In particular, how the pandemic eventually resolves, whether inflation subsides, and how the Fed reacts to these moves will remain key topics that we have to monitor closely for next year.
Markets were very profitable for buyers of dips in 2021, and December logged healthy gains. On the back of economic strength and higher inflation, the Federal Reserve has shifted to a more aggressive stance. While we need to see how these policy shifts play out, one thing is clear: next year will probably not be as ‘easy’ as a market as this year was. We are positive on the fundamentals and expect continuing positive returns, but it would be naïve to expect a straight-line recovery. In our view, managing volatility via prudent risk management will be essential for investors in 2022 and beyond.
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The Dow Jones Industrial Average is a price-weighted index of 30 actively traded blue-chip stocks. The Nasdaq Composite is a market-capitalization- weighted index consisting of all Nasdaq Stock Exchange listed stocks that are not derivatives, preferred shares, funds, exchange-traded funds or debenture securities. The Bloomberg Barclays U.S. Aggregate Bond Index measures the investment-grade U.S. dollar-denominated, fixed-rate taxable bond market and includes Treasury securities, government-related securities, corporate securities, residential and commercial mortgage-backed securities, and asset-backed securities.
The S&P 500 Index is an unmanaged, market value-weighted index of 500 stocks generally considered representative of the broad U.S. stock market. The MSCI All Country World Index (ACWI) is designed to represent the performance of large- and mid-cap stocks across 23 developed and 26 emerging markets and represents approximately 85% of the free float-adjusted market capitalization of each market. The MSCI Europe Index captures large- and mid-cap representation across 15 developed market countries in Europe and covers approximately 85% of the free float-adjusted market capitalization across the European developed market equity universe. The MSCI Emerging Markets Index captures large- and mid-cap representation across 26 emerging market countries and covers approximately 85% of the free float-adjusted market capitalization in each country.