MARKET RETURNS:  Global equities rallied to finish out the year, building upon substantial gains from the first three quarters.  This marks the third year in a row that the world stock market has generated return percentages in the high teens or twenties.  U.S. large company stocks led the way in 2021, as has been the case for much of that three-year period.  U.S. small and mid-caps followed closely behind, while foreign equities struggled to keep pace as they faced a headwind from U.S. dollar appreciation of 6.7%.  Developed markets fared better within that international group, as the regulatory crackdown in China created additional uncertainty around the prospects for some of the largest companies within the emerging markets.  High quality bond returns were negative in the face of rising interest rates, with the yield on the 10-year Treasury recently exceeding its pre-Covid level.  U.S. bonds proved more resilient than their overseas counterparts mainly due to the strengthening dollar.  Cash returns remained negligible, though the Fed has signaled several probable rate hikes for 2022.

LOOKING FORWARD:

A Less Extreme Version of 2021:  There are many similarities between the outlook heading into this year and last.  The key distinction is that almost everything appears less extreme in 2022.  Economic and profit growth should remain robust, just not quite as strong as 2021’s “firing on all cylinders” levels.  Monetary and fiscal policy should remain generally supportive, though the Fed’s zero interest rate policy is coming to an end and additional trillion-dollar spending packages appear unlikely.  Stock and bond market valuations remain elevated relative to history but are not as stretched as they were a year ago.  While many market commentators expect lower returns and more volatility in 2022, this more moderate setup and lower uncertainty may provide a partial counterbalance.  Society is also adaptive, with each successive Covid wave thus far causing less disruption to the economy than the previous one.  We remain constructive on the potential for risk assets while tempering return expectations on the heels of a very strong three-year period for stocks.

Historical Comparisons to 2018 and 1997:  The past provides a reference point around potential outcomes and two prior year analogies may help to frame how 2022 could play out.  The 2018 experience shown above implies that the Fed is indeed sensitive to the stock market’s response to policy actions.  It’s possible that we could see a similar series of events unfold whereby the Fed tightens aggressively, stocks react, the Fed pauses, then stocks rebound.  The 1997 case in the chart below illustrates how much further equities could run if a comparable bubble were to form.  After increasing nearly fivefold from 1984 to 1997, the S&P 500 price index went on to appreciate by another 56% before peaking in early 2000.  Of course, the index endured several corrections along the way and proceeded to lose almost half its value over the subsequent two years when the bubble eventually burst.  This example underscores the risk of being too early in trying to call market tops, and the dilemma inherent in attempting to time the market.

Conclusion:  Fewer extremes in the economy and markets suggest a return to an increasingly normalized investment environment with more subdued stock returns and a reclaimed income generation role for bonds.  While signs of excess are present from meme stocks to digital assets to housing market bidding wars, we believe a cautious tone from market strategists and single stock retrenchments obscured by record index levels provide signs that we haven’t yet reached bona fide bubble territory.  Key risks that we see for 2022 include the potential for a hawkish Fed, geopolitical conflict (especially involving Russia or China), and a virus strain that is both highly transmissible and severe.  Inflation will be another important factor to watch, particularly as bottleneck-driven increases give way to pressure from wage hikes while inflation readings settle at more sustainable levels.  In anticipation of these potential risks, we have made portfolio shifts including taking profits on equities, limiting exposure to emerging markets, incorporating real estate and other inflation beneficiaries, and adding to bond positions opportunistically to take advantage of higher interest rates and undervalued foreign currencies.

Index Descriptions:

S&P 500 Index TR is a market capitalization weighted index which represents the broad market for large company U.S. stocks.  Returns reflect the reinvestment of dividends.

The MSCI EAFE Index NR USD is a market capitalization weighted index which represents the broad market for large and mid-sized developed market stocks excluding those from the U.S. and Canada.  Returns reflect the reinvestment of dividends and foreign withholding taxes and are translated into U.S. Dollars.

The MSCI EM Index NR USD is a market capitalization weighted index which represents the broad market for large and mid-sized developing market stocks.  Returns reflect the reinvestment of dividends and foreign withholding taxes and are translated into U.S. Dollars.

The Bloomberg Barclays U.S. Agg Bond Index is a market capitalization weighted index which represents the broad market for taxable investment grade U.S. dollar-denominated bonds. Returns reflect the reinvestment of interest.

The US Treasury Bill Auction Avg 1-month is an index comprised of short-term U.S. government-issued investments with yields collected weekly and can be considered a proxy for cash.

Portfolio performance, characteristics, and volatility may differ from the benchmarks shown. Opes portfolios are managed according to their respective strategies which may differ significantly in terms of security holdings, industry weightings, and asset allocation from those of the benchmarks. Benchmarks are unmanaged and provided to represent the investment environment in existence during the time periods shown. An index is not available for direct investment, and does not reflect advisory fees, any of the costs associated with buying and selling individual securities, or any other fees, expenses, or charges. Past performance may not be indicative of future results.

The opinions expressed in this article are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security. All opinions expressed herein constitute the judgment of the author(s) as of the date of the report and are subject to change without notice. The material has been gathered from sources believed to be reliable, however Opes cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. This information may contain certain statements that may be deemed forward looking. Please note that any such statements are not guarantees of any future performance, and actual results or developments may differ materially from those discussed.  Opes does not provide tax or legal advice, and nothing contained in these materials should be taken as such. As always please remember investing involves risk and possible loss of principal capital. Advisory services are only offered to clients or prospective clients where Opes and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Opes unless a client service agreement is in place.