2021 Overview and 2022 Market Outlook
In 2021, U.S. stocks continued to make new all-time highs, as investors brushed off most negative headlines, focusing instead on the economic expansion underway and a strong run of corporate earnings. In fact, the U.S. stock market has recorded significant gains over the past three years, with the S&P 500 index averaging greater than 25% annual returns over this period (including the 34% correction experienced in early 2020).  In response to the COVID-induced recession nearly two years ago, the U.S. has aggressively instituted a series of domestic policies aimed to stabilize the financial markets and stimulate the economy, including direct stimulus packages to business and consumers, and favorable monetary conditions established by the Federal Reserve (Fed).
Looking ahead to 2022, investors will again be focused on the strength of the economy’s expansion, while facing less accommodative fiscal and monetary policy. Most notably, the Fed is expected to ease support throughout the year, after announcing plans to slow its monthly bond-buying program and increase the fed funds interest rate several times.
In addition to the Fed’s tapering, other risks remain to economic expansion, such as high inflation and the sustainability of strong consumer spending. These risks are likely manageable though, in our opinion, and while we expect volatility to remain elevated as the Fed continues backing off its crisis-era policies, we believe that we are in the midst of a recovery cycle and we reiterate the importance of staying committed to a long-term investment strategy.
2021 Market Highlights
Major Asset Class Returns in Q4 & Full Year 2021
Source: 2021 Total Return as of 12/31/21, Bloomberg; See Chart A in Appendix
U.S. stocks continued to appreciate during the 4th quarter, advancing overall returns for the full year. The large-cap segment of the market, represented by the S&P 500 Total Return Index, was up 28.7% for the year. Followed by small-cap and mid-cap stocks, which were up 26.8% and 24.8%, respectively for the year. 
2021 began with the U.S. economy in its early stages of economic recovery, following the mid-2020 COVID-induced recession. Stocks continued to make new all-time highs supported by record earnings and an improving outlook on the economy. In fact, the S&P 500 index hit 68 record highs during the year. 
International developed market stocks continue to lag U.S. returns, yet finished the year up 11.3%. This segment of the market experienced a tough second half of the year, hurt by inflationary pressures, tightening monetary conditions from Central Banks, and the resurgent pandemic. Emerging market stocks were a disappointment, facing additional pressures from the struggles out of China, and finished the year down 2.5%. 
In contrast to strong equity markets, 2021 could be characterized as a year in transition for the fixed income markets. Fixed income markets have been focused on when the Fed will begin to raise rates and how many rate increases we might see in 2022. We saw the front end of the yield curve repriced as the odds of a 0.25% rate increase in March of 2022 became more likely. In addition to the short end, we saw yields increase across the curve into year end, but we did not see the breakout to higher levels that many had predicted. The yield on the 10-year Treasury bond ended the year at 1.51% (up from .92% at the beginning of 2021). The result of this increase in yields was negative returns across most segments of the fixed income market for the year. The Bloomberg Barclays US Aggregate Bond Index, a broad measure of investment grade bonds, returned -1.54% for the year.
Favorable Conditions Persist Heading Into 2022
Financial conditions remain easy despite the eventual transition from Quantitative Easing (QE) to Quantitative Tightening (QT). Short-term interest rates are near zero, and should remain at historically low levels for the foreseeable future.
The U.S. economy continues to recover from the COVID-19 pandemic. Gross Domestic Product (GDP) growth in 2021 is expected to be reported at the highest level in decades. Though the rate of growth will slow in 2022, it should remain above pre-pandemic averages.
The strength of the U.S. consumer has not been slowed by the pandemic. Household balance sheets continue to be strong, keeping spending and consumer confidence high.
The virus that causes COVID-19 is expected to pose less danger to people over time and reducing the risks of lockdowns and prolonged supply chain disruptions.
The government is in gridlock, which tends to be positive for the markets. The legislative agenda will be limited, besides government funding bills that must be resolved. Additional fiscal stimulus, if approved, would have added to inflationary concerns.
Stock price valuations are elevated, however, financial and economic conditions remain accommodative and rising earning expectations should support higher stock prices.
Expanded View on Headline Market Risks
Inflation remains the biggest story heading into 2022. The residual effects of inflation will be closely monitored as will the reaction from the Fed in its policy decisions. For a deeper read on inflation, please refer to our December update which can be found here.
CPI Readings; Will Inflation Normalize?
Inflation surged in the second half of 2021, driven by massive stimulus, post-lockdown reopening, robust consumer demand, soaring energy costs, and supply constraints. The headline Consumer Price Index (CPI) reached 7% in December, up from 6.8% in November, and is the highest reading since June of 1982. 
It is possible that headline and core CPI rates peak early in 2022. Commodity prices have started to slow in some segments of the economy and the supply of goods has risen of late. In addition to rising supply, slower consumer spending should also dampen the inflation outlook.
Central Banks across the globe have already been tightening over the past 12 months and the U.S. Fed is expected to start raising interest rates as early as March. This policy is anticipated to cool down global economic growth and pricing pressures.
Impact on Consumer Spending and GDP Growth
Inflationary pressure on the consumer has generally been low for many years. Currently, as costs rise for commonly relied upon goods and services, we would expect to see an impact to spending behavior.
