Market Performance Recap: Strong Finish for Stocks

Despite news of another Covid variant, US stocks ended 2021 on a high note as investors drove the Russell 1000 up +9.9% in the quarter to finish the year at +26.4%. Energy, tech and real estate stock sectors were market leaders in 2021, while telecom and utilities lagged. The best gains were in large caps as the small cap Russell 2000 rose a more moderate +14.3% for 2021. In international stocks, the developed-country EAFE index posted 2021 gains of +11.3%, while Emerging Markets index slid -2.5% as China policy changes hurt EM stocks. Bonds slipped further in Q4 to finish 2021 off -1.4% as measured by Barclays Intermediate Gov’t/Credit bond index.

Economic & Market Discussion: 2022 – A Year of Transitions

We enter 2022 in a similar way to 2021 with a new wave of Covid infections causing investor anxiety. However, there are key differences. We are starting the year from a different base medically as most people have some vaccination protection, markets are at higher valuations, inflation is spiking to highs not seen since the 1980s, and the Fed is poised to increase rates this year.  Welcome to a year of transition.

• The Great Moderation – Following last year’s pandemic-recovery GNP growth of +5.6%, we expect the US economic growth to moderate in 2022 with estimated GNP growth at +3.8%, still well above pre-pandemic levels. Along with solid, albeit slower growth, high inflation over +5% will likely persist for a while, then also moderate in our view to around +3% by the end of 2022. We believe Fed rate hikes, fewer supply-chain constraints and moderating economic demand will help cool inflation.
• Hut, Hut, Hike – The level of US growth and inflation moderation this year will most likely be tied to action by the Federal Reserve. The pace and timing of the next Fed rate hike cycle will be a key driver of market sentiment in 2022. As shown below, investors expect the Fed to hike rates at least three times in 2022 starting as early as its March meeting. The Fed will be walking a fine line as it aims to cool inflation while allowing growth continue on its current strong trajectory.

CME FedWatch Tool, January 10, 2022

• Buckle Up – The transitions we are likely see this year in the economy and financial markets are unique to the pandemic environment and difficult to model. The constantly evolving pandemic and anticipated Fed funds hikes will cause investor sentiment gyrations and market volatility almost certainly greater than last year. As such, this action can create opportunities and lead to tactical shifts in our portfolio strategy. We will monitor developments closely and make adjustments as events unfold this year.

Portfolio Strategy: Steady as We Go

While we expect a year of transition featuring plenty of ups and down, we remain positive on the equity markets. However, with stocks fully valued and close to all-time highs, gains will depend on solid growth and will likely be lower than returns during the past three years.

• Favor Equities over Bonds – We continue to favor equities over bonds, especially given current inflation levels, growth expectations and the Fed’s plan to increase short-term rates this year. Within equities, we are maintaining our diversified allocation to positions in large, mid and small cap US stocks, and international developed and emerging markets stocks. While interest-rate sensitive bonds may struggle this year, we do see opportunity in high-yielding securities tied to economic growth and middle market lending. 
• Non-Equity Allocations – Our managed-risk strategy includes portfolio elements that have low or no correlation to US and international equity holdings. These holdings have return streams that differ from equities and serve as sources of funds to rebalance portfolios during equity market declines. Holdings include real assets, high yield and income positions as well as cash.
• Rebalancing, Not Market Timing – With expected volatility this year, we are often asked how we prepare for a potential market decline. We don’t market time in the classic sense of selling stocks at an arbitrary market high and then hold a chunk of cash awaiting a market drop. We believe no one can time both an exit and an entry well enough. Instead, we actively rebalance each quarter according to our market view. In the case of a market decline, we will actively rebalance, again in line with market conditions and each portfolio’s investment policy.

Market Performance Recap: Markets Stall Amid Worries

After a positive start to Q3, stocks turned down in September as a number of headwinds and uncertainties raised investor concerns. As a result, the Russell 1000 finished the third quarter essentially flat at +0.2%. Small cap stocks as measured by the Russell 2000 fell -4.4% in the quarter as the rate of economic growth slowed. International developed markets equity followed a similar path to US stocks with EAFE off slightly at -0.4%, while the Emerging Markets index fell -8.1% as China concerns hurt all EM stocks. Like stocks, bonds were also up early in the quarter and then suffered declines as Treasury yields rose in September, leading to a flat return for Barclays Intermediate Gov’t/Credit bond index.

Economic & Market Discussion: Growth, But Slower

Softening economic reports in Q3 resulting from increasing supply chain constraints and an upswing in Covid infections indicate a slowing pace to the US economic recovery. The key question is whether these issues as well as above-trend inflation, upcoming Fed tapering, and fiscal policy developments will choke off or severely slow the ongoing economic recovery, the ultimate driver of financial markets.

