You probably wouldn’t know it after reading one negative headline after another, but the stock market just closed out another stellar year. New variants, supply shortages, and three-decade-high inflation couldn’t keep stocks down as the S&P 500 posted a surprisingly strong 9.8% gain in the fourth quarter and 28.7% gain for the year.
Large-cap stocks stole the spotlight as other asset classes couldn’t keep pace. Small-cap stocks still performed well though they scored roughly half the gains of their large-cap counterparts. International equities earned just over a quarter of the S&P 500’s return.
Still, taxable bonds struggled in 2021 following unusually strong returns in recent years. Interest rates rose due to inflationary pressures and expected Fed actions. The Barclays Aggregate Bond Index fell 1.5% for the year, marking the index’s worst year since 2013.
With another year coming to a close, it’s a good time to reflect on the storylines that dominated 2021 and consider how they will continue to impact 2022:
Globally, we made great progress this year. Death rates fell as over 9 billion vaccine doses have been administered worldwide. As we move into our third year of the pandemic, you still can’t talk to anybody without the conversation moving to COVID-19.
One big difference from a year ago is that people have stopped saying, “When COVID is gone…” Every time one wave declines, a new variant pops up. First Beta, then Delta, and now Omicron. COVID has become a part of our everyday life and won’t go away anytime soon. The good news is that we’re building up better immunity over time through vaccines and infection and that the worst impacts of each new variant seem to be more muted than the last. That’s not to downplay the deaths that continue to happen but to look optimistically at the fact that fewer are occurring among those infected.
Likewise, we’re also seeing smaller effects on the economy with each successive wave due to fewer lockdowns and restrictions. Yes, we are back to wearing masks to go to the store but for the most part, people are still going out and spending money. COVID is likely to have smaller effects on the economy going forward.
After averaging just 1.9% annually over the previous 15 years, inflation jumped to 6.8% over the 12 months ended in November, as measured by the Consumer Price Index. That is the highest rate since chairman Paul Volker fought inflation back in the early 1980s. Many of these price increases resulted from rampant shortages caused by lower production rates and shipping logjams. Federal Reserve economists kept telling us these price increases were temporary but many of them still persist today, as you may have noticed while shopping for the holidays.
While shortages in some things like microchips and houses won’t be resolved quickly, we still expect many to be worked out over the next year as companies invest in additional capacity and logistics. Overall, manufacturing output has already recovered to pre-COVID levels. At this point, we are more concerned that producers might overshoot their targets and cause supply gluts. That would lead to falling prices and falling profits for the companies we invest in.
Major stimulus bills from the Federal government kept the world afloat in our darkest moments dealing with the pandemic. Including November’s $550 billion infrastructure bill, nearly $6.5 trillion will have been injected into the economy. Congress’s willingness to act when most businesses were cutting back spared the economy and the stock market from a much harder landing.
While Congress’s willingness to spend is a shift from past policy, it may be time to stop expecting more help from the Federal government. As of late December, President Biden’s $2 trillion Build Back Better (BBB) plan has failed to garner enough support to pass through the Senate. The bill may still pass but not with as much spending as Biden had originally hoped, and that’s not necessarily the worst news.
These massive stimulus bills all flooded the economy with cash. The problem is that the economic boost received from government spending is similar to the short-lived boost of energy you get from eating candy. The government’s goal of spending is generally social in nature while a company’s goal is real financial growth. Long-term growth comes when companies and people invest in their own futures. Without additional stimulus, our hope is that we will see more companies invest in capacity and technology that will boost long-term earnings.
Also, the stimulus bills amplified many of the shortages we have faced. Giving checks directly to American citizens raised demand as millions of people hurried to spend on things like TVs and home improvement. Plus, an additional $300 in weekly unemployment benefits kept many workers from rushing to find new jobs, which constrained the amount of goods produced. After additional unemployment benefits expired in September, the unemployment rate fell from 5.2% in August to 4.2% in November.
Finally, with the BBB bill on hold, so are the bill’s tax increases which would have cut into earnings for individuals and businesses.
Looking ahead, some of the inflation we have experienced will stick. The raises workers have seen aren’t going to be taken back but material costs should eventually return to pre-COVID levels. Plus, the Fed is expected to stop monthly bond purchases by April and raise short-term interest rates by 0.75% this year which will slow much of the excess cash circulating in the economy. Most estimates for inflation project overall prices to rise 3%–4% for 2022, which is still higher than what we’ve seen over most of the last few decades but much lower than 2021.
Earlier in the year, we received several questions about “hot” investments in meme stocks popularized on the internet, cryptocurrencies and NFTs, and Special Purpose Acquisition Companies (SPACs), aka blank check companies. Our general reply is that these are very speculative and that we don’t know if they will make good investments. Quite often, we feel pretty dumb as we watch these things double in price but time usually wins out as true value trumps price. As we end the year, many of these hot investments are well off their highs as interest has moved on to other investments.
Given all the disruption to daily life, it’s no surprise that consumers feel worse about the state of things than they have since the recovery from the Financial Crisis of 2008. Consumer confidence, as measured by the University of Michigan’s monthly Consumer Sentiment Index, fell in November to levels not seen since 2011, and yet the stock market charged higher throughout the year.
How is it that the stock market can be so optimistic while American households are so worried? If you follow the numbers, 2021 was a stellar year for the growth of wealth overall. Even adjusted for the 6.8% inflation rate, US GDP is expected to have grown around 5.6% in 2021—the strongest annual growth rate since 1983. Earnings for S&P 500 companies are also expected to have grown by about 45% once fourth-quarter earnings are reported, according to FactSet.
Looking ahead, there are plenty of reasons to be concerned. COVID is here to stay. Inflation could continue to devalue our savings as the cost of everything goes up. There are significant geopolitical concerns over potential invasions of Ukraine and Taiwan, as well as nuclear weapons in Iran. Plus, we have midterm elections to look forward to this year.
There are also plenty of reasons to be optimistic. Major investments in added capacity and new technologies like artificial intelligence and zero carbon energy will support the next leg of economic growth now that the economy has recovered what was lost in 2020. Stocks may still look pricey relative to long-term averages but that has been the case throughout this period of extremely low interest rates. Even after gaining 28.7%, the forward-price-to-earnings ratio of the S&P 500 is lower now than it was a year ago. Earnings growth won’t match last year’s enormous gains but is expected to remain strong. FactSet is projecting S&P 500 earnings to grow 9.1% in 2022.
It’s easy to say 2022 won’t be a repeat of 2021. Guessing what will happen in 2022 is much harder. As always, there are reasons to be hopeful and reasons to be concerned. We’re keeping our expectations in check as we go forward.