Consumer spending on discretionary items, such as retail shopping and home goods, helped support economic growth following the recession. With costs rising on these items, spending in this segment of the economy has slowed.
Overall, the consumer continues to remain strong, however, consumer confidence is being tested with growing concerns over COVID variants, inflation, and rising interest rates.
As a reminder, consumer spending accounts for more than two-thirds of GDP. GDP dipped to 2.3% in 3Q 2021, but the economy is expected to have grown at a faster pace when 4Q preliminary results are released in late January. 
Rising Interest Rates
The economy is entering a period of “normalizing” rates. Real rates, which consider inflation, have been negative for some time now. The Fed has stated its intention to raise interest rates, however, stocks have absorbed this expectation. It is our opinion that going from negative real rates to slightly positive real rates, will not materially affect financing and profitability or abruptly halt the economic recovery underway.
Nominal rates are set to go up, however the peak for this cycle will be historically low. The initial rate increase is expected in March, starting what could be a multi-year process. 
Since the Fed has limited monetary policy options available to revive a struggling economy, it would like to slowly end Quantitative Easing and bring up short term interest rates (in order to have these tools available for when the economy gets near the end of its current growth cycle). The Fed must move carefully and communicate clearly to avoid unintentionally triggering a slowdown in its efforts to normalize rates.
Stock Price Valuation; Specifically, High Growth Segment of the Market
Earnings growth was a significant driver of stock performance in 2021. Corporations will be challenged to continue to outperform expectations. Potential challenges to earnings include, prolonged supply chain disruptions, an inability to pass along higher costs to consumers, labor constraints and overall tougher earnings comparisons in 2022.
High growth companies often experience heightened price volatility in a rising interest rate environment, since market price multiples account for future earnings that are valued less when interest rates are higher. Technology companies, in particular, have already experienced significant volatility to start the new year and we expect this to continue.
Investor sentiment shifting away from growth stocks in favor of value stocks is normal behavior that will occur within a market cycle. One thing to monitor is that a few of these mega cap technology companies now hold material weightings within the major stock indexes. For example, Apple and Microsoft comprise 6.8% and 5.9% of the S&P 500 index, respectively. While this may add to heightened volatility during the year, we don’t expect investors to rush to sell Apple and Microsoft positions simply because interest rates are expected rise (as these are blue chip companies whose earnings will likely benefit from a growing economy).
Additional Risks to Markets in 2022
Geopolitical risk is a constant variable each and every year, with a current focus on tensions between China & Taiwan, and Russia & Ukraine to name a couple.
The probability that COVID continues with new variants that further slow global growth, disrupt supply chains, and hinder employment growth.
Consumer sentiment could change during the year, with tighter financial conditions and persistent inflation.
Corporate earnings will be facing tougher earnings growth comparisons throughout the year. Stock price valuations will come into greater focus if earnings growth stalls.
The return of market volatility could spook investors. In 2021 there was significantly less volatility than in 2020, with only one market drawdown during the year greater than 5%. In 2020 the S&P 500 had a 9% drawdown as well as the 34% decline when COVID-19 surfaced. 
We believe that investors have many reasons to remain optimistic heading into 2022. The prospects for moderating inflation, mid-single digit GDP growth, historically low (albeit rising) interest rates, and an improving labor market would signal the continuation of a multi-year economic expansion. Additionally, two years into the COVID-19 pandemic, we are starting to see a path forward to mitigate the impact of the virus. We are all anticipating a return to normal, living with this virus like many others.
Of course, there is risk to this outlook, with concerns over inflation and how it could derail the prospects for prolonged economic expansion. This means, the path forward, and particularly the next several quarters, is still highly uncertain. We believe that this uncertainty is an acceptable and commonplace risk and planning for market volatility is essential to the construction of a long-term investment strategy.
The S&P 500 index has not had a “correction” (defined as a decline greater than 10%) since early 2020, experiencing only modest pull-backs over this time. Market volatility is an ongoing risk to any long-term strategy and the existence of volatility should not result in any deviation from that strategy. As a reminder, we manage risk exposures through individualized portfolio design (built alongside your investment policy statement) and respond to any volatility with active portfolio rebalancing and tax-efficient strategy implementation.
As we move forward in the new year, we look forward to speaking with you and revisiting your plan for the future. We wish you and your families a happy and healthy 2022.
Gregory Slater, CFA, CFP®, CIPM®
Chief Investment Officer
Chart A: 2021 Total Return of Major Asset Class Indexes
Source: Bloomberg; 2021 Total Return, MSCI EAFE, MSCI Emerging market, S&P 500, Barclays Agg & Barclays Muni indexes
1 - Source: Bloomberg: S&P 500 Index; Annual market returns 2019-2021
2 - Source: Bloomberg: S&P 500 Total Return Index; Emerging Markets Stock Index = MSCI Emerging Markets Net Total Return Index; International Markets Stock Index = MSCI EAFE Total Return Index. Bloomberg Barclays Aggregate Bond Index
3 - https://tradingeconomics.com/united-states/consumer-price-index-cpi
4 - https://tradingeconomics.com/united-states/gdp-growth
5 – Federalreserve.gov FOMC Meeting Minutes
6 – Source: Bloomberg: S&P 500 Index; Annual market drawdowns 2020-2021
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