Q-4 2021 MARKET REVIEW
The COVID-19 Omicron variant, inflation and coming Federal Reserve action to address rising inflation preoccupied market watchers throughout the quarter. Despite market agita caused by these concerns, the price of US stock equities in several asset classes moved higher. Fixed income yield floundered. This quarter, the US S&P 500 Index was up 11% and the iShares Core US Aggregate Bond ETF, which has Bloomberg US Aggregate Bond Index as its benchmark was -0.99912%.
Employment has rebounded sharply from the contraction of March 2020. By quarter-end the US added 6.4 million jobs over the course of the year and by year-end the unemployment rate was 3.9%.
Seventy plus percent of US economic activity relies on domestic consumption of goods and services. Dislocation in either demand or supply has a considerable impact on US economic well-being and ripples through almost all economic sectors.
Despite the spread of the Delta variant in regions of the country in the summer months of 2021, economic activity rebounded. Widespread subscription to anti-COVID-19 vaccines allowed many to move beyond self-imposed isolation to re-engaging professionally and socially. Household savings that grew during months of pandemic restraints were directed to purchasing housing, goods and services.
Consumer demand peaked at a time when inventories were depleted, logistic distribution channels were under stress from reduced staffing, and labor shortages constrained manufacturing and production. These realities resulted in an upward pressure on prices to deliver intermediate and finished goods.
The overhang of fiscal stimulus and unemployment benefits frustrated employer efforts to get workers back to full-time work. The dynamics of family life had also changed over the preceding sixteen or so months. Parents have had to prioritize between at-home child care and remote learning versus parents returning to full time work. The intervening months had also caused many to reevaluate how they defined meaningful work. The early quarters of the year and these socio-employment forces set the stage for the price inflation that increased significantly in the fourth quarter of 2021.
The emergence and spread of a more contagious COVID variant in the latter weeks of Q-4 has once again reversed some economic reopening achievements. Increased infections mean fewer workers available for a work force already constrained by factors previously discussed.
Manufacturing sentiment remains strong with the US managers Indices (PMI) at 57.8. Global PMI indices provide timely insight into changing worldwide business conditions and are viewed as leading economic indicators. Readings above 50 signal continued growth and economic expansion. PMI is viewed by economist as a leading economic indicator.
In Q-4 2021, the Federal Reserve pivoted from considering price increases as transitory to something with a more significant ability to destabilize the economy. A 6.8% jump in the US Consumer Price Index (CPI), the highest reading in 39-years, unsettled policy makers as well as market investors.
CPI increases will undoubtedly modulate if not revert as some of the economic pressures previously mentioned abate. The Federal Reserve change of stance, however, signals concern that what is now occurring has the potential to untether the tenuous relationship between household income and product prices and morph into a wage/price demand driven inflation.
In 2022, economic forecast models are pricing three increases in short term interest rates following an end to quantitative easing (the Federal Reserve’s open market purchase of securities aimed at ensuring liquidity in the financial system). The resulting projected flattening of the interest rate curve between short and long-term yields does suggest that the financial markets continue to view inflation as transitory, albeit with a more extended tail following it peaking sometime in 2022.
Long-term in contrast to shorter term bond yields are not expected to increase significantly. Higher rates will have a negative impact on stock equity share price. A higher discount rate adjusts the value of future corporate profitability. Spending on R&D for some companies may also become more expensive as the cost of borrowed funds increases.
The continued reopening of the economy suggests there remains good prospects for increased economic activity and investor returns. Identifying sectors that will benefit most in a reopened but post-COVID-19 world presents challenges as does identifying those businesses that will most advantageously capitalize on changes to consumer and business outlook and spending.
In Q-4 2021, European economies continued to require expanded monetary policy intervention. The tourist sector of many countries experienced successive shocks from business reopening only to be shortly followed by closing because of succeeding waves of virus spread. The demand for services imposed on national health services by the unvaccinated required the shuttering of consumer activity to stave off virus spread. European inflation, though significantly less than its United States counterpart, is in large part driven by higher energy prices. Russia has politicized natural gas supply to Europe and limited supply has increased prices. National efforts to reduce carbon intensive energy use is not yet off-set by replacement supply from renewables. Reduced production from existing nuclear power plants further impacts the relationship between supply, demand and price.