• GDP Momentum Intact– Despite ongoing headwinds, the path of GDP recovery to the pre-pandemic growth trend line appears to be intact according to the latest economic estimates from the Bureau of Economic Analysis, Oxford Economics, and S&P Global Economics. While their GDP estimates for Q3 and Q4 have been reduced, the chart below shows that the upward slope of the recovery remains in line with earlier expectations.

The Evolution of U.S. Real GDP

 

• Confidence in Growth – We remain confident that the US economic recovery will continue to move forward, but at a slower pace. The country remains open and Covid infection rates are improving after a summertime spike. Ample money and credit are available for businesses and consumers. Job growth continues albeit on an uneven pace. Supply chain bottlenecks will continue, but are likely to ease over time and help reduce inflation pressures. This points to continued economic recovery with expectations for above-average corporate earnings growth, which should support current market valuations.

• Ongoing Risks = More Volatility = More Normal – The recent slide in the market shows investors are no longer complacent and will respond to headline risks. We view this as good news. Markets typically experience high-single, low double-digit declines even in positive years. When investors seem immune to bad news, market bubbles are more likely to surface. Given the constantly evolving Covid news, upcoming fiscal policy decisions as well as Fed tapering action, we expect more market volatility as we close out the year. As always, we will monitor the action and its impact on the economy and market sentiment, while searching for new investment opportunities and tactical shifts.

Portfolio Strategy: Staying In

Although US equity indices have declined over the past few weeks, we are not turning defensive. As the above discussion indicates, our view is that the US economic recovery continues and additional upside is possible in this current cycle.

• Long-Term Investor Advantage – As long-term investors, one of our advantages is that we stay invested and rebalance to client specific allocations, and do not engage in all-in or all-out market timing. Our discipline allows us to ride out bouts of market turbulence without missing unexpected market upswings. This has been very useful during the past 18 months as the market recovery has experienced several zig and zags on its way to new highs.
• Staying Active – While maintaining our overall stock and fixed income weightings, we made several moves in the past quarter. We switched investments in both the financials sector and floating rate loan area to securities we believe offer more attractive upside. And in emerging markets stock, we added a China stock fund to get specific exposure to this important global market.
• Private Investments – We search for and review non-public investments in private equity, real estate, private credit and venture capital as part of our investment process. We specifically look for private investments that provide both differentiated returns from publicly-traded securities and portfolio diversification. While many private investments have investor eligibility requirements, we are increasingly finding opportunities available for all clients. In fact, we recently added a private debt fund available to our Fidelity RIA platform clients.

Market Performance Recap: Stock Gains Continue

The recovering US economy boosted stocks once again in the second quarter. Investors were buoyed by the reopening of local economies across the US as the pandemic ebbs. The Russell 1000 ended the second quarter on a fresh high, up +8.5%, led by tech, energy, and health care sectors. The tech-heavy NASDAQ was the best performing major index for Q2, gaining +11.7%. International stocks posted solid gains as well with EAFE up +5.2% and Emerging Markets index climbing +5.0%. After a down first quarter, fixed income rebounded to post a gain of +1.0% per the Barclays Intermediate Gov’t/Credit bond index.

Economic & Market Discussion: Surprise! Labor is Front & Center

A fascinating aspect of the pandemic recovery economy is the change in labor market dynamics from pre-pandemic times. The continued rebound in new jobs has seen significant wage growth along with other changes. What does this mean for companies, earnings and the stock market now and going forward?

• Jobs Rebound, But Still Lag – The US job market lost over 20 million jobs in April/May of 2020. The job recovery has strengthened recently as employers have enticed workers back with higher wages and other perks. However, the economy is still down 6.5 million jobs from pre-pandemic levels and the unemployment rate stands at 5.9% vs. 3.5% pre-pandemic.
• Wage Gains, Good or Bad? – Compared with February 2020, the month before the pandemic plunged the U.S. into a recession, average hourly earnings among private-sector workers have risen 6.6%. The chart below shows how wages have outpaced the job recovery. The consensus opinion is that workers finally have some wage power and ability to demand better work conditions. The other side of this is that higher wages and benefits can negatively impact company profits and drive inflation. Will this development hurt earnings growth or will worker productivity and efficiency gains offset higher wages? We believe the latter outcome will play out, but this is a market risk we will monitor going forward.

 

• New Work World – While recent wage gains are a key new labor development, the pandemic has also caused other changes – increased home from work, different office configurations, reduced travel and a more flexible work force. We believe that many of these changes will become a permanent part of US and global work conditions.  Along with increased tech-enabled productivity, we are positive on how workers will benefit and companies can profit from this changed work environment. All of this bears watching as we move through the end stages of the pandemic into a new normal for work.

Portfolio Strategy: Diversification is Risk Management

The recent record highs in US stock market index have created some nervousness among investors. Are US equity markets overextended and too risky? Is a major correction around the corner? In this environment, it makes sense to quickly review how our active asset allocation portfolio management strategy works to manage risk.

