As we put 2021 in our rearview mirror, it will certainly be remembered for continued political friction as the legal contest of the presidential election results ushered in the year, along with the storming of the Capitol, followed by fierce partisan battles over stimulus spending and mask mandates. Social tensions also remained high as several high-profile cases came to verdicts. And by the end of the year, despite the record-paced development and adoption of vaccines, the COVID-19 pandemic raged on in the form of Delta and later Omicron—although with a declining morbidity rate.
These hurdles, along with inflation and supply and labor shortages, provided a strong headwind. However, GDP, corporate earnings and the markets pressed forward, fueled by accommodative fiscal policies and record monetary stimulus, producing strong results. GDP was up an estimated 6.0% and S&P 500 earnings growth is estimated to be a staggering 45.1%. Such increases produced a robust 28.7% return for the S&P 500 for the year, with relatively low volatility as the largest decline was 5%.
The record amounts of stimulus, Fed tapering, along with supply and labor shortages created inflation pressures that gave interest rates essentially nowhere to go but up. As a result, the broad bond market lost 1.7%. In early 2022 the climb continues as the yield on the 10-year treasury approaches 2.0%, currently hovering around 1.8%.
Residential real estate experienced another record year as supply continued to lag demand, and low interest rates helped maintain a strong pool of qualified buyers. The pace of homes sold in 2021 increased 6.8%, with an estimated 6 million homes sold. Commercial real estate performance for 2021 was mixed as owners, tenants, and lenders all took advantage of the various relief programs to service their debt, keep their businesses going, and maintain the property or office location.
As we look forward and prepare to navigate 2022 with many of the same risks and headwinds, we will be keenly watching the following key factors and variables:
OVERALL HEALTH GROWTH OF THE ECONOMY
The recession of 2020, triggered by Covid, was one of the deepest in history, but it only lasted for 2 months. And the recovery has been quick and dramatic. Inflation and various shortages and pressures will persist, but strong earnings and consumer and capital spending should help the economy and GDP record another year of growth, projected to be close to a normalized rate of about 3%. Leading economic indicators remain positive heading into the New Year despite early market volatility.
THE FED vs INFLATION
“Persistent” replaced “Transitory” as the adjective of choice used to describe the current inflationary environment. In November, Headline CPI peaked at 6.9% annualized. The Fed is expected to raise the Fed Funds Rate three times this year, alongside Tapering, in an effort to cool inflationary pressures that are running well above the Fed target and historical averages of 2% - 3%. The lack of any additional monetary stimulus and mandated loan repayment forbearances should also help starve the inflationary fire. However, inflation is still expected to run in the 5% range for most of the year.
JOBS & UNEMPLOYMENT
While December job gains signaled some cooling amid Omicron fueled disruptions (199,000 jobs added in December vs. 249,000 jobs in November), the calendar year 2021 picture is one of tremendous recovery. For 2021, the US economy added 6.4 million jobs, more than any year on record. 4Q2021 job gains totaled 1.1 million. Year over year, the unemployment rate fell from 6.7% to 3.9%, a shortfall of 3.9 million jobs (0.4%). On an industry basis, retailers and manufacturers got close to fully recovering jobs lost from the pandemic while leisure and hospitality employers are still 7% below pre-pandemic levels. Also of note is that wage growth is increasing at a faster rate than the unemployment rate. That’s good news for the consumer, but it will probably add to inflationary pressures.
CONSUMER ACTIVITY & CORPORATE EARNINGS
Looking forward into 2022, JP Morgan expects 10-14% earnings growth for the S&P 500 as trend growth returns and the Federal Reserve begins to raise rates. During 2021, earnings for the index rose 35% while P/E multiples fell by 7%. Interestingly, despite the rising labor, intermediate goods, and raw materials costs, S&P 500 profit margins defied analyst expectations and rose compared to pre-pandemic levels (12.3% in Q3 2021 vs. 11% in 2019). That shows that many companies simply passed these cost increases on to consumers. The more near-term future will likely prove to be more difficult. JP Morgan expects input cost increases to prove more challenging for companies in the new year.
Consumer confidence and retails are moderating due to the various headwinds but remain strong nonetheless and are expected to help drive the continued recovery and economic growth through the current year.
A diversified investment portfolio will continue to be key in reducing volatility and in preserving and growing capital in the face of the persistent headwind risks. It is important to remember that “time in the markets” and not “timing the markets” is an important principle in a disciplined investment strategy. The following are our asset class expectations for the upcoming year:
FIXED INCOME
Despite high inflation and strong economic growth, longer-term Treasury yields continue to be acceptable relative to lower, international yields, which in some cases are still negative.
Corporate spreads are up from cyclical lows but remain well below the long-term average.
Muni yield spreads have also increased modestly but there are few credit concerns due in part to strong fiscal support.
With at least two, but as many as four, Feds Fund rate hikes looming, another year of negative returns is likely. This view justifies an underweight to the asset class but not an abandonment due to continued economic headwinds and uncertainty.
EQUITIES
Continued strong earnings growth in the U.S. are expected to keep valuations in check—albeit at rich levels.
U.S. Large Cap stocks outperformed in 2021 and are expected to take the lead again in the face of rising interest rates relative to their Small Cap, International, and Emerging Markets counterparts.
Despite continued Large Cap dominance, diversification is still highly advised as investors are expected to seek value opportunities amid a broad environment of rich valuations.
Equities are expected to remain the preferred liquid risk asset and therefore produce returns in the range of their long-term averages of 7% - 10%, at least until inflation recedes and interest rates rise enough to avoid negative real returns.
Be prepared for increased volatility.
ALTERNATIVES
Real Estate is expected to have another solid year with supply remaining below demand in single-family and multi-family residences. However, performance will be nothing close to the surge experienced in 2021 because interest rates are expected to rise. The rise will disqualify those with shaking income and balance sheets. Commercial real estate trends will be hard to predict as continued Covid variants and mandates could bottle-neck returns to office and retail.
Private Credit will continue to offer an attractive risk/reward ratio relative to traditional publicly-traded fixed income due to high liquidity in the markets, protection from rising interest rates with their floating-rate structures, and a backdrop of strong earnings in the private markets.
Commodities will continue to gain attention as investors seek protections from the erosion of returns by inflation. Gold was modestly higher and is expected to trend higher throughout the year. Demand for oil will continue to recover despite supply being curtailed by OPEC and the slow return of U.S. production capacity. The rise of U.S. rig counts and stabilizing inventories should bring more balance to the market in the coming year.
Cryptocurrencies continue to grow interest, acceptance, and market cap, and appear to offer diversification and opportunity for wealth. However, with most of the asset class being very new and the correlation, market risk, and regulation still being unknown, the assets still offer too much danger to a traditional portfolio.