January 19, 2022

 

Although we will not be able to address the tremendous amount of hardship and disruption the pandemic has caused, we hope this letter finds you well. As we, yet again, look for the light at the end of the COVID tunnel on a cold January day, we feel it is still a good time to elaborate on what we see to be the most important financial topics of 2021 and 2022.

Markets in 2021: Concentration of Winners and Losers

A big winner in 2021, was the S&P 500. Its return was the 7th highest in the past 50 years and five of the biggest stocks accounted for more than half of that return from April to year-end. An obvious loser was the broad index for US bonds (the Bloomberg Barclays US Aggregate Bond Index). It saw negative returns for only the fourth time since the index’s inception in 1976.         

Large US stocks performed well in 2021 because of low interest rates and the economy was stronger than expected (due largely to stimulus, reopening, and corporate profits). The economy, however, has run headlong into restricted supply of goods and workers, triggering higher prices. Bonds struggled in 2021 because when interest rates increase, it brings down the price of most bonds. As a result, additional time must pass so more interest can be earned and offset the decrease in price.

We can also observe clear dispersion of winners and losers between the sub-categories (based on company size, geography, and business type) of stocks and bonds beneath the broad index level. For example, broad US indices outperformed those for emerging markets, like China, Brazil, India, etc., and smaller US companies growing at a more steady, predictable pace outperformed similar size companies growing more quickly but with more unpredictable profits.

Looking forward to 2022, CFRA Research noted that 2022 has the potential to be a positive but volatile year. Despite the challenges, CFRA believes that U.S. stock markets will be able to overcome and achieve “single-digit price appreciation” in 2022 as it contends with slowing growth and a new cycle of rising interest rates.

Interest Rates: They Matter

Interest rates are important for two main reasons: one, they set the tone for how much the economy can grow based on how expensive it is for business and consumers to borrow and, two, they significantly influence how investors evaluate the risk v. return characteristics of different investments.

The Federal Reserve Bank (Fed) announced last December that it will begin increasing interest rates in 2022 to cool the economy and reduce inflationary pressures. The Fed raised interest rates in 2018 causing the economy to slow and the S&P 500 to have a modestly negative year. In early 2019, the Fed reversed and began to lower interest rates. Stocks, bonds, and real estate all responded positively. Rising interest rates will likely negatively effect all financial assets to some degree. The question is how much and how quickly.

This does not necessarily mean that there will be a negative return associated with a fully diversified portfolio – it may simply be that returns are less. Predicting returns over the short-term has been nearly impossible, but the longer your timeframe the more likely you are to experience positive returns consistent with the long-term average.

Inflation: Not Likely to be a Repeat of 1970’s

Many things influence the price of goods and services, and inflation rates measure the change in prices over a fixed time period. It’s important to distinguish the rate of change from the actual price, however. For example, the national average for a gallon of gas is currently 8.3% lower today than it was in 2008 despite going up about 58% in 2021.[1]

It’s also important to distinguish “sticky” categories of inflation (e.g., rent, insurance, medical expenses, etc.) and flexible categories of inflation (e.g., food, energy, cars, etc.). Through November 2021, the sticky inflation rate was 3.4% while the flexible inflation rate was 17.9%.[2] The IMF projects that the headline inflation rate (measured by the consumer Price Index) will be 3.5% in 2022 and 2.7% in 2023.[3]

According to Capital Group’s 2022 Outlook:

First, some inflation can be healthy for companies. It allows them to raise prices and enhance profitability in ways they may not have been able to in recent years. Particularly, banks and commodity- linked companies.

Second, even during times of higher inflation, stocks and bonds have generally provided solid returns…It’s mostly at the extremes – when inflation is above 6% or negative – that financial assets have tended to struggle.

Conclusion: Remain Disciplined

We encourage clients to have all the pieces to their financial puzzle in place and understand their respective risk exposure so to allow themselves the ability remain disciplined with their portfolio and investment objective. As Jason Zweig recently wrote in his Wall Street Journal column, “[T]he best investment of 2022 is likely to be discipline…When you drastically change your long-term course based on what feels like a short-term thing, you are likely to end up caught by surprise – and racked with regret.”

For our part, we continue to rebalance and maintain broadly diversified portfolios while also positioning models and evaluating managers based on the risks we see most likely to impact the markets – higher interest rates, inflation, and an economy that continues to work out the kinks from COVID disruptions. We are watching for opportunities abroad by monitoring how developed and emerging societies recover from COVID relative to the US and maintain that bonds play an important role in portfolios by providing stability, diversification, and liquidity, despite rising interest rates.

 

Securities and advisory services offered through LPL Financial, a registered investment advisor. Member FINRA/SIPC

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

 

[1] 2008 price based on data from Office of Energy Efficiency and Renewable Energy; Current price based on gasprices.aaa.com.

[2] Federal Reserve Bank of Atlanta, Refinitive Data stream.

[3] As of October 2021.