A year ago, 2021 seemed poised to bring back a sense of normalcy following the pandemic-stricken 2020, but a series of atypical events provided plenty of high- and low-lights throughout the year. The emergence of COVID variants contributed to a sense of unease felt throughout the year, while geopolitical events also captured headlines. Surprisingly, one constant was that the year produced strong equity markets, with the S&P 500 gaining nearly 29% in 2021, the third straight year of exceptional returns for the broad stock market index, which has doubled over the past three years on a total return basis.
The post-pandemic economic recovery generally remains on course and has provided fuel for the strong market returns. However, tight labor markets and global supply chain struggles have tainted third-quarter growth and stoked inflation fears. The final estimate of third-quarter GDP came in at 2.3%, a sharp deceleration from the 6.5% growth seen in the first half of 2021. The Federal Reserve now estimates full-year 2021 GDP growth of 5.5% for 2021 (down from 5.9%), while the initial outlook for 2022 is for 4.0% economic growth.
The consumer is the primary engine for the U.S. economy and remains generally strong and viable. Despite an array of headwinds, including COVID restrictions and surging inflation, consumer confidence surveys are rebounding and nearing pre-pandemic levels. Consumer confidence reached 115.8 in December as expectations for short-term growth prospects improved. However, retail sales did slow in November to 0.3% growth, a deceleration from stronger readings as wallet share shifted from goods to services. Also boosting the consumer side is a booming housing market where the S&P CoreLogic Case-Shiller Index showed an 18% annual gain in home prices.
An important component of consumer confidence is a strong jobs backdrop. The unemployment rate has fallen to 4.2%, which is the lowest level since the pandemic began. Jobs appear to be plentiful right now, and the labor force participation rate has edged up to 61.8%, but is still below levels prior to the pandemic’s onset. The strong labor market has unsurprisingly led to an increase in wages, which on average increased 4.8% over the past year.
A surge in inflationary pressures has resulted from a combination of the strong labor market, supply chain disruptions, and fiscal and monetary stimuli. The broadly watched Consumer Price Index reached a near 40-year high of 6.8% in December, as energy prices, food, and used car prices have seen some of the biggest jumps. Using the Federal Reserve’s preferred inflation gauge (which excludes food and energy), inflation stands north of 4%, well above the traditional 2% target. The Fed expects heightened inflation to linger into 2022 before inevitably abating.
The manufacturing side of the economy remains on solid footing, with recent readings of the ISM manufacturing survey at or above 60, which is considered “exceptional.” However, December’s report fell to 58.7, which, while still solidly in expansionary territory, matched the lowest level of the year. The slowdown appears to be much more of a supply issue versus a demand concern, as manufacturers noted persistent labor shortages and difficulties procuring materials as the primary reasons for the slowdown.
While there are several economic data points that bear watching, it’s likely that a few curve balls will emerge as the world continues to deal with the lingering effects of COVID, while the White House struggles to pass legislation that would impact spending and taxes, and finally, when the mid-term elections take place later this year.
Bond yields ended the quarter slightly higher, with the 10-year Treasury yielding 1.51%, compared to 1.49% one quarter ago. However, a much more significant move was seen on the shorter end of the curve, with the 2-year Treasury ending the year with a 0.73% yield, well above the 0.28% seen at the end of September. These moves resulted in a significant flattening of the yield curve, as the bond market appears in sync with the Fed’s intent to begin to hike the Federal Funds rate in 2022.
The aforementioned yield movement resulted in relatively flat returns in the bond market, as interest earned was largely offset by falling bond prices (yields and prices move inversely). For the quarter, shorter-term bonds fared worse than the broad bond market, but corporate and high-yield bonds were in positive territory. In fact, high-yield bonds were virtually the only area of the bond market with decent gains, as they participated alongside the strong equity sentiment for the year.
Due to current high inflation levels being viewed less and less as “transitory,” the Federal Reserve meetings during the quarter were closely watched. At its November meeting, the Fed announced a tapering of its bond buying program. The December meeting provided additional color, as the Fed accelerated the pace of the reduction in its bond buying plan, which appears to indicate that its “Quantitative Easing” program is completed a few months earlier than previously expected in 2022.
As the economic recovery is expected to continue, the Fed has also signaled that it is ready to move on from the 0% Fed Funds rate policy. In fact, the market now expects up to three rate hikes during 2022, which could start as early as mid-year. The hawkish pivot from the Fed has come as it deals with inflation levels hovering near four-decade highs and unemployment rates back near pre-pandemic levels.
