Despite the emergence of a new variant of COVID-19 in November, strong corporate earnings were sufficient to boost the S&P 500 by 11% in the final three months of 2021. S&P 500 earnings jumped almost 40% in the third quarter even with a modest 2.3% U.S. gross domestic product (GDP) growth. Domestically focused mid and small-cap U.S. stocks posted more modest gains of 6.4% and 2.1%, respectively. Overseas, the MSCI EAFE Index added 2.7% while the MSCI Emerging Markets Index declined -1.3% in the quarter. Both recent variants have had a more negative impact on international stocks, which tend to be more cyclical and adversely impacted if growth slows. In fixed-income markets, the Bloomberg U.S. Aggregate Index was close to flat, adding a marginal .01%. Shorter maturity bond yields climbed sharply after the Federal Reserve (Fed) began the process of unwinding monthly asset purchases and announced they intended to hike interest rates three times in 2022. Overseas, most developed market central banks are expected to remain accommodative through at least 2022. With corporate earnings growth forecast to moderate in 2022, expect more modest returns for higher valuation domestic equities in the coming year. In the face of low yields and persistent inflation, fixed-income investors face another challenging year.
The S&P 500 added 11% over the final quarter of 2021, bringing annual returns for the large-cap index to 28.7%. Despite facing the headwind of a new variant of Covid, earnings by the S&P 500 companies proved substantial enough to propel a resilient market higher. Stocks jumped over 7% in October, the best return of any month after Delta cases peaked in September and fears subsided. Year-over-year earnings for the S&P 500 rose 39.6% in the third quarter and are projected to increase almost 20% in the fourth quarter. Three-fourths of S&P 500 companies beat third-quarter revenue estimates and 82% of S&P 500 companies beat third-quarter earnings estimates.
As alluded to above, the quarter witnessed the emergence of a new variant of Covid, dubbed Omicron. The discovery of the Omicron variant caused a short-term market pullback. The variant has caused new daily cases of Covid to spike to their highest level at any point in the pandemic. Nonetheless, as the quarter progressed, market volatility subsided as investors responded favorably to indications that the Omicron variant, though more infectious, is less lethal than past variants.
Ten of the underlying 11 sectors within the S&P 500 increased over the quarter, with real estate and information technology leading the pack. Large-cap stocks outpaced mid and small-cap stocks after volatility increased. Stocks retraced some of October’s gains in November after the Fed announced tapering and rates hikes in 2022 and Omicron surfaced near Thanksgiving. These events threatened to dampen domestic growth and raised concerns, especially within more domestically focused small-cap stocks. Rising domestic interest rates put downward pressure on small and mid-cap growth stocks and value stocks handily outperformed in the quarter and for the year.
International stocks were once again outpaced by their domestic counterparts. The MSCI EAFE Index of international developed stocks added 2.7% for the quarter. The hangover from the Delta variant and the negative impact of Omicron was more substantial in Europe and Japan, despite higher vaccination rates. Developed market stocks are generally more cyclical and the threat of further shutdowns and a worsening supply chain had a larger negative impact than it did on domestic stocks. Japan, which is heavily reliant on exports, fell 4% in the quarter and dampened international performance. Returns were also negatively impacted by currency weakness, with the Euro declining -1.7% and the Yen falling -3.2% in the quarter. The MSCI Emerging Markets Index continued its poor performance and was the only major index to decline, falling 1.3% for the quarter. The largest weighting within the Index, China, continued its yearly descent, falling -6.1%. Chinese officials were emboldened by the country’s quick recovery from Covid and enacted new regulations that specifically targeted certain industries and companies and were largely viewed as less market-friendly. Near the end of the year, Chinese officials started taking actions to boost growth, but it was too little too late and Chinese stocks were among the only country to decline in December.
For the quarter, the Bloomberg U.S. Aggregate Index inched up .01%, and the broader Bloomberg U.S. Universal Index ticked down -.03%.
The yield on the 10-year U.S. Treasury was flat, starting and ending the quarter at 1.52%. The Fed’s minutes from the November meeting indicated an interest in raising the overnight rate three times in 2022, catching those who expected zero rate hikes by surprise. More persistent inflation and a falling unemployment rate gave the Fed the support it needed to initiate increasing rates. Shorter-term interest rates, which are more impacted by Fed actions, responded by moving higher. During the quarter, the two-year Treasury yield moved up .45% while the five-year Treasury yield increased .28%. Rising interest rates put downward pressure on bond prices and resulted in poor performance for fixed-income securities.
