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December 2021 - Market Update
Key Observations
Looking back at where we were last January, it seemed unlikely that stocks would perform as well as they did in 2021 given all of the risks still on the table. The original COVID strain was in full force and vaccines were in their early stages of distribution. The Federal Reserve was on a war path to prop up the economy by conducting massive bond purchases and holding interest rates at virtually zero. The economic reopening story was looking plausible, assuming consumers would be willing to leave their quarantines and start patronizing local businesses. Alas, the reopening story played out, and stocks had one of their best years. Broad bond indexes lost value as interest rates rose due to higher inflation and expectations for a normalization of interest rates.
Heading into 2022, COVID has become less of an economic threat. The focus will be on the persistence of inflation and the speed at which the Fed reacts. The supply chain should loosen up in the first quarter, leading to tailwinds from pent-up demand. US Stocks are at all-time highs, but a large pullback is not a high probability event if the economy can continue to maintain its resilience and the enormous money supply continues to loop through the economy.
Data Dashboard
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Stock Market
US stocks had a record year on the back of easy monetary policy and a strong reopening story. The S&P 500 had a Total Return of 28%, led by the Energy sector. Earnings growth for the year was driven by both strong revenue growth and margin expansion, leading to more than 50% earnings growth (albeit compared to a depressed 2020 number). Unlike recent years, the largest stocks in the S&P 500 were not the driving force in the market-cap weighted index’s returns. The Equal Weight S&P 500, an index with all 500 stocks equally weighted, had a very similar return (29%) for the year. Small cap stocks underperformed, as did foreign stocks on average.
Year to Date Returns (by US Sector)
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Bond Market
Broad bond indexes lost money in 2021 due to rising rates and higher inflation. The 10-year US Treasury started the year at 0.91% and rose to 1.51% by year-end. The Fed’s indication that they would slow down the purchases of bonds and start raising short-term rates in 2022 pushed longer-term rates higher. Bonds with significant interest rate sensitivity (Treasuries, Investment Grade Corporates, Munis, and MBS) saw their prices decline throughout the year.
On the flip side, bonds with more credit exposure (High Yield Corporate Bonds, Floating Rate Bank Loans, etc.) benefited from the increase in equity valuations and therefore lower default risk. Treasury Inflation Protected Securities (TIPS) also benefited from the higher inflation rate, proving their value in a bond portfolio during a period with large monetary stimulus.
Economics
While we don’t yet have the final December numbers for many of the economic indicators we follow, the previous months’ indicators show us that the reopening story unfolded just as we had hoped. Economic activity (as measured by GDP) is expected to come in around 5.5% for 2021 (after adjusting for inflation). Coupled with a dramatically improved Unemployment Rate (4.3%), the economy more than recovered from the initial COVID-19 driven slowdown in 2020.
Inflation also increased at a faster than expected rate in 2021. The most recent read on Core Inflation Rate (excluding Food and Energy) was 4.9% YoY (year over year). While temporary inflation is not problematic, elevated inflation long-term can be trouble for the economy. The Fed’s plan to reduce stimulus via removing monthly bond purchases and raising the Federal Funds Rate is geared toward slowing down inflation, although some economist fear that the Fed is behind the curve. The Fed’s current projection is to slow purchases in the first quarter and make 3 increases in the Fed Funds rate this year (0.25% each).
The consumer is in relatively good shape. Low credit card debt , rising housing prices and a record stock market, government stimulus payments, and plentiful jobs have put consumers in a good financial position. The threat of COVID-19 is not over, but vaccinations, new treatments, and less severe variants are allowing people to resume many of their daily activities that lead to economic growth.
Finally, the supply chain is slowly loosening up. The average delivery time for imported goods is still elevated, but the cost of shipping is starting to come down from the peak, indicating that shipping supply should be ramping up. The supply chain issues are global, so we have to watch the economic conditions of our biggest trade partners, (e.g. China) for insight on the state of supply chain dynamics. Some experts point to the second quarter of 2022 for a major reduction in supply chain pressures on US companies.
GDP, Inflation, Unemployment
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Tactical Updates
For our Tactical Portfolios, we remain primarily invested in US domestic equities with only a small exposure to foreign Indian equities. Throughout December, we cut losses in Russia, Blockchain, and Commodities for better opportunities in Consumer Discretionary, Energy, and the overall S&P 500. We remain invested in a handful of consistent positions such as Real Estate, Oil and Gas Exploration, Financials, and Cybersecurity related companies.
As for Fixed Income, we continue to see strong opportunities in Treasury Inflation Protected Securities (TIPS) and in high yield corporate bonds with exposure to credit risk. We remain concentrated in both government and corporate issued securities.
General Client Considerations
The beginning of 2022 isn’t just a new year. It marks the second-year anniversary of when we first discovered COVID. The pandemic caught almost all of us by surprise. Today, many of our lives look at least a little different than they did before 2020.
No matter how COVID has affected you, one thing for sure is that it has caused us to self-reflect upon our health, family, and finances among many other areas in our lives. Many people are now reevaluating their careers or retirement timelines, how and where they live and many other upcoming goals in light of the variant uncertainties and other continued unknowns.
It’s a great time to think about your life priorities, reassess each of your goals, and ask yourself, “Am I setting myself up to make these happen?”
Now is the best time to reach out and discuss any changes to your life plan or situation. Please don’t hesitate to give us a call or schedule a meeting. We are looking forward to hearing from you soon!
Happy New Year to you and your family from everyone here at Friedenthal Financial!
Ryan Wheeler
Chief Investment Officer