2021 was yet another stellar year for financial markets, with the S&P 500 Index gaining over 28%. The index, a commonly used basket of the 500 largest stocks in the U.S. market, ended the day at all-time highs 70 different times in 2021 and has now posted three straight years of strong double-digit returns. As has been the case in recent times, mega-cap blue-chip names, such as Apple and Microsoft, and high-flying tech superstars with cult followings, such as Tesla, were responsible for an outsized share of the market’s gains. As a result, large-cap domestic equities outperformed their mid- and small-cap peers significantly, while growth stocks beat out their value counterparts for both the quarter and year.
International equities fared notably worse than the domestic market in the fourth quarter, with the MSCI EAFE Index finishing in the green only thanks to a late-quarter rally. A relatively cautious approach to Covid, fiscal austerity measures, and a persistent valuation discount were all factors that weighed on European equities relative to the U.S., and many developed markets contended with the same supply chain limitations and subsequent inflation fears being experienced in the states as well. Emerging markets, on the other hand, were not able to stop the skid and finished the quarter slightly negative. As was the case in the third quarter, China was a main culprit here. Following a handful of crises in recent months, including red flags in its previously booming real estate market and out-of-the-blue crackdowns on everything from cryptocurrencies to video games, foreign investors have lost a good deal of confidence in Chinese markets over the latter half of 2021.
Fixed income holdings had a relatively flat quarter, with high-yield issuances generally posting small gains and short-term bonds posting slight losses in both the corporate and municipal bond markets. The Federal Reserve is firmly in the spotlight here, as their decisions surrounding the unwinding of easy monetary policies will have significant consequences. At the short end of the yield curve, investors expect about three or four rate hikes from the Fed in 2022, perhaps starting as early as March. Given the inverse relationship between price and yield, investors are wary of these rate increases, contributing to recent selling pressure. On the balance sheet side, the Fed will begin unwinding some of its bond buying program, further reducing the current demand for Treasury and mortgage-backed assets.
Before looking ahead to 2022, it is important to note where we are. The S&P 500 Index has posted gains of 28.68%, 18.39%, and 31.48% over the past three years, respectively, despite a global pandemic, supply shortages, inflation fears, a divisive presidential election, and a government shutdown, among other negative headlines over those years. We at Condor are certainly not anticipating a sustained market crash, and stocks do not drop simply because prior years were good or an arbitrary amount of time has passed between corrections, but it needs to be noted that the past three years of returns are outside of the statistical norm. While we remain optimistic, it should be said that, in our estimation, the odds of another 20%+ up year are much lower than they were in years past.
With this in mind, our expectations for 2022 are for corporate earnings to continue to grow in the high single digits, less economic disruption from Covid as we work through the Omicron variant, and, in the best-case scenario, for supply chain issues and inflation fears to subside by the second half of the year. In this environment, we would hope to see a broadening of the market with some less-loved sectors and value names contributing to returns alongside the high-flying FAANG names.
On the fixed income side, there are headwinds at this time. The Fed is clearly signaling that they expect to begin raising rates in 2022. Meanwhile, the central bank’s tapering of its balance sheet will reduce demand for Treasuries and mortgage-backed securities as it elects not to reinvest proceeds as existing holdings mature. The result is a situation in which bond investors must work around a more hawkish Fed.
That said, unwinding some of its more dovish policies is a nod to the Fed’s confidence in underlying U.S. macroeconomic strength, and higher rates would mark a more proactive response to the inflation headlines swirling in recent quarters. While it is true that a rising rate environment is not ideal for bond prices, it also proportionally increases the yield that bonds throw off, which only makes for more attractive entry points down the road. Finally, government bonds issued by the Bank of Japan, the U.K., and other developed nations still have yields firmly in the negatives, meaning that the relative demand for U.S. Treasuries should remain high regardless of the Fed’s tapering.
We cannot expect the Fed to keep interest rates at zero and maintain an $8.5 trillion balance sheet forever, and thus far their plans have been signaled to market participants relatively clearly. Additionally, the current central bank regime has generally proven more cautious than reckless, so if rising rates do shake markets more than anticipated or there is an unexpected shock to the economy, we would expect them to back away into a more accommodative stance relatively quickly.
All told, we are heading into 2022 hopeful for another strong year but also aware of the headwinds we face. We have already made some moves, such as taking steps to safely add yield and shorten duration a bit in our fixed income portfolio, to best position ourselves and our clients for the coming year, and as always, we will remain vigilant for attractive opportunities and entry points as events unfold. We thank you for your business and continued trust and wish you all a happy, healthy, and safe 2022!