1. US Stock Markets Power through Concerns
There is no better way to describe it – 2021 was a historic year for US Stock markets. Stocks overcame numerous headwinds during the past three months, including a resurgence in COVID cases, the Federal Reserve moving aggressively to end the current Quantitative Easing program, and a lack of additional stimulus from Washington, to hit new all-time highs in the fourth quarter and produce very strong returns for 2021.
The fourth quarter started with a continuation of the volatility that we saw at the end of the third quarter, as in early October there was still little progress in Washington on extending the debt ceiling, avoiding a government shutdown, or providing investors’ clarity on future tax changes contained in the Build Back Better bill. That political uncertainty combined with concerns over third-quarter corporate earnings results following a series of negative earnings pre-announcements to send stocks lower to start the fourth quarter. But by the middle of October, Republicans and Democrats had extended the debt ceiling and avoided a government shutdown, while many of the tax increases proposed in the Build Back Better bill were removed, which eased investor anxiety about future tax increases.
Additionally, the third-quarter earnings season proved to be better than feared as corporate America again proved resilient. The vast majority of companies posted better-than-expected results and 2022 S&P 500 earnings expectations rose yet again. Each of those positive developments helped send the S&P 500 sharply higher in October as the S&P 500 recouped all the September losses and hit a new all-time high late in the month.
The positive momentum continued in early November, as the S&P 500 drifted steadily higher given the tailwinds of:
- Clarity from Washington
- Strong earnings, and
- Declining COVID cases
Additionally, while the Federal Reserve announced it would begin to reduce, or taper, its Quantitative Easing (QE) program starting in November, the pace of the reductions met investor expectations and markets continued to rally and hit new all-time highs in mid-November. But on Thanksgiving Day, the World Health Organization declared the Omicron variant of COVID-19, which had just been discovered in South Africa, a “variant of concern” and that designation caused a sharp selloff in stocks, partially thanks to very low liquidity, as governments once again closed borders to international travel, and the world wearily braced for another increase in cases.
At Congressional testimony in late November, Federal Reserve Chairman Jerome Powell surprised markets by stating that due to persistently high inflation, the Fed would likely need to accelerate the just-announced tapering of QE and endorsed doubling the pace of reduction. That acceleration came less than a month after the Fed’s initial tapering announcement, and it caused markets to price in sooner-than-expected interest rate hikes in 2022. Concerns about future Fed policy combined with Omicron uncertainty led to declines in stocks late in November and the S&P 500 finished the month with a small loss.
Markets rebounded in December, however, thanks to less aggressive messaging on rate hikes from the Fed combined with governments not imposing economically crippling lockdowns in response to the surging Omicron outbreak. First, at its December meeting, the Fed announced it will accelerate the tapering of QE in 2022, and that QE would end in mid-March, about three months earlier than expected. The Fed also signalled it expected to raise interest rates three times in 2022 to combat rising inflation. But both of those announcements largely met the latest market expectations, and some reassuring commentary by Chair Powell that the Fed would remain supportive of the economy helped ease investors’ concerns that interest rates would rise too quickly in 2022, and stocks rallied in the wake of the Fed decision.
Then, late in the month, multiple studies implied that the Omicron variant, while more contagious than previous strains, resulted in substantially fewer severe COVID cases. So, while there would likely be new records in daily cases due to Omicron, the risk of hospitalizations and deaths remained low, and as such governments could avoid lockdowns such as those seen in March 2020. That news helped stocks extend the rally late in December, and the S&P 500 finished the month with a four percent gain.
All four of the major U.S. stock indices were higher for the fourth quarter, with the tech-heavy Nasdaq slightly outperforming the S&P 500 while the Dow Industrials modestly lagged both aforementioned indices. The small-cap focused Russell 2000, meanwhile, registered only a small gain for the fourth quarter. Concerns about economic headwinds from the Omicron variant and the Fed’s more aggressive QE tapering and rate hike schedule weighed on small-cap companies especially, as investors sought relative safety in large-cap tech amidst the rising possibility of slower economic growth in 2022.
In summary, 2021 was another historic year for US markets and the S&P 500 ended near new all-time highs, as the governmental policy remained supportive of the economy, corporate earnings growth was strong, and substantial progress was made against the pandemic in the form of widespread vaccination and advancement in treatments. Those positives, in aggregate, were reflected in the very strong market returns, especially in the final quarter of the year.
