The stock market kicked off the fourth quarter with a powerful rally in October and added to those gains into November. Markets, as a rule, do not like surprises, and the Q4 one-two punch of an emerging and highly transmissible COVID-19 Omicron variant combined with a suddenly more hawkish Fed sent stocks into a skid that largely erased November’s accumulated gains.
Investors soon learned the contours of what a less dovish monetary policy would look like. In the face of escalating inflation and an improving labor market, the Federal Open Market Committee (FOMC) announced plans in December to speed up its bond purchase tapering schedule. Once tapering is concluded in March 2022, the Fed signaled that up to three rate hikes might follow.
However, in the final weeks of the quarter, markets settled down. Strong third quarter corporate profits kept their momentum into Q4 with an earnings growth forecast of 20.9%. If realized, it will mark a historical high in corporate profits.1 Additionally, early indications suggested that Omicron’s health impact was not as severe as its predecessors. Relieved that the economic consequences of yet another virus variant may be less than initially feared, reinvigorated investors jumped back into the market, pushing stocks higher into the end of December and capping off a strong year of performance.
ECONOMIC CONDITIONS: MODERATING EXPECTATIONS
U.S. – Continuing Rebound
GDP: After a Delta variant-induced slowdown in Q3, signs are pointing to a strong economic rebound in the fourth quarter and solid growth into 2022. Though the official Q4 economic growth rate won’t be reported until January’s Gross Domestic Product (GDP) report, according to the Federal Reserve Bank of Atlanta, which tracks economic data in real time, their model is indicating a 7.2% annualized real rate of Q4 GDP growth. 
UNEMPLOYMENT: The labor market evidenced considerable recovery as initial jobless claims fell steadily. The unemployment rate shrank to 4.2% in November as some 600,000 Americans entered the labor market and the labor participation rate rose to pre-pandemic levels. 
HOUSING: Rising prices for homes have been a boon for sellers in 2021, but recent data suggests that buyers have felt a record-level strain in terms of affordability. A fourth- quarter 2021 U.S. Home Affordability report showed that median-priced, single-family homes in 75% of U.S. markets were historically less affordable during Q4 2021—up from 39% of markets in 2020.
INTERNATIONAL: Still in Recovery
The economic outlook in European Union (EU) countries remains encouraging despite the rise in Delta and Omicron variant infections and instances of some countries, e.g., Austria and Germany, instituting fresh economic restrictions. Maintaining this economic growth momentum has been primarily a result of continued progress in the region’s vaccination efforts. As a consequence, the EU economy is projected to grow by 5.0% for the full year 2021 and by 4.3% in 2022. Domestic demand and an improving labor market are expected to drive this economic improvement; but inflation, ongoing supply chain bottlenecks, and the Omicron variant are the main risk factors that could upend this otherwise strong forecast. 
The Bank of England is less sanguine about the United Kingdom’s outlook for economic growth. While U.K. GDP growth in 2021 is expected to be a very healthy 7.0%, the estimated growth rate for the fourth quarter was shaved due to supply chain disruptions. For 2022, the U.K.’s central bank is forecasting a 5.0% expansion in GDP. Similar to other countries, continuing supply chain problems, inflation, and the spread of COVID-19 represent risks to the U.K. economy in the months ahead. 
Economic growth in China slowed considerably in the latter part of 2021. In fact, GDP growth in the third quarter was the slowest growth rate in a year (+4.9%), and materially lower than the second quarter growth rate of 7.9%. Economic growth is forecasted to further decelerate in Q4 2021 and remain weak into the first half of 2022. There are a variety of factors that are weighing on China’s economy, including its zero-COVID policy, power shortages, massive debts held by property developers, and the drag of government regulation on private sector businesses. 
The Bank of Japan shaved its 2021 forecast for economic growth from 3.8% to 3.4% but raised its estimate for GDP expansion in 2022 to 2.9% (up from 2.7%) citing the effects of coronavirus infections and the expectation that the Japanese economy would rebound as the country slowly emerges from the pandemic. 
EQUITIES: Emerging Market Uncertainty
U.S. EQUITIES: U.S. equities rose robustly in Q4 despite a weak November marred by fears of Omicron and Fed policies. By year-end, these worries had largely subsided and data continues to indicate that the overall economy remains stable and corporate earnings are strong. After another strong quarter, the S&P 500 index finished up 28.71% for the year. The Nasdaq Composite ended 2021 on a six-month win streak, and the Dow Jones Industrial Average advanced for a fifth straight month in December. Small cap firms also did well on the whole. The Russell 2000, widely accepted as Wall Street’s leading small-company index, rose 13.70% across 2021. 
DEVELOPED INTERNATIONAL EQUITIES: The MSCI EAFE index, which tracks developed-economy stock market performance in Asia and Europe, gained 8.78% for the year. Many of the world’s consequential stock indexes made double-digit gains in 2021. France’s CAC 40 28.85%, Taiwan’s TWII 23.66%, Mexico’s Bolsa 20.89%, and the EuroStoxx 50 20.56%. Japan’s Nikkei 225 added 4.91%.