Over the third quarter of 2021, the latest period for which data is available, U.S. GDP increased at an annualized rate of 2.3%, its slowest pace since the current economic expansion began in mid-2020. The slowdown was largely attributed to the impact of the Delta variant of Covid and cases peaking in late September. Despite the slowdown, the Fed projects U.S. GDP will grow to recover in the fourth quarter and achieve a rate of 5.5% for 2021, which would represent the greatest year-over-year increase in economic growth since 1984. Growth is projected to moderate a little in 2022, with domestic and developed market growth around 4.0% and emerging market growth over 5%.
The U.S. consumer price index (CPI) rose 6.8% year-over-year in November, its fastest rate of increase since 1982. November marks the sixth straight month in which inflation has exceeded 5%. Core CPI, which removes inflation in volatile food and energy prices, rose 4.9% year-over-year in November. Inflation, which was initially determined to be transitionary, has become more persistent and rising wages and housing costs have jumped and are likely to keep inflation above pre-Covid levels. Global inflation is elevated, but the U.S. has among the highest inflation within the developed markets.
In response to this persistently elevated inflation, the Fed moved to decrease its monthly purchases of $120 billion of Treasuries and mortgage-backed securities by $30 billion per month. This winding down of purchases by the Fed, also known as “tapering,” is set to end by March 2022. Once its tapering has concluded, the Fed is expected to raise the federal funds rate by 25 bps three times in 2022. The current federal funds rate has sat in a range between 0% and .25% since March 2020, the onset of the pandemic.
2021 was a banner year for the S&P 500, with the large-cap index rising 28.7% (the third consecutive year of double-digit returns). In large part, the continued ascent of the S&P 500 in 2021 was driven by strong corporate earnings, which soared 45% over the year. Although the price-to-earnings ratio of the S&P 500 came in lower at the end of 2021 than in the prior year, valuations for large-cap stocks are still elevated relative to historical standards. Analysts project earnings for the S&P 500 to rise just 9.4% in 2022, far below their 45% growth rate in 2021. Lower earnings projections coupled with steep valuations suggest investors should anticipate more modest returns for domestic stocks in the coming year.
Going forward, in the mid and small-cap space, value stocks seem better positioned than growth stocks. Mid and small-cap value stocks handily outperformed their growth counterparts over 2021, and we expect this trend to carry on into 2022. The rationale is threefold. First, true to their name, value stocks trade at sizable discounts to growth stocks. These favorable valuations bode well for mid-and small-cap value stocks. Second, value stocks are more materially impacted by economic growth. With the Fed forecasting U.S. GDP to grow by 4% in 2022, value stocks stand to serve as beneficiaries of continued economic expansion. Third, rising interest rates represent a more substantial hurdle for growth stocks, which tend to trade more on future growth than current.
International stocks continued to be outpaced by their domestic counterparts in 2021. For example, the MSCI EAFE Index of international developed stocks rose 11.3% on the year. The MSCI Emerging Markets Index declined -2.5% on the year, in large part due to an ongoing crackdown by Chinese regulators. Still, international stocks continue to trade at attractive valuations relative to their U.S. peers. Coming off a down 2021, international and emerging market stocks are well-positioned to provide relatively strong performance in 2022 as global growth continues to recover and valuations are notably below their longer-term averages compared to domestic stocks.
The Bloomberg U.S. Aggregate Index declined -1.5% over 2021, while the broader Bloomberg U.S. Universal Index declined a more modest -1.1%. The yield on the 10-Year U.S. Treasury ended 2021 at 1.52% after starting the year at .92%. For 2022, investors should expect returns for U.S. investment-grade bonds to be disappointing, with modest gains to losses expected. The highest inflation in over 30 years and a low unemployment rate will force the Fed to hike rates in 2022 and rates are likely to move higher as a result. Low rates overseas offer little income as well. Bond yields are historically low and there are limited opportunities to achieve attractive returns without taking on elevated risks. Investors should prepare for another disappointing year for bonds.
Meet the Expert
Partner + Chief Investment Officer
Darin Richards, CFA®
Aldrich Wealth LP
Darin joined the Portland wealth management firm in 2004, bringing more than a decade of investment and financial consulting experience with him. As chief investment officer for Aldrich Wealth, Darin is responsible for developing, and implementing our investment philosophy and leading the investment committee. He works directly with some of our most complex and largest clients and also…
- Series 7 and 63 security exams
- Chartered Financial Analyst (CFA®)