2. Eurozone & Asian Markets
Beyond the US, markets saw modest gains in the fourth quarter as declines in emerging markets partially offset gains in developed markets. Emerging markets dropped in the fourth quarter in reaction to a stronger U.S. dollar while the Omicron variant also weighed on global economic growth estimates. Developed markets posted a positive return for the fourth quarter, although they badly underperformed the S&P 500. For the full year 2021, foreign markets registered solidly positive returns but, again, handily underperformed the S&P 500 as only moderate gains in developed markets were offset by a modest annual decline in emerging markets.
A number of countries in the Eurozone did introduce restrictions on sectors such as travel and hospitality in order to try and reduce the spread of the new variant. The flash composite purchasing managers’ index hit a nine-month low of 53.4 for December, as the service sector was affected by rising Covid cases. However, equity markets drew support from early data indicating a lower risk of severe illness with a number of defensive areas notably outperforming, including some of the large internationally diversified consumer staples and utilities while luxury goods, technology hardware and semiconductor stocks also performed particularly well.
Across Asian markets, there was a broad market sell-off in the fourth quarter on investor fears that new lockdown restrictions would be instigated following the rapid spread of the new Covid-19 variant. China was the worst performing market in the region with share prices sharply lower, along with neighbouring Hong Kong. Share prices in Singapore also ended the fourth quarter in negative territory as investors continued to track developments surrounding the new Omicron variant. There were also fears that the city-state’s government might have to scale back some recently relaxed curbs on activity.
India and South Korea also ended the quarter in negative territory although the declines in share prices were more modest. Taiwan and Indonesia were the best-performing index markets in the fourth quarter and the only two index markets to achieve gains in excess of 5% in the period. In Taiwan, positive economic data and a rise in exports boosted investor confidence, with chipmakers performing well. Share prices in Thailand, the Philippines and Malaysia also ended the quarter in positive territory.
From late November, renewed short-term uncertainty over the new Covid variant temporarily obscured the increasingly positive outlook for Japan with the country inevitably imported its first known case of Omicron in December, but overall infection rates remain remarkably low, as they had throughout 2021. With the Japanese election out of the way, the political focus shifted to a substantial fiscal stimulus package. This includes direct cash handouts to households in an effort to kick-start a consumption recovery in the first half of 2022. The US Fed’s discussion of accelerated tapering led to some short-term weakness in stock prices in December, despite the fact that such a move is very unlikely to be followed by Japan in the foreseeable future. The Bank of Japan’s own Tankan survey, released in December, contained no real surprises, although the overall tone was reasonably upbeat with the other economic data released during the quarter providing evidence of the strength of the rebound in industrial production as auto output began to recover from the temporary weakness caused by the global semiconductor shortage.
3. Global Bonds
Bond markets were buffeted over the quarter by persistent elevated inflation, hawkish central bank policy shifts and the emergence of the Omicron Covid-19 variant. In bond markets, 10-year government yields were largely unchanged. Yields followed a downward trajectory for most of the quarter before reversing in the final weeks of the year as sentiment improved. Yield curves flattened, with shorter-dated bonds hit as central banks turned more hawkish.
Most notably, US Federal Reserve (Fed) rhetoric turned increasingly hawkish in November. Chair Jay Powell and other members of the policy committee suggested tapering could be accelerated, which it was in December, and that they will stop referring to inflation as “transitory”.
The US 10-year Treasury yield was little changed for the quarter, from 1.49% to 1.51%. It reached 1.7% in October amid elevated inflation and expectations of policy tightening, then a low of 1.36% in early-December amid fears over the Omicron Covid-19 variant. The US 2-year yield increased from 0.28% to 0.73%.
The UK 10-year yield fell from 1.02% to 0.97%, dropping sharply in early November as the Bank of England (BoE) unexpectedly elected not to raise rates. The BoE did, however, raise rates in December and with fears over the Omicron variant fading, yields rose. The 2-year yield sold-off, from 0.41% to 0.68%.
Germany’s 10-year yield was little changed, from -0.17% to -0.19%, but this reflected a late sell-off with the yield having fallen below -0.40% in December. Italy’s 10-year yield increased from 0.86% to 1.18%. Eurozone inflation picked up considerably, rising to the highest level since 2008 and to a near 30-year high in Germany. European Central Bank President Christine Lagarde broadly affirmed dovish messages, but comments from other ECB officials were more hawkish.
Commodities saw gains in the fourth quarter as both oil and gold logged positive returns. Oil rallied late in the quarter on fading concerns that Omicron would materially impact consumer demand for refined products around the globe. Gold & Silver, meanwhile, saw a small gain in the fourth quarter thanks to continued high inflation readings and a general increase in market volatility following the Omicron surge. For 2021, commodities posted a large, positive return due to the significant gains in oil futures and other energy commodities which surged as the global economy reopened and demand increased amidst still-constrained supply thanks to a disciplined OPEC+ group. Gold, however, saw a modestly negative return for 2021 as the increasing attractiveness of alternative investments, such as Bitcoin and other cryptocurrencies, combined with a stronger dollar to weigh on precious metals.
