Week ended December 31, 2021
“The function of economic forecasting is to make astrology look respectable.”
John Kenneth Galbraith
This is the year-end edition of the weekly update, having skipped last week because of Christmas (and COVID).
There was a smattering of macroeconomic news during the last two weeks of the year, but nothing particularly market moving. Perhaps the news that was most influential during this period is the acceptance of omicron as a highly transmittable but relatively mild variant compared to prior variants, comforting to investors vis-à-vis the initial concerns when omicron was first identified in South Africa a little more than one month ago. The outcome was very much business as usual, with every single equity index I track continuing the 2021 pattern of “up, up & away”. Another important indicator of market risk is the VIX, which surged in late November / early December to above 30, but then reversed course and steadily declined the rest of the month, closing at 17.2 to end the year. US Treasuries have also been relatively well behaved, with intermediate and longer maturity USTs weakening only slightly across the curve the last two weeks, now back at late November levels. The real action in the UST market has been at the front end of the curve, with the 2-year yield now around 20bps wider than it was at the end of November, reflecting a more hawkish approach by the Fed which now (finally) seems hellbent on addressing inflation in the US more aggressively as each day passes. Corporate bond spreads and yields have been remarkably resilient, too, throughout the year. As I anticipated, it was mainly the investment grade (BBB) corporate bond arena that suffered the most from higher UST yields, especially early in the year. However, more risky high yield bond spreads continued to compress during 2021, completely offsetting the increases in underlying UST yields and leading to flattish results in 2021 (from a price perspective). The riskiest CCC/un-rated high yield segment even notched year-over-year gains, reflecting the ongoing quest for yield involving the riskiest assets as rates remain anchored at record-low levels. As bearish as I have been on USTs and corporate bonds, the reality is that both have performed admirably during 2021 (aside from shorter-dated USTs) even with all sorts of inflation and credit-sensitive news that could have upended bonds. As far as safe haven assets, gold has been disappointing as far as its 2021 return, perhaps because – net-net – investors feel that risk has lessened during the course of the year (even though we have endured several periods of harsh negative swings in sentiment). The US Dollar has continued its march upwards as US assets generally have outperformed markets in other countries. As far as other asset classes, you might be surprised to learn that WTI crude oil (+55.5% FY2021) nearly – but not quite – outperformed Bitcoin (+59.7% FY 2021) this year, although both oil and cryptocurrencies very much march to their own beat.
The usual tables I include in the weekly update are further down in this commentary, because I thought you might find it interesting first to consider 2021 returns in the context of prior years and longer periods of time. The focus in this respect is mainly on equity markets, although I also examine yields in the US Treasury market over longer periods in a separate table. I am hopeful that these tables will provide you with thoughtful context as you “place your bets” for 2022.
I can draw three conclusions from looking at this table. Firstly, US equity indices outperformed indices in other major developed markets, China and the emerging markets over long periods of time, not just recently. I attribute superior US equity returns to the following:
“business-friendly” regulatory environment in the US coupled with an entrepreneurial mindset that has supported the evolution of large and internationally-relevant companies in a variety of industries over many decades;
large and globally dominant technology companies that are US-based (the FAMAGs+);
the availability of large and liquid capital markets – both equity and debt – for funding;
limited government interference and support, and a willingness to let poorly-performing companies fail;
a large and diverse consumer-driven economy; and
fiscal and monetary stimulus measures.
The second thing to note is that returns in US indices have been so exceptional the past three years that almost certainly some sort of reversion to the mean is in order. This is the way that mathematics in markets work over long periods of time. Such a reversion is even more likely because supportive monetary and fiscal policy (Build Back Better notwithstanding) is set to slow in the US. The third thing to note is that the poorer-performing indices over time, particularly the European stock indices and emerging markets, could be poised to close the gap on leading US indices – in spite of my earlier comments about the superiority of US equities – simply because the value proposition is much better in many of these markets.
The chart below shows US Treasury yields over longer periods, similar to the table for equities.
The effect of the onset of quantitative easing during the GFC in 2009 is clearly evident in this table, as yields fell across the curve (see end of 2011 vs prior periods), more or less ushering in a “new normal” in which the Fed has remained accommodative ever since. Even when the Fed began to taper in December 2013, followed by a series of 25bps increases in the Fed Funds rate (from effectively zero) starting in December 2015, yields on intermediate and longer-dated UST’s remained stubbornly low. This occurred even as the US economy was continuing to steadily grow. When US equity markets stumbled in 4Q2018, the Fed stopped raising overnight borrowing rates and in fact began to reverse course by lowering rates beginning in the summer of 2019. The onset of the pandemic in March 2020 ushered in another highly unusual set of accommodative measures – including the lowering of the Fed Funds rate to effectively zero and starting a broad and large QE programme – that have kept yields at near-record lows since then across the curve. This is becoming a more interesting scenario now because the US (and global) economy are experiencing a recurrence of inflation – completely absent for the last 35 or so years – which will need to be addressed. The Fed has finally tilted hawkish and yields at the intermediate and longer maturity part of the curve have drifted wider but remain below levels experienced during the period since the GFC, and well below levels prior to the GFC. Nonetheless, I continue to have concerns on just how monetary policy shifts will be able to address inflation without negative economic consequences eventually.
Let’s turn to the weekly tables now, which I have included below in their entirety without further commentary.
Global Equity Indices
US Equity Indices
International Government Bonds
US Corporate Credit
Risk-Free and Other Assets
Here’s wishing you successful investing in 2022. Thank you again for following E-MorningCoffee, and please recommend this blog to your friends if you find it interesting and helpful.