Considering the world’s second largest economy, “Chinese equities significantly underperformed global equities” throughout 2021 “…contributing to the 25% underperformance of emerging market equities vs. developed markets.”1 China continues to ease monetary policy to offset concerns of existing downside risks to economic growth. Agricultural and small enterprises require support in the form of lower re-lending rates 2.
Government monetary and regulatory policies continue to heighten investor concern surrounding China’s continued robust economic growth.
Over the course of the year, the Chinese government has vowed to strengthen regulation of the country’s wealthy people, including ‘reasonably adjusting excessive income’ and encouraging high-earning groups and enterprises to give back to society. 3 The government has tightened regulations that affect business operations in technology, e-commerce, education and entertainment sectors. The government has made clear its intent to restrict how information obtained by certain companies specific to its user base is retained and used. These restrictions on how information can be monetized may reduce the growth and profitability of affected companies. The objective of these regulations is to reduce economic activity not viewed as positively contributing to overall patriotic well-being.
The China technology sector, for many years enjoyed global investment interest. It is now viewed by many market investors as no longer an attractive investment.
Investors are also concerned that the significant debt burden of China’s real estate developer sector may contribute to destabilizing the economy. Proceeds from these borrowing were used to acquire land and to build housing. Local governments benefited from these borrowings as government revenues increased from the sale of developable land. In Q-4 several developers struggled to make timely debt repayment. Investments in housing is one of the few available investment opportunities for middle class families. Dislocation and losses will, therefore, impact local government revenues, the banking sector that funded these borrowing, the manufacturing sector that supports real estate development and the Chinese middle class. It is believed that the central government will go to considerable lengths to stem contagion brought about by debt payment defaults.
MARKET STATISTICS
|
The following illustrate the breadth of change in the domestic equity and debt markets over the past three months. Asset Class: |
Q-4 2020 |
Q-1 2021 |
Q-2 2021 |
Q-3 2021 |
Q-4 2021 |
|
US S&P 500** |
12.2% |
6.2% |
8.5% |
0.6% |
11.0% |
|
Growth** |
12.6% |
0.3% |
11.0% |
0.8% |
8.2% |
|
Value** |
15.9% |
9.8% |
4.9% |
-0.7% |
7.4% |
|
Small cap** |
24% |
9.5% |
5.1% |
-1.3% |
2.3% |
|
US Aggregate Bond Index* |
1.00589% |
-0.97354% |
1.01026% |
-0.98883% |
-0.99912% |
**Asset Class Data: JP Morgan, Quarterly Review of Markets
Seslia Activity
We continue to remain on the sidelines in the absence of clarity as to how markets will perform in this volatile economic environment.
Though Seslia client portfolios for the most part do not hold individual corporate or fixed income securities, our practice of investing client assets in sector portfolios through the use of mutual, index or exchange traded fund means that market perception of sector profitability performance and that perceptions impact on asset or share value will impact the performance of our clients’ portfolios.
We have positioned client portfolios to provide exposure to defensive equities, as well as to enjoy monthly or quarterly returns from bond funds. We have not, however, abandoned technology and growth investments though we have trimmed some positions. Broad scale repositioning of portfolios when losses have already occurred simply makes real what is at the moment paper losses . Seeking to guess the direction and timing of future market moves does our clients no favor. The preferred investment strategy that we pursue is patience which will over time allows portfolios under management to enjoying the benefit of share price rebound once we are through this market dislocation.
Clients with investments pursuing dividend and or interest returns may continue to see losses in the market price of these holdings as prices adjust to changes in interest rates. Investors in these securities should, however, continue to receive the interest or dividend returns expected at the time the investments were made. The share price of these portfolios, similar to those of equity investments, will right themselves over time.
1 JP Morgan Asset Management, Quarterly Market Review of markets over the fourth quarter of 2021 by Tilmann Galler.
2 ibid
3 Wang Xintong, “China Pledges to Rein in Incomes of the Wealthy and Build Common Prosperity”, Caixin Global 08/18/2021.