Market Review: The Standard and Poor’s 500 Stock Index got back on track in the fourth quarter, gaining 11.0% and re-asserting the relative dominance of the large cap U.S market. The Russell 2000 Small Cap Index gained 2.1% in the quarter and the MSCI World ex-US International Index gained 1.8%. The Bloomberg Bond Aggregate Index was flat.
For the year, the S&P 500 returned a stellar 28.7%, with sharp rotations between sectors substituting for any meaningful corrections. All 11 industry sectors posted double digit gains for the first time since 1995. Of note, Microsoft, Pfizer, Alphabet and CVS Health all generated a total return greater than 50%. The strength in mega-caps may overstate the strength of the equity market. The Russell 2000 gained 14.8% with the Growth component only up 2.8%. The 8.3% gain of the MSCI World Index was dragged down by emerging markets, particularly China. In other asset classes, the Bloomberg Bond Index declined 1.5%, Gold fell 3.6%, and commodities surged higher with the PimCo Commodity Total Return Fund gaining 33.5%.
A New Year: 2021 was an extraordinary year for portfolio growth and succeeded a number of previous years of very solid returns. This performance was in no small part assisted by the massive stimulus by the Federal Reserve that exploded the Fed’s balance sheet from $4 trillion to almost $9 trillion in only two years. However, 2022 likely introduces a very different dynamic than recent years as the Fed has all but admitted they are late in turning off the spigot as inflationary forces have proven to be far less transitory than they modeled. The year-over-year CPI of 7.0% in December was the highest in forty years while the 5.5% reading for the core CPI, excluding food and energy, was the highest in thirty years. A “neutral” Fed Funds rate has historically matched the inflation rate, yet the current Fed Funds target remains at 0% – 0.25% with Chairman Powell signaling only three 0.25% hikes this year. Thus far equity and bond investors have largely remained sanguine, perhaps because the Fed of recent vintage has been averse to damaging the equity market. The move to normalizing policy will now need to be condensed with the end of the QE bond buying program and the initial rate hike coming in the first quarter, and with the shrinking of the Fed’s balance sheet potentially starting later in the year. The pace of rate hikes has historically been an important factor in equity market performance, so inflation data and expectations should be a key driver of the market.
Portfolios: High inflation and rising rates should set up an ideal environment for a sustained period of outperformance by value stocks, which in general currently enjoy a significant and attractive valuation discount to their growth counterparts after years of underperformance. However, many high-quality growth companies should continue to report robust earnings over the next several quarters and may be viewed as safe havens in a volatile market as they have been in the past. So, we will continue to maintain exposure to both styles as well as staying diversified across industries. We are never interested in predicting market moves, especially when the pandemic and associated measures have usurped the traditional economic cycles. However, we will monitor and temper overall equity and specific company exposure as warranted while being tax sensitive. As a result of the past twelve years, seasoned taxable portfolios carry significant unrealized gains, which remains the best tax avoidance strategy available. Bonds continue to be largely un-investable at this point, though over the next two years cash and short-term bonds should start to offer more attractive yields.