Treasury yields of selected maturities for recent time periods are displayed below (data from Bloomberg).
|Treasury Bill||Treasury Notes & Bonds|
|3 mo.||2 yr.||5 yr.||10 yr.||30 yr.|
Total return numbers for various fixed income indices over the past quarter and 12 months are below (data from Bloomberg).
|4th Quarter 2021 Returns|
Barclays US Aggregate Bond Index
|0.01%||BofA US High Yield Bond Index||0.66%|
|Barclays US Gov't Intermediate Index||-0.57%||BofA US Corporate Bond Index||0.17%|
|Barclays Global Aggregate Bond Index||-0.67%||BofA ML US Municipal AAA Securities Index||0.88%|
The primary factor behind the equity market’s strong gains were booming earnings, which are expected to show an advance of approximately 45% for 2021, according to FactSet. The earnings surge was enabled by a strong rebound in revenues coupled with high profit margins as companies were able to manage expenses during the pandemic. However, the impact of rising input costs as well as slowing revenue growth will likely challenge the profit growth outlook in 2022.
During the fourth quarter, stocks generally enjoyed a strong finish to an exceptional year, especially for the domestic large-cap indices. The S&P 500 hit a record close 70 times this year, the second-highest annual total since 1995’s 75 closing highs. The S&P 500 tacked on an 11% gain in the quarter to finish 2021 with a gain of 28.7%, as growth stocks provided outperformance due to strong profit growth among the mega-caps and a favorable interest rate backdrop.
The Dow Jones Industrial Average and the tech-heavy NASDAQ Composite also posted strong fourth quarter gains of approximately 8%, while each advanced over 20% for the year. Moving down the size spectrum within domestic stocks generally led to lower returns during the year, with the small-cap Russell 2000 benchmark gaining just over 2% for the quarter and nearly 15% for the year.
Meanwhile, international stocks continue to lag their domestic counterparts by a fairly wide margin. International developed markets dealt with slower growing economies in part from continued COVID issues, while a strong U.S. dollar also presents headwinds for international equity returns. The MSCI EAFE benchmark still posted respectable double-digit returns for the year despite these headwinds.
Emerging markets were the clear laggard among equities, registering negative returns for the quarter and full-year periods. Notably affecting emerging markets throughout the year were fears of a financial contagion related to the Chinese real estate markets as well as Beijing’s regulatory intervention with some of its largest companies. China accounts for around one-third of emerging market equities and its direction will likely continue to have an outsized impact on emerging market equity returns going forward.
While U.S. equity valuations (especially large-cap growth stocks) appear somewhat stretched, stocks may remain in favor for the time being relative to the low level of interest rates. However, investor sentiment may soon be tested as the Fed begins to hike rates and profit growth is poised to slow from 2021’s robust levels.
Below is a table displaying various equity index returns for the past quarter (data from Bloomberg).
|Equity Indices||4th Quarter 2021||2021|
|Dow Jones Industrial||7.87%||20.95%|
|S&P 500 Growth||13.37%||32.00%|
|S&P 500 Value||8.30%||24.86%|
|Russell 2000 (small-cap)||2.12%||14.78%|
|MSCI/EAFE (developed international)||2.74%||11.86%|
|MSCI/EM (emerging markets)||-1.36%||-2.47%|
Real Estate, Technology, and Materials stocks paced the S&P 500 in the fourth quarter, with each sector posting gains over 15%. Furthermore, participation was broad-based among all sectors for the quarter, as seven sectors posted double-digit gains and only one sector failed to put up a positive return for the period. Defensive areas of the market including Consumer Staples and Utilities showed their best returns for the year during the fourth quarter. Investors continued to bid up shares of stocks where profit growth was evident, either from organic growth or simply rebounding from depressed levels.
Communications Services was the only sector to not show a gain for the quarter, as media and telecom companies saw their share prices stagnate as their businesses evolve in a changing landscape. Financial stocks were also relative laggards as the flattening yield curve experienced during the quarter may present profit headwinds for many firms in that industry.
For the full year, Energy stocks turned in the best performance, advancing over 50% on the back of strong commodity prices. Real Estate and Financials also outpaced the market due to relatively inexpensive valuations and a rebound in economic activity. In a year with robust gains of nearly 29%, the most defensive areas of the market were not surprisingly the biggest relative laggards, but the Utilities and Consumer Staples sectors still managed to participate in the upside and post double-digit gains for the year.
The following table details S&P 500 sector total returns for the quarter (data from Bloomberg).
|Return by Stock Sector||4th Quarter 2021|
|1. Real Estate||17.50%|
|2. Information Technology||16.69%|
|3. Basic Materials||15.20%|
|4. Consumer Staples||13.31%|
|6. Consumer Discretionary||12.84%|
|11. Communication Services||-0.01%|
The Investment Overview is published quarterly by the Union Investment Management Group of Union Bank & Trust Company. Please address correspondence to: Union Bank & Trust, Attn: UIMG, PO Box 82535, Lincoln, NE 68501-2535.