2021 was a noteworthy year for many investors. Nearly two years after one of the steepest declines from the COVID pandemic, the equity markets managed to continue their resilient path higher. For the year, both the S&P 500 and Dow Jones Industrial Average printed numerous record closes with the S&P 500 posting its last one in the final week of the year.
Despite the uptick in new omicron variant cases, equity markets maintained much strength for the quarter rewarding investors for their perseverance. The ultra-low interest rate policy of the Fed along with the healthy economic recovery caused stock valuations to climb. Even though U.S. stocks led the global markets for the year, not all asset classes participated as the threat of rising rates and inflation created headwinds for some bonds and gold.
As we enter 2022, navigating the capital markets will require more patience than in 2021. There are still several factors that could create more volatility for investors. These include:
·The emergence of new COVID variants and continued development of new vaccines & therapeutics in response to virus mutations.
·The Fed’s plan to increase interest rates to help ease the persistence of higher inflation.
·High stock valuations being challenged by higher interest rates and the potential for slowing economic growth, particularly in China – the world’s second largest economy.
INTEREST RATES & INFLATION
Interest rates and inflation concerns continue to be at the forefront of economic news, especially after the Fed announced in December that it will speed up its timeline for tapering its stimulus.
In December, the headline CPI (Consumer Price Index), rose 7% versus the preceding twelve months. This was the fastest rise in inflation in the past 40 years. Energy, food and used cars topped the list for the highest price increases for the year. Although the inflation experienced in 2021 is broad based, there are several factors that contributed to the drastic rise. These include the surge in demand for goods, supply chain bottle necks and a shrinking labor force.
The demand for goods consumption continued to increase above pre-pandemic levels for the year. However, the demand for service-based consumption remains below the pre-pandemic levels. This dynamic is supported by the real PCE (Personal Consumption Expenses) readings for Goods and Services.
Many economists site the influx of stimulus along with the economy restarting as the primary causes of the demand imbalance for goods. While the services demand continues to be stymied by travel restrictions.
The shutdown of most world economies in 2020, created a range of supply chain bottle necks that exacerbated the inflationary impact of the supply/demand imbalance for goods. Both new and used automobile prices epitomize this dynamic. During the pandemic, rental car companies were forced to liquidate their fleets to avoid bankruptcy. However, when the Federal Reserve and U.S. government provided stimulus to aid the economic recovery, many of these rental car companies were forced to replace their fleets to meet the rebounding demand. At the same time, many city commuters became less willing to travel by mass transit due to health concerns. Even as vehicle demand surged, the semiconductor shortage put further pricing pressure on autos.
There are some signs that supply chain issues are being resolved. The backlog of cargo vessels at the California ports seems to have peaked, semiconductors shortages are easing and there is some indication that shipping prices have plateaued. We will be watching to see if the supply/demand imbalances have a lasting effect on goods prices or if prices return to pre-pandemic levels once these logistics problems are resolved.
Although wage inflation rose nominally for the quarter, it is up noticeably for the year at just under 6%. Wages are an important inflationary metric as they account for around 50% of the cost of goods sold in the U.S. As of November, the JOLTS (Job Openings and Labor Turnover Survey), showed that 10.6 million jobs were unfilled representing a record 6.6% jobs open rate. Prior to the pandemic, the highest rate in this survey’s 20-year history was 4.8%.
The shortage of workers has undoubtedly contributed to wage pressures. Granted much of the wage inflation experienced in the past year affected lower wage jobs as many employers in the hospitality space were forced to increase wages to lure workers back. However, when we assess the overall state of the labor market, there are still 4.2 million fewer people working than before the pandemic. The Fed estimates that nearly 2.4 million of this decline was attributed to early retirements during the pandemic. Since many Baby Boomers tend to retire from high skill and high wage jobs, we will be watching to see if wage inflation persists into 2022 and if it starts to affect higher wage professions.
With all these inflationary pressures, the Federal Reserve has admitted that it may in fact be behind the curve with fighting inflation. Despite this acknowledgement, the Fed kept the Fed Funds Rate near zero at the conclusion of its December meeting. However, median forecasts for the Fed point to three 0.25% rate increases in 2022. In addition to these slated rate hikes, the Fed also decided to reduce its monthly treasury and mortgage-backed bond purchases by $30 billion. Both actions should help tighten the money supply and fight inflation.
However, Fed Chair Jerome Powell did emphasize that the decision to raise rates and taper bond purchases would be dependent on the strength of the labor market as well as the continued progress of the pandemic recovery. We will be keeping a close eye on inflation and interest rate policy in the quarters ahead to see if the Fed is successful in combating the steep rise.
U.S. markets captured over a third of their annual gains for the quarter ending the year at a valuation level higher than pre-pandemic levels. The S&P now sits at a P/E multiple of 21.2 versus 19.2 as of February 2020. By historical measures, this level does seem a bit rich. However, prevailing interest rates are still low enough to justify such valuations. U.S. markets outpaced international markets by a wide margin for the quarter and year as COVID related restrictions abroad and a waning Chinese economy weighed on international indexes.
Growth stocks outperformed value stocks again but by a wider margin than the past quarter. Despite concerns of rising inflation and interest rates, the energy and financial sectors underperformed the broad U.S. market for the quarter. This was surprising given how inflation/rate sensitive these two sectors are.
Increased lockdowns in Europe and Asia continued to weigh on international developed and emerging markets for the quarter. Both categories underperformed the broad U.S. markets by double digits for the year with emerging market stocks ending 2021 in the red. Most of the fallout in the emerging markets continues to stem from the economic slowdown in China and its faltering real estate market that shows little signs of improvement at the present.
