Our best to you for 2022; we hope the year has started off well for all of you and your families. We are now almost two years into the Covid-19 pandemic, and we know many have been impacted by this latest Omicron variant. Fortunately, 64% of the U.S. population is now fully vaccinated (according to the Mayo Clinic) and over 76% have received at least one dose, and many have also built up a natural resistance from contracting the illness. As a result, we may be reaching the “endemic” stage, and we are hopeful that 2022 will see a return to a more normal level of activity in all facets of our daily lives. The balance of my comments will focus on the financial markets across a few of the major asset classes, to provide our best thinking.
In the US, the S&P 500 finished up 28% in 2021, but several sectors performed far better, with Financials and Technology stocks both earning 34-35% for the year and Energy and Real Estate earning 52% and 42% returns, respectively. Although markets pulled back in January 2022, we believe our thematic, long-term approach of broad market exposure, with some exposure to sectors with strong fundamentals, should continue to serve investors well. For example, Energy and Real Estate were by far the best performing sectors in the overall market last year, yet each represented less than a 3% weighting in the S&P 500 index. We were fortunate enough to have a material weighting to Real Estate last year, our best performing investment selection.
The investment management arm of Goldman Sachs describes our current U.S. equity markets as being “in the third or fourth inning of a nine inning stretch” and we agree with that logic. We feel the U.S. economy should continue to expand, for AT LEAST another 12-24 months, regardless of policy, politics, interest rates, inflation, or the occasional geo-political threat (which always seem to come at the worst time). The market is trading at a forward P/E of about 20, as opposed to historical averages closer to 16 or 17; this slightly over-valued market is offset, in our minds, by the number and variety of appealing companies and industries that trade well below those multiples. Even the tech-heavy NASDAQ market, with over 2500 stocks, illustrates this point — as of 12/31 approximately 40% of those companies were down 50% from their previous all-time highs. We believe selectivity will matter even more this year, as returns become more varied across market sectors. As stocks reached all-time highs in recent months, we reminded clients that, as an asset class, stocks should only be used for investments expected to be held for five years or longer.
The US Aggregate Bond Market index declined -1.54% in 2021, its worst showing in some time. However, a look under the hood of this index reveals that 75% of the index’s weighting is made up of U.S. Treasuries and mortgage-backed securities; those securities are very sensitive to rising interest rates. With the 10-year U.S. Treasury Bond rate increasing from 0.93% at the start of 2021 to over 1.5% at the end, it is little surprise the Aggregate Index turned in last year’s disappointing performance. So far this year, the yield on the U.S. 10-year rose further to 1.8% as of this writing (1-26-2022). While our investment process does not depend on predicting interest rate movements, the Federal Reserve has articulated their plan to discontinue asset purchases (so-called “quantitative easing”) and to also raise interest rates in 2022, possibly two or three times. Given this backdrop, our continued focus will be on ultra-short bonds, which tend to hold up relatively well in a rising rate environment, as well as asset backed securities (e.g. auto loans, equipment financing loans), and investment grade corporate or municipal bonds. All these sectors had positive returns in 2021, and we have confidence in them going forward. Recall our article from the Q4 2021 newsletter- “Why Do I Have Any Bonds In My Portfolio?—for income, diversification, and stability in times of financial market volatility. All of these attributes seem relevant in the coming quarters. The Fed thinks the economy is doing well and doesn’t need as much stimulus, so it can handle a slightly higher cost of capital.
Foreign stocks earned roughly a +12% return in U.S. dollar terms for 2021, less than half the U.S. market’s return (MSCI EAFE index vs. S&P 500). Foreign developed markets are now priced one-third lower than the U.S. markets, as measured by P/E ratio, and may seem poised for a stock market rebound that has been anticipated for several years. Germany, a strong exporter which produces a quarter of Europe’s economic output and has often been called the “engine of Europe”, would typically be expected to lead Europe’s comeback from the Covid-related setback. Unfortunately, its export focus has been hampered by a post-pandemic world of broken supply chains and rising energy prices. Not surprisingly, Germany’s GDP grew by 2.7% last year (not nearly as robust as the U.S.), and market pundits are less optimistic about a quick stock market rebound. Overall, the expected growth in many foreign developed markets is simply not as robust as in the United States, and thus we continue to underweight this sector overall.
Emerging markets were down slightly last year (-2.2%), following a strong 2020, as measured by the MSCI Emerging Markets index. With vaccinations lagging in most emerging markets, and rising U.S. interest rates posing an additional headwind (emerging market bond issuers frequently borrow in dollars), we see ongoing challenges for this asset class. However, as we have said before, it is a market of stocks not a stock market, and thus we favor an active, focused portfolio in this sector.
Lastly, some clients have the requisite time frame and investment experience to commit to alternative investments, which often are illiquid and may require ten-plus years to reach their potential. This is not an asset class for every investor. That said, we would consider a focused real estate portfolio, commodities, private equity, or private debt investments for the right scenario.
We hope this overview has given you some insight into our thinking for 2022. We are not in the prediction business, as our investment process is not dependent on any concept that we “know what is going to happen”, but rather on time-tested investment principles, sound economic theory and diligent research. We look forward to connecting with you in 2022!