Q4 - reflation and omicron optimism
COMMENTARY FROM THE INVESTMENT COMMITTEE OF CORAL GABLES TRUST COMPANY
Q4 2021 - Reflation & Omicron Optimism
The fourth quarter challenged markets as investor worries were front and center with the new Omicron variant; along with, a Federal Reserve pivot towards a faster tightening cycle to address recent increased inflation. Both the stock and bond markets were volatile as concerns about future actions and repercussions of potential government actions caused investors to re-examine risks. Fortunately, the fast-spreading Omicron variant is less severe than initially feared. Furthermore, thanks to vaccines and rising herd immunity, we do not see the variant altering the global re-opening trajectory. Despite this turbulence, the S&P 500, and the technology heavy NASDAQ, were resilient posting a fourth quarter return of +11.02% and +8.47% return, respectively. After back-to-back years of strong performance across most equity and credit sectors, we caution investors to use greater selectivity to identify future opportunities. While earnings growth remains strong, we expect a tug of war between interest rates and valuation which will act as a headwind for future market gains. Market gains have been largely concentrated in a handful of companies with stretched valuations as illustrated below. As interest rates are positioned to increase in 2022, P/E compression is expected in the technology sector as growth equities reprice under a higher interest rate regime.
Sources: FactSet, Standard & Poor's, J.P. Morgan Asset Management, U.S. Data are as of December 31, 2021. AAPL (6.8%), MSFT (6.5%), AMZN (3.9%), TSLA (2.3%), GOOGL (2.2%), NVDA (2.1%), FB (1.9%), BRK.B (1.3%), JPM (1.2%) and JNJ (1.2%)
On the economic front, the fourth quarter employment report was mixed, showing an addition of only 210,000 jobs added to the economy. While the number of jobs added was disappointing, the report showed continuation of a tightening labor market. The unemployment rate fell from 4.6% to 4.2% in November, with total employment rising by 1.14 million workers. The strength of the labor market alongside rapidly rising inflation will be key for the Federal Reserve regarding when and how much to raise short-term interest rates from near zero. As we write, aggressive rate hikes are being priced into the market causing market volatility early in the new year. At the December Federal Reserve meeting, Chairman Powell acknowledged the persistence of inflation and pivoted to a hawkish stance with their announcement of accelerating the tapering of bond purchases, concluding with a rate hike as early as March. As the Federal Reserve withdraws monetary stimulus, and with fast approaching rate hikes, this will only intensify the upward pressure on yields. Looking at past market reactions, the 2013 "taper tantrum" initially created unexpected market volatility, however, markets rallied and trended higher a short time after.
Sources: BMO Capital Markets Investment Strategy Group, FactSet, Haver and FRB.
Fixed income displayed characteristics of a risk-off environment in the fourth quarter as investors reduced their appetite for bond assets like investment grade and government bonds. The low yield on the 10-year Treasury note has been one of the more puzzling features of this year. Peaking at about 1.75% in March, before falling back below 1.25% by the summer, and ending the year just 60 basis points higher than at the start, at 1.51%. While central banks around the world transition to tighter policies, our Investment Committee believes investors should shorten duration and strategically position for higher rates later in the year. The performance of the Barclays Aggregate Bond index finished slightly down in 2021 with a -1.54% return, however, high-yield finished the year modestly positive as economic conditions continued to improve.
Across the pond, the European Central Bank is taking very gradual steps toward tighter policy as the medium-term balance of risks remains tilted to inflation being too low. The latest forecast unveiled inflation stubbornly below target in 2023 and beyond. While international markets continue to underperform their domestic peers, they are well positioned to benefit from tailwinds of lower inflationary pressures, accommodative central bank policies, and a relative valuation advantage compared to the U.S. The MSCI ACWI ex-US index returned 8.29%, the MSCI EAFE index returned 11.78% and the MSCI Emerging Markets returned -2.54% for the year. International equities currently find themselves at a 30% discount to U.S. equities which is the most in two decades.
THOUGHTS ON ASSET ALLOCATION
As we look ahead to a new year, it is important to reflect on 2021 and how the market reacted to different macroeconomic pressures and the response evoked by market participants. In all, the stock market had another strong year as investors continued to ride the wave of accommodative monetary policy and economic recovery. The S&P 500 reached over 70 new highs in the year alone. Looking at 2022, our Investment Committee believes the key variables for investors this year will be the path of inflation and the Federal Reserve's response. Performance of various asset classes could depend not just on when, but also how forcefully the Federal Reserve and other central banks withdraw the unprecedented stimulus unleased in 2020. Our Investment Committee thoroughly reviewed our positioning for the new year and believe client portfolios would be best positioned with a slight value lean, complemented with a shorter duration within fixed income. The Investment Committee elected a change in the emerging markets arena with the addition of the WCM Focused Emerging Markets strategy. Extensive due diligence was performed on this strategy, and they possess attributes we look for like a proven investment process, conviction, and most importantly emphasis on downside protection. As shown below, value outperformed growth-oriented companies across all market cap levels in December; whereas, large cap growth singularly outperformed value in the fourth quarter and for 2021. The value advantage in December is not out of the ordinary when a higher interest rate bias begins to be priced into the markets
Our Investment Committee believes that our investment managers are well suited for the evolving landscape and are poised to benefit from long-term thematic investment themes. Listed below is a subset of our equity and fixed income managers that performed exceptionally well versus their stated benchmarks for the year.
*Returns are from actual portfolio results. Results may vary. Past performance is no guarantee of future returns.
We look forward to speaking with each of you regarding our views and the performance of your respective portfolios. For additional information or questions please contact Mason Williams, Chief Investment Officer, at 786-497-1214 or Michael Unger, Investment Officer, at 786-292-0310