Investment Management Newsletter - 4th Quarter 2021
Transitory is now…transitory
The strong uptick in inflation witnessed during 2021 had been hotly debated as to whether it was transitory, as the Fed claimed, or persistent. As increasingly stronger inflation data surfaced, Chairman Powell and other Federal Open Market Committee (FOMC) members pivoted to eliminate the term “transitory” from their statements in early December. Recent data that spurred the FOMC’s change in stance included year-over-year increases in Consumer Prices of 6.8%, Producer Prices of 9.6% and Personal Consumption Expenditures of 5.7%. The Fed’s change in tack resulted in several significant policy changes at the year’s last FOMC meeting. First, the previously established timetable for reducing asset purchases and slowing quantitative easing was accelerated by a factor of two. At that pace, new asset purchases will cease around March 2022. More importantly, projections from Fed board members and regional bank presidents showed a projected Fed Funds rate of 0.75% by the end of 2022, implying three one-quarter point rate hikes during the year. Markets are reflecting anticipation that the first of these rate hikes will be announced following the March FOMC meeting.
The Fed has two mandates which drive their monetary policy decisions. While “price stability” (inflation) has commanded much attention during 2021, the Fed has been quite successful in pursuing its other mandate of “maximum employment.” In fact, the Fed let the economy run hot amid labor market strengthening and tolerated higher-than- normal inflation. The Fed’s projection of a 3.5% unemployment rate by year-end 2022 would represent full employment.
With December’s unemployment rate at 3.9%, the labor market is tight, forcing bidding wars for talent. Though it’s only one component of inflation, wage inflation is a significant factor. Bonuses and raises are being offered for both skilled and unskilled labor. Demand and supply imbalances for raw materials and finished goods continue. Supply chain delays, increased shipping costs, scarcer, more expensive labor along with higher input costs have forced companies to raise prices on end products across-the-board.
The S&P 500 ended the year, on a relative basis, where it was for much of the year: near a new all-time record. The index set new record closing levels over 70 times during 2021. Atypically, in a positive return year, very large companies performed better than smaller ones. The S&P 500 was up 28.7%, mid-caps were up 24.6%, and small caps were up 26.7%. About one-third of the S&P 500’s gains came from the five largest companies.
As vaccines went in arms in the first half of the year, euphoria surrounding meme stocks, Special Purpose Acquisition Companies (SPACs), and companies at the lower end of the quality spectrum hit a peak. The markets eventually shifted to a more rational basis and now are trying to factor in inflation pressures and continuing supply chain disruptions. Domestically, the Energy sector led during 2021 followed by Real Estate and Financials as investors switched their focus to rising rates, inflation, and a strong growth economy.
International markets, continuing the trend of recent past years, underperformed domestic markets as their economies endured stricter COVID lockdowns. A stronger dollar also weighed on U.S. investors’ returns on overseas investments. Developed market international stocks rose 11.9% while emerging market stocks declined 2.5%. When pressures from COVID-19 ease abroad, we expect pent-up demand will drive significant economic growth.
Capital Gains in Perspective
When equities have an exceptionally strong year as in 2021, it is not unusual for us to realize higher-than-usual capital gains. When realized capital gains are higher, we tend to get more questions from clients on our rationale for having realized gains which drive higher tax bills, so we decided to share our perspective on that. Until an asset is sold and a gain is realized, no tax is due; however, to benefit from a gain, an investor will have to pay tax on it sooner or later. All else equal, the only ways to permanently avoid the tax are either to 1) give the asset to charity, 2) die, or 3) hold the asset until its value declines and the gain is no longer there.
Rest assured, before we realize a gain, we consider the expected tax impact in the context of each client’s individual circumstances. When we realize gains, it is always with the conviction that doing so is in a client’s interests. Typically, we will opt to realize gains either to sell one asset to buy another we believe has better prospects or to manage risk associated with improper allocations that have the potential to do more damage than what would be caused by incurring the tax liability. We review taxable accounts near the end of every year looking for opportunities to realize offsetting losses in a way consistent with maintaining a proper allocation. With the S&P 500 having posted cumulative returns over the last three years of just over 100%, opportunities to realize offsetting losses in 2021 were scarce. While we don’t ignore tax consequences of our decisions, we assign a higher priority to maintaining a proper allocation.
Interest rates broadly increased during the year as investors began to incorporate the expectation of higher inflation ahead. The 10-year Treasury yield ended the year at 1.51% after starting the year at 0.91%. The 2-year Treasury yield ended the year at 0.73% after beginning the year at 0.12%. This rise in interest rates put the Bloomberg Aggregate Bond Index into negative territory for the year by over 1.5%. High-yield bonds gained 5.3% as investors took on more credit risk in the strengthening economy. Should inflation continue to be elevated because of labor shortages, supply chain problems, and raw material prices, longterm interest rates will likely rise during 2022 as well. Likewise, short-term interest rates will also rise as the Fed begins to lift its overnight rate, possibly starting in March.
Alternative assets had a generally positive year as investors looked for investments to hedge against inflation. Real Estate (as represented by the FTSE All Equity REIT Index) was up 41.3% during 2021. Low interest rates and a high demand for property helped support Real Estate prices. Crude Oil was even stronger as prices jumped 57% during the year. Tight control from OPEC and restraint from domestic producers thinned inventories helping to send prices surging. Similarly, demand for raw materials and inflation concerns drove broad commodities higher by 27.1%.
Written by Broadway Wealth Management's Portfolio Managers.
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