• Seven Asset Classes – We segment portfolios into seven asset classes, each with different return/risk profiles: Growth, Emerging Growth, Real Assets, High Yield, Income, Alternatives and Cash. For each client portfolio, we manage to specific weights for each of the seven asset classes. We continually set and manage overweights and underweights to each class and subsector to manage and reduce risk of any single asset class or subclass. while creating differentiated sources of return.
• US Equity is only One Allocation – US equity is one allocation within the Growth asset class. For our clients, the portfolio allocation to US equity ranges roughly from 20-50% of total portfolio assets depending on risk profile. In no case is US equity ever a 100% allocation. Investment news flow creates the perception that US large cap stocks are the only investment held by investors, and thereby overemphasize the general risk of investing. The reality is diversified portfolios, like those we manage, carry less risk than a 100% US large cap stock portfolio.
• International Equity, Real Estate and Bank Loans – Demonstrating diversification in our portfolios, we recently added exposure in these three very different areas – real estate, international equity and bank loan bonds – to most portfolios. These elements provide differing return potential at different risk levels. Together with other portfolio elements, we continue to seek attractive long-term returns with appropriate levels of risk.

 

Market Performance Recap: Stocks Up, Bonds Down

Accelerating vaccinations, diminishing economic restrictions and a $2 trillion stimulus led to a strong 2021 opening quarter for the stock market. However, those same elements also drove up Treasury yields, causing concerns about bonds and the tech sector. The good news drove the Russell 1000 up +5.9% in the quarter led by economically-sensitive materials, energy, financials and industrials sectors. US small cap stocks were the best performer for the quarter with a gain of +12.7%. International stocks posted smaller gains of +3.5% for EAFE and +2.2% for Emerging Markets index. Higher yields hurt bond returns, which posted their first quarterly loss in three years at -1.9% per the Barclays Intermediate Gov’t/Credit bond index.

Economic & Market Discussion: Inflation Fear Factor

Most agree we are in an unusual economic cycle featuring a global pandemic, economic lockdowns and massive monetary and fiscal support. As such, there is a large degree of uncertainty regarding the recovery phase, particularly how the upcoming cyclical boom will affect inflation. The fear is that an overheating economy boosts inflation and leads the Federal Reserve to raise rates and thus choke off a nascent recovery. Let’s look at the inflation issue more closely.

• Boom Time – The US and most major global economies are poised to exit the most severe elements of the global recession later this year. Low borrowing rates and powerful stimulus packages across most developed countries will likely ignite a roaring recovery unlike any we have experienced in over 30 years. Current forecasts point to 2021 US GDP growth exceeding 6%. With rapid growth comes a scramble for resources, goods and services that will most likely lead to price increases. The question is what level of inflation might we expect and for how long?
• Temporary Spike? – We agree that US consumer prices will rise as demand for goods and services surges later this year. However, we also agree with PIMCO’s forecast (chart below) that the rise in US inflation will be temporary. Here’s why: While consumer prices will most certainly rise, we believe full employment will prove elusive as companies incorporate more automation and digitization into their processes. We expect that will dampen inflation following a temporary price run-up. Moreover, the chances of the Fed raising rates quickly to combat even a temporary inflation spike are unlikely as they have stated they will let core inflation run above 2% for at least a year before any rate increases.

• New Opportunity Set – While we don’t foresee a new higher level of inflation persisting into 2022 and beyond, financial markets will likely focus on elevated inflation fears in 2021 and thus create volatility in the bond and equity sectors most sensitive to rate risks. We will look for new opportunities amid this anticipated volatility to add to our favored positions across the portfolio. At the same time, we are mindful that inflation risks can persist and central banks can make policy mistakes. So, we will monitor the inflation situation closely as the economy ramps up in the next several quarters.

Portfolio Strategy: Base Policy Changes

Our current investment strategy is based on our view that easy money policies and positive earnings growth will continue to support stocks in 2021 despite volatility and full valuations. Within this strategy, we are favoring specific classes and sectors that we believe will benefit from the recovery growth scenario.

• Overweight Mid & Small Cap Stocks – In a shift from 2020, we believe the economic recovery will have a relatively larger positive impact on mid and small cap stocks over large caps. Therefore, we have increased our equity weighting toward mid and small caps in most portfolios.
• Sectors Focus – We added equity exposure to the financial sector in the first quarter. Along with the industrials sector, we feel these two economically-sensitive areas will benefit as the expected recovery accelerates. We continue to hold tech and healthcare overweights in this environment. Even though these sectors may not enjoy a short-term advantage, we believe both provide attractive long-term value.
• Staying in Balance – Investors have focused on high flying stocks during the past year. While we share that view, we have kept portfolios balanced with allocations to bond, real assets and alternative investments to create diversified sources of return and to help manage overall portfolio risk.