The industrial metals component was the best-performing commodities segment in the quarter as the global economic recovery gathered pace. There were strong gains in the prices of zinc, nickel, lead and copper.
The agriculture component also achieved a positive return in the quarter, with losses in Sugar and Cocoa being offset by robust gains recorded for coffee, cotton, rice, corn and Kansas Wheat.
2022 Market Outlook
Global Stock markets have exhibited very impressive resilience since the pandemic began and that remained the case throughout the fourth quarter and all of 2021, as the strength of the U.S. economy and corporate America helped produce another year of substantially positive returns in stocks. And that resilient nature will continue to support markets and the economy as we begin a new year.
Like all years, however, 2022 presents numerous potential challenges to economic growth, corporate earnings, and market returns, including a reduction in global stimulus, still stubbornly high inflation pressures, political uncertainty, and the ongoing pandemic.
Firstly, the fires of inflation are now burning not only in the U.S. but all around the world. Of course, central bankers have no one else to blame other than themselves along with their fiscal policy maker counterparts for painting themselves into a very tight corner by grossly, wildly, excessively, recklessly overstimulating the economy and financial markets in response to, not a financial crisis, but a health crisis from early 2020. And after first proclaiming back in 2020 that they would remain accommodative for as long as it takes and since repeatedly promising that inflation pressures would be “transient,” the Fed is now more recently shifting with swiftness toward pressing increasingly hard on the brakes in tightening monetary policy. In other words, the increasing rise of inflationary pressures has monetary policy and financial markets now in direct cross currents against one another.
Global central banks, led by the Federal Reserve, have already begun to reverse the historically accommodative policies that were enacted in response to the pandemic. The Fed specifically expects to end its QE program by mid-March and increase interest rates three times in 2022. That transition to more normal monetary policy will likely create headwinds on the economy and potentially corporate earnings, and while historically U.S. stocks have performed well during the initial phases of a Fed rate hike campaign, we will closely monitor the impact of rate hikes on economic growth and the corporate earnings outlook as we move through 2022.
The reason the Fed is more aggressively removing accommodative policies is because inflation surged to 30-plus-year highs in 2021. Positively, rising inflation did not have a negative impact on consumer spending or corporate earnings in 2021. But that risk remains as even optimists do not expect inflation to decline substantially in 2022. As we did in 2021, we will continue to monitor inflation closely to see if it becomes a negative influence on corporate margins and earnings, or consumer spending more broadly, because if that’s the case it will result in a rise in market volatility.
Politics will also be a source of potential volatility in the first quarter of 2022 and beyond. Democrats failed to pass the Build Back Better social spending bill in 2021, but the process is not over, and none of us should be surprised if that legislation passes in early 2022. From a market standpoint, investors will be most focused on any potential tax increases that might reduce corporate profits or consumer spending. Given the current version of the bill, market-negative tax increases look unlikely, but the legislative process is unpredictable, and we’ll continue to monitor the situation for any negative tax implications. Additionally, there will be midterm elections in November, and as is usually the case, we can expect the run-up towards the midterms to cause at least temporary market volatility.
Finally, COVID is not over. The Omicron variant, which is currently spreading across the globe, thankfully does not result in nearly as many severe cases as previous COVID variants, but it’s still impacting society and businesses via worker shortages and more supply chain disruptions. And as we look ahead to 2022, we sadly must be prepared for more variants to impact the global economy, and we will continue to watch for any sustainably negative impacts from COVID on the economy or markets.
So while investors have been conditioned for the last 13 years for the Fed to scramble to the rescue of financial markets at the first signs of trouble, the Fed no longer has this flexibility at least for the time being. And the next time that the S&P 500 Index is careening to the downside for some seemingly inexplicable reason over the coming year (see December 2018, for example), the Federal Reserve and its global central bank brethren very likely will no longer have the flexibility to abruptly change course toward monetary easing as it has so many times in the past.
In conclusion, as we consider all that has occurred in 2021 and look forward to 2022, one of the biggest takeaways from another unpredictable year in the markets is that a well-planned, long-term-focused and diversified financial plan can withstand virtually any market surprise and a related bout of volatility, including multiple COVID waves, inflation reaching 30-year highs, and the Federal Reserve removing historic accommodation.