The market dynamics of the past few years have made it exceedingly difficult for investors to establish expectations with any degree of confidence, given the wide range of unprecedented developments in the global economy, politics, and the capital markets.
The nexus of this uncertainty has been the COVID-19 virus and its multiple variants. Handicapping market expectations in the coming year will again be a challenge. However, now that two years have passed since COVID-19 burst onto the scene, it is possible to identify some key developments, trends, and surprises that began in 2021 that may remain influential in the coming year.
COVID-19...and ’20 and ’21...
“Disruption” is the term now widely used to characterize major technological changes in many industries. However, the biggest global disruptor of the past two years has been COVID-19 and its multiple variants. Although it will take some time to determine the impact of the latest variant (Omicron), a major surprising (and positive) development has been the speed with which the pharmaceutical and bio-technology industries have developed, manufactured, and distributed vaccines and therapeutics to treat the virus.
The remarkable success in this area will help transition the perception of COVID-19 from a pandemic crisis to an endemic (a virus that circulates broadly and with regularity) that is acknowledged, anticipated, and presumably managed with vaccines and therapeutics – analogous to the seasonal flu. Although this transition may be in its early stages in the developed world, getting badly needed vaccines to the less developed and vastly poorer regions of the world will remain a challenge.
Key economic trends and developments
- The labor market has recovered with amazing speed. Unemployment claims, which totaled approximately 900,000 on a weekly basis at the beginning of the year, are now nearly back to pre-pandemic levels of approximately 200,000. The unemployment rate has plunged from 6.7% at the beginning of the year to 4.2%. Most striking is the nearly 30% increase in job openings that remain unfilled. This has led to meaningful wage increases. This dramatic improvement in the extremely important labor sector of the economy should persist.
- In addition to a strong labor market, consumers are sitting on a record amount of liquid assets. This surge in liquidity is the result of the enormous, two-barreled shot of fiscal and monetary policy support from the federal government. Checkable deposits and currency held by the public now total $3.4 trillion, up from approximately $1 trillion in 2020. This is an astounding sum that should continue to support economic activity.
- The complexity and fragility of the global supply chain was clearly exposed over the past 18 months. Severe supply shortages seriously affected the economy, with the shipping, trucking, manufacturing, and retail sectors bearing the brunt of a chaotic environment. These challenges were exacerbated by the meaningful shift in consumer demand from services to goods, as well as the accelerating trend of purchasing goods online. Although some bottlenecks are showing signs of diminishing, this issue likely will persist well into 2022, sparking changes in global commerce. Companies are already moving to “on-shore” more production in the U.S. and simplify supply chains.
- The most worrisome development of the past year was the dramatic and widespread increase in inflationary pressures. Inflation had been moribund for years, with inflation indices increasing at barely 2% annually. Supply challenges along with abundant liquidity from businesses and consumers accumulating huge cash balances helped spark significant price increases throughout the economy.
- Various inflation statistics have hit a worrisome 5% to 6% rate, while many specific high-profile commodities, real estate and specific goods have been increasing at double digit rates. Rising prices, along with a rapidly tightening labor market, have led to increasing wage demands. Rising wage demands have historically been the precursor to a more widespread inflationary environment. The degree to which inflation accelerates in the coming years is probably the most important consideration for investors. Following are some key factors in considering whether this surprising and worrisome trend in inflation will continue:
- The Federal Reserve (Fed) has now moved away from its narrative that inflationary pressures will soon abate and is beginning to wind down its extraordinary policies of providing liquidity to the economy and markets. The Fed already has started tapering purchases of Treasuries and mortgages and expects to stop altogether in the first part of next year. Rate hikes likely will follow shortly after that. However, long-term secular forces that have depressed inflation, such as aging demographics and technological innovation, remain in place.
- Commodity prices are showing some signs of meaningful moderation. Also, consumer demand may be shifting from goods back to services after the unusual pull-forward of demand caused by the pandemic. Inflationary pressure in service-related industries has been significantly lower than for goods.
Key market trends and developments
- The bond market remains a surprise, if not an enigma. Bond yields remain exceptionally low, even in the face of a dramatic spike in inflation. The 10-year treasury yield has only moved up about 50 basis points during the course of the year, from 0.85% to 1.40% currently. The consequence is that bond investors continue to lose the race against inflation. Although bond yields are surprisingly low, the global savings glut and, even more surprising, negative bond yields abroad, should keep interest rates and bond yields from spiking. In short, it seems like this modest and erratic churn to higher yields will persist.
- Although there were some shifts in equity sector leadership throughout 2021, large cap growth stocks, especially technology stocks, dramatically reasserted their long-running performance dominance. However, there was meaningful dispersion of returns within the small and mid-cap stock sectors, which provided opportunities for astute active managers to shine through stock selection.
- Strong earnings trends for U.S. companies continued to surprise to the upside, mirroring the snapback in economic activity. However, strong overall earnings for the market continue to be generated by a relatively small number of incredibly profitable behemoths. Earnings comparisons for companies collectively in the coming year will be more difficult coming off such stellar results. In short, profits may be solid, but positive surprises may diminish.
- International equity markets – and emerging market equities in particular – dramatically underperformed U.S. markets, continuing their long stretch of disappointing performance. Far reaching and intrusive mandates from Chinese authorities into the strategic and financial management of Chinese companies was a shock to investors. It seems clear this newly assertive political and regulatory approach will continue. Although stock valuations in emerging markets look to be very cheap relative to historic valuations, the operating environment for these companies has changed dramatically, providing real long-term challenges for investors to consider.
Other key investment market developments
- “Democratization” of investing became a new buzzword, as millions of individual investors turned to their smart phones to invest, trade, or just entertain themselves. A growing number of investors using the Robinhood app, along with the surge in “meme” investing, proved to be a market-rattling development. Seemingly irrational trading behavior erupted throughout the year, although it waned significantly during bouts of market weakness. These new investing platforms will likely persist, but we don’t expect that “meme” stock behavior will have a lasting effect on the overall market.
- Cryptocurrencies continued to capture interest from an increasing number of both individual and institutional investors. In fact, in its relatively short history, crypto has carved out an impressive niche of acceptance as an alternative investment (and, to a lesser degree, as an alternative currency). It is seen as a store of value for certain investors fearful of inflation, politics, or regulated fiat currencies. It is very difficult to determine if this trend will continue, or if crypto is just another manifestation of speculation in an ultra-low interest rate world. But while the popularity of cryptocurrencies has grown dramatically, interest in traditional inflation hedges like gold and precious metals has declined – along with their prices.
- Investor interest and product proliferation in environmental, social and governance (ESG) investing continues to grow. ESG dimensions have now become a mainstream risk to be evaluated and managed both by investment managers and corporations. However, ESG is not without its growing pains. Regulatory scrutiny has increased around ESG disclosure, policies, and implementation. Initiatives are also underway to improve standardization of information, metrics, and efficacy of ESG policies. ESG variables remain important risks to evaluate. ESG information relevancy and standardization of metrics across a myriad of industries will continue to evolve, as will the processes that investment managers use to effectively incorporate these ethical criteria into their decision-making process.