Judging by last year’s outsized returns in the stock market (the S&P 500 index advanced over 28%), you would never know that our country began the year in turmoil and ended in anxiety. Remember the riots in the capitol a year ago? There were ongoing geopolitical uncertainties from China and Russia among others. The fear of inflation – topping at the highest rate since 1982 – weighed heavy on both Wall Street and Main Street. Shortages of basic materials, everyday items and even labor brought constant concern over a potential 1970’s style stagflation economy. The persistence of the global COVID-19 pandemic and its variants caused a start/stop ripple effect in economic activity as well as daily life. If all this wasn’t enough, in December, the Federal Reserve Chairman finally abandoned its forecast of temporary inflation and indicated the beginning of a tighter monetary policy.
Despite all this, the markets were not only resilient, but downright bullish. Admittedly, some sectors fared far better than others, so once again, security selection, sector weightings, and investment style were critical components in achieving success. For example, the S&P was +28%, the Russell 1000 Value index was +25%, and the usually high-flying technology index, NASDAQ, lagged at +21%. Under the surface of those large company stocks, there was a significantly different set of markets. The small cap Russell 2000 was only +12% and the international index MSCI ACWI IMI advanced 18%. Over 50% of stocks in the S&P 500 experienced “rolling” or “stealth” corrections (declines in excess of 10%) during the year, even though indices were advancing. This is due to the large cap effect, where capitalization-weighted indexes are mathematically influenced more by the largest 10% of companies in that index.
A primary reason for this disparity in stock performance is due to a simple fact. Many companies (over 2/3 of the S&P 500) were more profitable in 2021 than in 2019 (pre-pandemic). Not all companies could boast that fact, and it appears that it was the largest of companies that had the highest operating margins since 1950. Since the “rising tide” of the economy did not lift all boats, security selection became even more important to investors. Despite the fears of inflation and Covid-19, consumers continued to spend and companies were able to pass on increased costs without hesitation.
The bond market, on the other hand, seemed out of step with the stock market. Bond markets are considered the “guardians of the inflation watch,” as they are the most sensitive and susceptible to inflationary pressures. Most of the year, however, bond yields did not reflect either long- or short-term concern over inflation data. They appeared to be far more concerned with economic contractions that might occur due to the global shut down caused by COVID-19 l. Furthermore, Fed Chairman Powell projected hope and confidence that supply chain issues and labor force shortages were near the end of their cycle. By December, the Fed Governors had changed their outlook, which has changed a number of things in both markets.
Some inflation increases, Powell said, are permanent in nature (think 6% COLA, that never goes away and is forever compounded). Supply chain disruptions, while improving, are taking longer to unwind than originally thought. There are 3-5 million missing workers. Granted, the unemployment rate is very low – 4.2% – but that only measures workers who are looking for work. The Labor Participation Rate of 61.8% measures all workers that are eligible to work. Pre-pandemic, that number was closer to 64%. So despite higher wages this year, more workers are either retiring or changing jobs at never-before-seen levels. That still does not account for millions of workers that the Labor Department cannot reconcile, so many have been referring to the “vanishing” worker.
Fed Chairman Powell has drawn a line in the monetary sand by indicating the Fed will raise short-term interest rates 1-3 times in 2022. It remains data-dependent, as Powell is very sensitive to not upsetting credit and equity markets with sudden, jerky policy moves. In fact, many say he should have acted sooner. Additionally, the Fed will suspend their open market purchases of bonds and mortgages at a rate twice as fast as originally indicated. This, too, will put pressure on rates, especially at the longer end of the maturity range. Even though they have not begun these actions, the bond market has reacted with higher rates with all maturities. Interestingly, the shape of the yield curve (that picture graph of yields on everything from overnight T-Bills to 30-year treasuries) has gotten steeper beyond the seven-year mark. While that means greater losses in principal for long maturity bondholders, it does signify that the bond market foresees sustained economic growth in the months ahead.
