The fourth quarter of 2021 ushered in a new variant and a new wave of COVID-19 infections, a trend seemingly commonplace for each quarterly letter. Fortunately, the new virus wave was accompanied by major developments in treatment options, hopefully furthering the return to normalcy. Below is a brief summary of what happened in financial markets between October 1 and December 31, 2021, followed by some perspective on markets in both the present and the future.
Stock markets rallied through the fourth quarter with the S&P 500 up a strong +11.0% and the Russell 3000 rising +9.3%. International markets lagged with the MSCI EAFE adding +2.7% for the quarter and the MSCI Emerging Market Index slipping -2.5%. Style performance for Q4 was mixed with large growth stocks edging out large value stocks and small value stocks outperforming small growth stocks.
The strong quarter marked the end to a strong year for the stock market as the S&P 500 finished up +28.7% and the Russell 3000 grew +25.7% for 2021. Internationally, equity markets had a more measured year as the MSCI EAFE added only +11.3% and the MSCI EM Index was down -2.5%. After a powerful start to the year for value stocks across the cap spectrum, style performance ended the year more mixed with large growth stocks narrowly beating large value stocks but small value stocks significantly outpacing small growth stocks.
In fixed income markets for the fourth quarter, the yield curve flattened slightly. Despite some interim volatility, corporate spreads finished December near their September levels. Just as strength begot strength in the equity markets, fixed income market weakness continued into the fourth quarter after a dismal start to the year. The core US government and credit market fell -0.6% for the quarter, high yield bonds finished positive at +0.5% and global bonds lost -0.7%.
As indicated, fixed income performance for the full year was also poor. High yield bonds managed to return +5.0%, but both the core US government and credit market as well as global bonds were weak for 2021 at -1.4% and -4.7%, respectively. This performance came on the back of tightening credit spreads and a steepening yield curve.
After the rapid spread of a global virus, a horrific market sell-off and an ensuing market rally, it feels important to conduct a bit of a market gut check. What has all ensued, and what is coming up next?
Action by governments and central banks all over the world, triumphs of modern medicine and a common global purpose created this market whiplash. Looking back, investors experienced nearly all parts of the economic cycle in an unbelievably short period, most notably evident in one of the shortest bear markets on record.1 With the benefit of hindsight, the forward-looking comments of the Federal Reserve and some basic economic analysis, investors can break down this investment cycle into three distinct phases.
Phase 1: The Pandemic Actions Unprecedented Policy
The most obvious phase of this investment cycle was the beginning. In January of 2020, the first US cases of COVID-19 (which at the time the world simply referred to as the Coronavirus) were identified, indicating that this was no longer just a China problem but a global one. By March, the World Health Organization had declared COVID-19 a pandemic, the US was in an official state of emergency and lockdowns began. This triggered a massive disruption in business activity and a swift, deep recession.
In response to the economic disruption, Congress and the Federal Reserve began to take action. Passing its first bill by the end of March 2020, Congress began stimulating the economy. Seven bills and roughly 20 months later stimulus reached a grand total of $6.3 trillion in COVID-19 relief.
The Fed ignited the economy by lowering its policy rate and purchasing bonds across the market spectrum. This combined effort of stimulative action was something never seen before.
Phase 2: Companies and Consumers React to the Stimulus
Given its unprecedented nature, it was difficult to predict how companies and consumers would react to this level of stimulus. Combining the stimulus with the shutdown itself also meant that most economic participants were limited in the activities upon which they could spend money.
For a while, the majority of consumers chose to save money and service their debts, a move not originally anticipated by most economists. Carrying less debt and significant savings and investments, household balance sheets are at some of the strongest levels in history.2 This robust positioning gave consumers the confidence to start spending as the economy reopened. As demand abounded, consumer spending levels recovered quickly.
On the corporate side, companies repositioned their balance sheets to take advantage of ultra-low interest rates. With huge piles of cash, these companies began to ramp up capital expenditure plans to position their business models for a post-pandemic world.
Together, high levels of spending by both companies and consumers have stoked inflation. Both inflation and wages have accelerated to the fastest growth rates seen in the last 20 years.
Phase 3: A Careful Unwinding Begins
Investors must now look to what is next. While past economic cycles are a lens with which to analyze and forecast the next phase of this one, the intensity and uniqueness of the original stimulus means the unwinding of that stimulus will be similarly uncharted territory.
Forward-looking comments by the Federal Reserve give investors a peek into what the coming months and years will look like. To reverse Phase 1, the Fed will signal tightening policy (something evident in recent meetings), taper asset purchases and finally raise policy rates. The cautious pace at which the Fed unwinds will be crucial to economic stability.
The benefit of hindsight makes dissecting the last two years a simple exercise, but we caution you to remember the not-so-distant feeling of uncertainty prevalent at most points during this cycle.
Hindsight is 20/20, and just as we were not sure what was in store for financial markets over the next twelve months as indices shed their values in March of 2020, we again look with cautious optimism to 2022 and beyond. While we can identify we are entering Phase 3 of this cycle, we do not know how long it will last, nor the triumphs and tribulations we will experience along the way.
At WoodTrust, we consistently maintain a long-term view, investing strategically over multiple cycles and maintaining our discipline. As always, we thank you for your trust and look forward to our meetings with you in the near future.
1There have been 11 bear markets since 1929 including the COVID-19 selloff. The average bear market length of these 11 instances is 23 months vs. the COVID-19 bear market length of 6 months. The only bear market shorter was the one following the crash of 1987 which lasted only 3 months. A bear market represents a 20% or more decline from the previous market high and recovery to the prior high.