- Tailwinds from highly supportive monetary and fiscal policy are likely to diminish
- The pandemic, inflation and the Fed, Washington, China, and earnings are key focus areas moving into 2022
- Most Sequoia strategies remain generally neutral equities/fixed income, with modest tilts toward higher quality U.S. equities, U.S. Small Cap, and lower fixed income duration than broad indices
“Transitory” was the financial word for 2021. The Federal Reserve insisted for most of the year that clearly rising inflationary pressures were transitory and would go away rather quickly. They did not, and inflation rates on many measures hit highs not seen since the early 1980s1. As a result, the Fed was playing catch-up in Q4 by quickly “retiring” the word transitory, reducing the amount of quantitative easing significantly, and signaling the potential for 2-3 interest rate hikes in 2022. Delta and Omicron were two other important words in 2021. Many, including our team, expected vaccines to be widely accepted across the globe and the beginnings of the end of the Coronavirus pandemic to appear. Delta and Omicron have shown the resilience of the Coronavirus and how unpredictable pandemics can be, but we are still holding out hope we will see a significant reduction in the rates of infection and more normal life patterns emerge in 2022. It was also a year of excessive speculation (in our view) with things like SPACs, IPOs, meme stocks, cryptocurrencies, and many others garnering demand from excessive liquidity from the Fed and Fiscal Authorities.
Yet, in the face of rising inflation, surges in the pandemic, and excessive speculation, the US economy was resilient with strong GDP growth and significant job creation. It appears U.S. GDP growth will come in around 6% for 2021, which will be one of the highest rates since 19841. Given this strong economic backdrop, stock markets performed remarkably well as corporations generated record earnings growth1. The S&P 500 was up 28.71% for the year and our global equity benchmark, the MSCI ACWI IMI was up 18.22%, which are clearly fantastic gains2. Cyclical sectors that typically perform well in a strong economy like Energy, Real Estate, and Financials led the pack in the U.S2. However, Emerging Markets equities had a tough year in 2021 with the MSCI EM Index down -2.54%2. This was heavily driven by poor equity performance in China as the MSCI China Index was down -21.18% in 2021 as geopolitical and slow economic data emerged throughout the year2.
Government bonds had a volatile year, however, as the 10 Year US Treasury yield rose from 0.93% to 1.52%3 over the course of the year, which led the Bloomberg Aggregate Bond Index to a loss of -1.54%2. This was the worst loss for the Index since 2013. While a tough year for high-quality fixed income, we will remind investors that this was only the 4th calendar year loss for the Aggregate Bond Index since its inception in 19761. We still think bonds are an important risk management tool in diversified portfolios. A summary of major asset class and sector performance as well as changes in key rates are at the end of this document.
As we look forward into 2022, we think economic activity is likely to slow but remain robust which is likely to continue supporting earnings growth for corporations. However, many of the other tailwinds that supported financial markets in 2021 are likely to start becoming headwinds. We are therefore focused on the following five key areas to start 2022:
- The Pandemic: The Omicron Coronavirus variant is unfortunately spreading rapidly across the globe as we enter 20221. The surge in cases was felt by consumers as the University of Michigan Consumer Sentiment Index weakened in Q44. However, we do think we are learning to deal with the virus better as a society so broader economic shutdowns appear much less likely. We also think newer treatments will emerge such as the recent news about Pfizer and Merck’s antiviral pill, and perhaps even a vaccine that more people are comfortable with will become available. However, the pandemic is still a key risk for the economy and financial markets as we move into 2022. We will be monitoring how it continues to impact consumer behavior and supply chains in the new year.
- Inflation & Fed Policy: The Federal Reserve’s extraordinarily accommodative monetary policies that were instituted in the depths of the economic lockdowns in early 2020 have been vastly stimulative for risk assets like stocks, corporate bonds, real estate, and speculative areas such as cryptocurrencies. In most commentaries we’ve written, we’ve highlighted that higher trajectories for both the economy and inflation would likely warrant a reduction in the amount of large-scale monetary accommodation as 2021 progressed. In our opinion, with the Consumer Price Index running at rates not seen since the early 1980s1, large supply side disruptions in many materials and labor1, and risk assets near all-time highs1, the Fed has little choice but to become much less friendly to investors. Further, the demand functions in the manufacturing sector, typically a leading economic indicator, remain mostly robust according to the Institute for Supply Chain Management1. Without question, the economy has slowed somewhat with the pandemic surge, but aggregate demand in the economy still appears quite strong thereby necessitating little monetary accommodation. The Fed has clearly been a key supportive force for equities and other risk assets, but we are now moving into a period where the Fed will be significantly reducing accommodation given much stickier inflation than expected. We expect reduced Fed support to create volatility as financial markets adjust in 2022. How much and how quickly the Fed must move in reducing asset purchases and raising interest rates will be something we watch closely.