Entering 2021, the S&P 500 index forward-looking price earnings ratio (a measurement of valuation) stood at an elevated 22.5 times earnings. Even after last year’s 28% advance, the forward P/E is now only 20, due to extraordinary gains in corporate earnings. Higher interest rates, however, will have a negative impact on valuations of growth-type companies, as interest rates play a significant role in institutional valuation models. Companies seen as less “growth- oriented” and more “steady” in their earnings will probably benefit more in this type of interest rate environment. Additionally, a steeper yield curve will benefit financial-type companies (banks, insurance, non-bank financials), and provide a tailwind to their heretofore lackluster earnings growth.
About a year ago, someone remarked that AAFMAA Wealth Management & Trust (AWM&T) had kept the maximum allocation to equities for over four years. What would cause me to change my mind in that regard? Without hesitation, I replied that any change in monetary policy by the Fed would give me pause. I still feel that way, as history shows that the Fed has had more long-term influence on markets than any other factor. For that reason, we anticipate moving to a less aggressive weighting in equities for 2022. Of course, that is always subject to change, but we believe the Fed has thrown up the caution signal for now.
For many of our clients, fixed income yields and returns are very important. Unfortunately, the 40-year bull market in bonds is over (March 2020) and we are focused on preserving principal more than gathering higher yield. Investors would be prudent to plan their finances based on a 2-3% total return, instead of 6% that has been the norm for so long. AWM&T is very defensive in fixed income portfolios. This means shorter maturities, higher credit quality and greater use of floating-rate securities. This strategy paid off in 2021, and we believe will continue to provide principal protection this year.
We expect equity market volatility, not only in the market itself, but throughout style and sector rotations. This is not a permanent condition, but a normal part of the market working through a change in monetary and inflationary expectations. It may be frustrating at times, but eventually earnings growth will be too compelling for prices to remain negative or stagnant. To be clear, AWM&T is not bearish or negative on the equity markets. Pessimists do not get to realize the tremendous opportunities the U.S. stock has historically provided. We are simply a little cautious going into this year and will try to use this prudence as a way to take advantage of buying opportunities as they present themselves.
Despite a somewhat cautionary tale – probably the most cautious I’ve been since 2015 – I see 2022 more as a transition year to what could be a great setup for equity markets in 2023-24. There will always be uncertainties of one sort or another, so don’t allow the latest headline to deter you from your long-term objectives. Along the way, AWM&T will continue to provide its disciplined approach to security selection, asset allocation, and active investment management.
Past performance is not a guarantee or a reliable indicator of future results.
AAFMAA Wealth Management & Trust LLC (AWM&T) is a non-depository trust company organized under the laws of North Carolina as a limited liability company. AWM&T is a wholly owned subsidiary of American Armed Forces Mutual Aid Association (AAFMAA). This material has been prepared exclusively for AAFMAA for informational purposes only and is not intended to provide, and should not be relied on for, accounting, legal, tax, or other advice. All investors should consult their advisers regarding such matters. The investment strategies discussed herein are speculative and involve a high degree of risk, including loss of capital. Investments in any products described herein may be volatile, and investors should have the financial ability and be willing to accept such risks. It should not be assumed, and no representation is made, that past investment performance is reflective of future results. Nothing herein should be deemed to be a prediction or projection of future performance. References, either general or specific, to securities and/or issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Certain current and prior investments may be highlighted in order to provide additional information regarding AWM&T’s investment strategy, the types of investments it pursues, and anticipated exit strategies. The materials contain statements of opinion and belief. Any views expressed herein are those of AWM&T as of the date indicated, are based on information available to AWM&T as of such date, and are subject to change, without notice, based on market and other conditions. No representation is made or assurance given that such views are correct. AWM&T has no duty or obligation to update the information contained herein. Certain information contained herein concerning economic trends and/or data is based on or derived from information provided by independent third-party sources. AWM&T believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based.