Fourth Quarter Market Review

Fourth Quarter Market Review

Contributed by: Brad Meeks, CFA

"For investors able to bear the uncomfortable short-term volatility of a diversified/inflation-hedging portfolio, the near certainty of exceeding the long-term return on cash, and consequently accumulating wealth, doesn't seem like much of a risk at all."

- Death of the Risk-Free Rate, Research Affiliates, July 2016

The quote above is an excellent reminder of how much financial markets have changed in recent years. In 2016, fears of persistent deflation coupled with low-interest rates and slow economic growth were major concerns for the Federal Reserve. As a result, those heavily invested in bonds or holding outsized cash positions earned very little for their money. Growth stocks were in favor and owning a diverse mix of value stocks, bonds, and assets that could protect against the evils of inflation was an afterthought. Fast forward to 2021, and although growth-oriented equities continued dominance over value-oriented stocks, some things have most certainly changed.

Global equity returns in the quarter rivaled long-term averages, increasing double digits for the year, an impressive outcome. U.S. stocks continued their dominance relative to global equities, as the S&P 500 increased over 25% for the second time in the past three years, ending 2021 just off record highs. Many of the same headlines helped to push stocks higher, including increased vaccination adoption, continued macroeconomic improvement in the labor market, and increased consumer confidence and spending. However, the biggest driver of strong returns in equity markets continued to center on the accommodative monetary and fiscal policy globally. This provided a nice backdrop for strong earnings growth and a narrative that there are relatively few other asset classes to own, given paltry yields in cash and fixed income markets. To put some context to this statement, Bank of America reported inflows of new dollars into global stocks hovered around $1 trillion in 2021, while the previous nineteen years only saw $785 billion go into stocks.

Several asset classes had phenomenal returns as they bounced back from the global shutdown of 2020, mainly global real estate and commodities. WTI crude (oil) closed the year up 55% to over $75/barrel while the U.S. dollar advanced over 6%. This was quite the rebound from the $-38 barrel for oil in April 2020. The glaring weak spot this year was emerging market equities, which were led lower by the influence of China and its government's crackdown on some of its country's largest tech firms with heightened scrutiny and additional regulation.

Fixed income markets were less impressive than global stocks, mainly due to commentary out of the Federal Reserve around its timing and magnitude of ending the unprecedented level of monetary support to the economy. Fed Chair Powell suggested that the use of the term "transitory" to describe inflation should be retired, insinuating that inflation might be more sticky than initially thought. In addition, tight global supply chains and a labor market on the mend added more pressure to inflation readings. With this in mind, the Fed announced in their November meeting that it would start its taper of its current $120 billion per month in asset purchases by $15 billion per month, only to double that figure to a reduction of $30 billion by their December meeting. Fed committee members also adjusted their expectations of rate hikes, increasing to three in 2022, with another three hikes estimated in 2023 and two in 2024. This "Fed Pivot"-the recognition of more persistent inflation pressures, supply chain constraints, and concerns around stretched market valuations caused a spike in interest rates and a corresponding decline in major fixed income markets into the end of the year.

While fixed income markets left a lot to be desired in 2021, equity markets continued at their torrid pace, leaving a diversified portfolio with returns that investors should be happy with. What is left out of the conversation is a market that exhibited extremely low levels of volatility. The worst intra-year decline the S&P 500 saw in 2021 was just 5%…historically, the S&P 500 declines about 14% from peak to trough each year. Another way to look at market volatility is the days in which the markets fell or advanced +/-2% or more in a single day. In 2021, the S&P 500 only had six days where markets rose or declined by over +/-2%. Since 2001, the average has been nineteen days. This low level of volatility coupled with extremely strong equity returns is the holy grail of investing, a point in time that doesn't come around very often and we welcome, but has the habit of lulling investors into a false sense of market security.

To this end, we would be highly suspect if someone said we think this year will be anything like the last. Markets very rarely repeat their most recent trends. The aforementioned quote stood out to us given the point in time in which it was written. When "hope and dream" growth stocks with little-to-no profits are going higher, value stocks are "uninteresting," and real assets are viewed as less sexy. At this point, one could argue there is plenty of skepticism in the markets. During this time, we remained steadfast in our approach to portfolio construction and our philosophy to investing-owning high-quality, globally-diversified assets that provide peace of mind no matter the macro-economic backdrop. Back then, inflation was nonexistent, and the thought of interest rates rising was almost laughable. Just a few years later, markets are starting to realize that balance is key, and some of the "easy money" investments (growth stocks) really weren't so easy after all.

Howard Marks, Oaktree's co-founder and famous value investor, said that forecasting is akin to crystal ball gazing, stating that "there are no facts, just opinions" about the future. We couldn't agree more. Nonetheless, one thing we wouldn't be surprised by is heightened volatility in both the equity and fixed income markets in the coming year as the Fed tries to get the economy back to some semblance of economic normalization. So now more than ever it's vital to take a long-term perspective, keep balance across asset classes, and use volatility in financial markets to your advantage.

We wish everyone a happy and healthy 2022 and appreciate your continued trust in Madison Wealth Management.

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