- Washington: We think Congress and the Executive Branch will likely act on a bill that will offer a decent measure of infrastructure spending (needed to improve productivity and thereby help combat inflation) in 2022. We think the bill will likely be much smaller than the proposals in 2021. As with monetary policy, fiscal policy was decidedly supportive of the economy and financial markets in 2021. Also, like monetary policy, and regardless of the infrastructure bill, we think fiscal policy will be much less supportive to the economy and financial markets in 2022. Adding to this, mid-term election years are typically more volatile leading up to the elections, so this is another potential issue we will be following closely in 2022.
- China: China’s economy has slowed quite rapidly over the last few quarters. The Manufacturers Purchasing Managers Index (PMI) fell into contractionary territory (below 50) over the last several months of 20211. Further, stresses are showing with real estate developers such as China Evergrande1. The real estate market, as with most other nations, is a large portion of China’s economy. For perspective, it is estimated that China spent about 10% of GDP on real estate development in 20205. This all led to weak equity markets in China in 2021 as mentioned. We think China’s leadership will likely turn to stimulative measures and support for these issues in the short run but worry the slowdown may start to spill over to the global economy. As the world’s second largest economy, a slowing China can have large ramifications on financial markets. Should we see a disorderly unwind of China Evergrande and continued data prints like the recent PMI data, we would become more concerned that it could become contagious for the global economic system. We do not think this is the likely scenario presently, but something that was a tailwind (an improving Chinese economy in 2020 and early 2021) now appears to be more of a headwind.
- Earnings: Earnings growth was stellar in 2021 given strong monetary and fiscal stimulus along with economic reopening assisted by vaccines. The estimated earnings growth rate for 2021 was an astounding 45% for S&P 500 companies according to FactSet6. In 2022, we will be focused on what executive teams discuss during conference calls regarding inflation, supply chains, and labor shortages this year. Also, getting a better idea how executives view aggregate demand in the US and Chinese economies prospectively will be top of mind. Strong earnings growth has been a major tailwind for markets in 2021, but we may start witnessing that support turning into headwinds as earnings growth is likely to slow in 2022.
While we are still optimistic that the US economy will continue to perform quite well, we do worry financial markets may be in for a much bumpier ride in 2022 as recent tailwinds start to fade into headwinds. As such, most Sequoia strategies remain broadly balanced (neutral) relative to equity/fixed income targets, with modest tilts toward US higher quality equities, U.S. Small Cap, and lower fixed income duration than broad indices. For example, our 70% equity/30% fixed income strategies are generally in-line with these “neutral” points (i.e., not materially greater than or less than 70% equity). Also, within fixed income allocations, several strategies hold managers that have flexibility to adjust duration and search for sectors and bonds that are positioned relatively well and backed by well-capitalized assets. This is the same positioning and conclusions we drew at the start of 2021 and each quarter since. In Q4, we maintained an overweight to U.S. smaller companies which typically do well in rising inflationary environments. We also maintained exposure to equities in Europe and many developed nations that offer compelling valuations relative to the U.S. as they continue to reopen their economies. We do think international markets may offer value to investors if the pandemic doesn’t get materially worse, so we may reduce our U.S. overweight as we progress in the new year. Generally, our asset allocation decisions allowed us to perform reasonably well compared to our benchmarks net of fees, while not taking on excessive risk in an increasingly uncertain environment.
Our goal is to provide diversified, long-term focused strategies that fit well into our clients’ financial plans and objectives. In the current environment, we think it is paramount to be patient and disciplined. We also suggest investors temper expectations for future stock market performance after a strong 2021. As markets price how the pandemic continues to impact the economy, and we witness developments in inflation and Federal Reserve policy, fiscal policy from Washington, China’s economic slowdown, and monitor commentary from executives during earnings season, we think markets may be more volatile than we’ve experienced in quite some time. If so, we think opportunities to rebalance portfolios and find bargains may emerge as we progress in 2022.
As always, thank you for your confidence in our team,
Asset Management Department
Sequoia Financial Group
Sources: 1. Bloomberg 2. Morningstar Direct 3. Treasury.gov 4. NY Times COVID Tracker 5. https://www.wsj.com/articles/chinas-evergrande-debt-crisis-sizing-up-a-big-mess-11633253402?mod=searchresults_pos4&page=1 6. FactSet Earnings Insight 12/17/21
The views expressed represent the opinion of Sequoia Financial Group. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Sequoia believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Sequoia’s view as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements. Investing in equity securities involves risks, including the potential loss of principal. While equities may offer the potential for greater long-term growth than most debt securities, they generally have higher volatility. Past performance is not an indication of future results. Investment advisory services offered through Sequoia Financial Advisors, LLC, an SEC Registered Investment Advisor. Registration as an investment advisor does not imply a certain level of skill or training.