FIXED INCOME MARKETS
For the year, the broad U.S. bond market yield climbed by 0.60% achieving an ending yield of 1.75%. This rise in yields did contribute to very minimal losses for U.S. bonds. While rates are historically low, the Fed is expected to raise rates serval times over the next two years. When interest rates rise, the demand for bonds falls, reducing their prices and raising their yields. The rise in rates usually preempts the Fed’s decision to raise rates. However, as we ended December bond yields were at odds with the Fed’s hawkish stance on rates as the 10-year U.S. treasury yield rose to just 1.51%, a level just slightly above where it started for the quarter. Bond yields, particularly treasury yields have historically anticipated the Fed’s rate hikes months in advance of the actual event. With the Fed deciding to hike rates a few times in 2022, there is potential to see 10-year treasury yields increase by 0.50% or so in the upcoming quarter.
International bonds, which we have avoided completely, did not fare as well for both the quarter and year as rising global inflation along with weaker foreign currencies compounded losses in the space with the global aggregate bond index (excluding U.S.) losing over 6% for the year. The extremely low (and in some cases negative) starting yields of developed market bonds continue to plague investors in this space. With higher competing bond yields in the U.S., many international investors continue to show strong demand for U.S. bonds versus their own countries’ lower yielding bonds.
Given that supply chain issues will most likely persist well into the first half of 2022, we expect inflation to remain elevated. As the labor market normalizes, wage growth may also add to inflation pressures. However, with the Fed expected to tighten monetary policy and workers returning to the labor force, we may not see inflation subside to the Fed’s 2% long-term target until the second half of the year.
Rising interest rates and wages may start to eat into corporate profit margins which could challenge stock prices as the Fed begins it rate-hiking cycle. So, should we fear the Fed hiking rates?
Rising rates don’t always result in poor stock market performance according to Bank of America Strategist, Savita Subramanian. She noted that over the last 30 years the Fed has embarked on four interest rate hike cycles. During these periods, the S&P 500 has moved 1.8% lower in the three months after the first hike, but ultimately went on to gain 4.6% after six months and 7.7% higher twelve months later.
As the Fed postures to raise rates in the future, this could put further pressure on bond markets in the near term. However, as history has demonstrated, investors should not fear the effects of rising rate on their bond portfolio over the long run. Since 1994, the average time span from the initial Fed rate hike averaged 3.75 years with broad U.S. bond market returns averaging about 3.8% during that time. Granted the rate hike cycle of 1994 – 2000 is much different than the rate hike cycle we are about to embark upon. However, the rate hike cycle spanning 12/15/2016 – 12/19/2018 is indeed very similar to today’s circumstances when considering the Fed’s balance sheet and the fact that rates are effectively near zero. During that three-year lift-off from the zero bound, the broad bond market still managed to achieve annualized returns above 2% despite the Fed increasing from 0% to 2.5% during that time.
On the legislative front, we see two pieces of legislation that could affect the growth outlook for 2022: the Infrastructure and Investment Jobs Act (IIJA) and the Build Back Better (BBB) package. In relation to the IIJA, the headline figure of $1.2 trillion seems impressive, but the bipartisan infrastructure package only delivers about $500 billion of new spending. The much more consequential package for fiscal stimulus is the administration’s Build Back Better plan as it modifies the Child Tax Credit, expands the Affordable Care Act and directs spending on a number of green polices. Given the nature and timing of the spending and tax increases encompassed in the BBB plan, we believe that it has the potential to have a more sizeable impact on growth than the IIJA. Although the legislation for the BBB failed during the quarter, there is a decent likelihood that it will be passed by the end of the first quarter of 2022.
2022 will undoubtedly present many new challenges to investors. Although we are hopeful that the worst of the COVID pandemic is behind us, the emergence of new COVID variants could continue to put strain markets. The persistence of inflation and the pace of the Fed’s interest rate hikes are just a couple of the additional uncertainties that could increase volatility for both stocks and bonds as the business cycle advances. Regardless of what markets deliver in the short-term, it is ever so critical that as investors we stay disciplined according to our long-term objectives. However, if you are considering a change to your investment objective, it is important to consider how that change relates to your financial goals as well as your ability and willingness to accept risk.
QUARTERLY FINANCIAL PLANNING TIP
Given that we are entering a rising rate environment, lending rates will most likely begin to moderate upward. For individuals that have variable rate loans or revolving lines of credit, now may be a good time to review the benefits of converting these loans to a fixed rate product. Additionally, individuals or businesses that may be looking to refinance, establish or increase their credit lines, it may be beneficial to start that process now before banks start tightening their lending practices. Please keep in mind that we do not anticipate rates rising abruptly or banks reducing their lending capabilities soon. But taking the time to review your outstanding loan terms and options now could provide added savings and flexibility in the years ahead.
TAX PREP WITH PRESTIGE WEALTH ACCOUNTING GROUP
Preparing your own tax return can be extremely difficult with today's complex tax code and may often leave you with more questions than answers.
At Prestige Wealth Accounting Group (PWAG), we have the expertise that is needed to help you file your returns while also helping you to minimize your tax liability with careful planning.
Our tax preparation services include:
- Individual Tax Preparation
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Tax planning is essential to help make sure that your business is tax compliant. We also can suggest tax saving strategies that will maximize your after-tax income.
We also offer tax and education planning to assist start-ups, as well as, established businesses. We will provide you with a complete list of the most commonly overlooked deductions so that you can limit your tax liability for the following year.
For more information visit our website at www.PrestigeWAG.com.
DISCUSS YOUR CONCERNS WITH US!
Whether you are seeking investment advice, tax strategies, estate planning or a financial plan, our advice is not one-size fits all. We are ready to provide you with financial solutions to achieve a better retirement. We will always consider your feelings about risk and the markets and review your unique financial situation when making any recommendation.