EMERGING MARKETS: The MSCI Emerging Markets Index lost value in Q4 and underperformed the MSCI World Index, with U.S. dollar strength a headwind. Turkey was the weakest index market amid extreme volatility in currency. The central bank lowered its policy rate by a total of 400bps to 14%, despite ongoing above-target inflation which accelerated to 21.3% year-on-year in November. With the lira coming under significant pressure, President Erdogan announced an unorthodox scheme to compensate savers for lira weakness, in an effort to reduce the use of U.S. dollars. Russia lagged as geopolitical tensions with the West ratcheted up amid a build-up of Russian troops on its border with Ukraine. China also finished in negative territory as concerns over slowing growth persisted, exacerbated later in the quarter by uncertainty created by rising daily new cases of Covid-19. At quarter end, the FTSE Emerging Market index dropped -1.01%, bringing its full year return down to -0.19%.
FIXED INCOME: Hawkish Tone
U.S. FIXED INCOME: As bond prices dropped, interest rates in the bond market rose. The return on the 10-year Treasury reached 1.78% in March; when the bond market closed on New Year’s Eve, the 10-year note was yielding 1.51%. For much of 2020, its yield was below 1%. [16,17]
DEVELOPED INTERNATIONAL FIXED INCOME: The U.K. 10-year yield fell from 1.02% to 0.97%, dropping sharply in early November as the Bank of England (BoE) unexpectedly elected not to raise rates. The BoE did, however, raise rates in December and with fears over the Omicron variant fading, yields rose. The 2-year yield sold off, from 0.41% to 0.68%. Germany’s 10-year yield was little changed, from -0.17% to -0.19%, but this reflected a late sell-off with the yield having fallen below -0.40% in December. Italy’s 10-year yield increased from 0.86% to 1.18%. Eurozone inflation picked up considerably, rising to the highest level since 2008 and to a near 30-year high in Germany. European Central Bank President Christine Lagarde broadly affirmed dovish messages, but comments from other ECB officials were more hawkish.
QUARTERLY FOCUS: The Case for Investing Abroad
One of the leading storylines in equity markets over the past decade has been the seemingly impenetrable leadership of U.S. markets. Heading into 2020, U.S. stocks had outperformed both emerging markets (EMs) and other developed markets (DMs) in seven of the preceding nine years. Then, in 2020 and 2021, amid the pandemic and rapid economic rebound, the S&P 500 beat other DMs and EMs by a combined 29% and 32%, respectively.
Sticking to the script, international stocks continued to be outpaced by their domestic counterparts in 2021. For example, the MSCI EAFE Index of international developed stocks rose 11.3% on the year. The MSCI Emerging Markets Index declined -2.5% on the year, in large part due to an ongoing crackdown by Chinese regulators. The chart below is a clear visual of just how dominant U.S. equity outperformance has been with 2021 punctuating a fourteen-year domestic hot streak:
It’s no wonder international investors have been somewhat frustrated. But for the first time in a decade, earnings growth in 2021 for developed- and emerging-market equities both exceeded the earnings gain for the U.S. As a consequence, the relative valuation of international markets versus the U.S. has become much more attractive in the past year. The valuation premium being assigned to U.S. stocks is the highest it has been since the early 2000s. The U.S. forward Price to Earnings (P/E) ratio is nearly 1.5 times higher compared to the rest of the world. As we can see in the chart to the right, relative to the S&P 500, the ACWI ex-U.S. index, a commonly used barometer for international stocks, trades at an almost 3 standard deviation discount to the U.S.
The experience of the last decade has investors asking, is there any environment in which U.S. markets underperform? While we remain generally positive, we do believe there is a case to be made that 2022 could set the scene for U.S. markets to finally be outperformed abroad.
First, international and emerging market stocks are well-positioned to provide relatively strong performance in 2022 as global growth continues to recover and valuations are notably below their longer-term averages compared to domestic stocks. Second, the growth stock-dominated U.S. markets have become heavily reliant on changes in rates; relative performance of the U.S. vs. the rest of the world has a 0.36 correlation with changes in the shape of the yield curve (flatter = U.S. leads) over the past year, versus a historically negligible correlation. Should the recent curve flattening prove overdone, U.S. markets could lag. Finally, relative economic fundamentals could even out, with growth and earnings in places like Europe and EMs beginning to catch up.
DPWM OUTLOOK: Choppiness Underneath with a Potential for Blue Skies
It is unrealistic to expect a repeat of 2021’s outsized gains, but the consensus on Wall Street is one of modest price gains in 2022 amid continued economic growth and low, though rising, interest rates. While the market may be affected by multiple “known unknowns,” e.g., future coronavirus variants, geopolitical flare-ups, trade frictions, or inflation, we know enough to explore some potential influential factors:
The Federal Reserve began to pivot toward monetary normalization, announcing in December an acceleration of bond tapering and the possibility of up to three interest rate hikes. Markets were anticipating this pivot, and may have already priced it in. However, if the Fed finds itself behind the inflation curve and needs to increase the number of rate hikes or accelerate their pace, it may unsettle investors.
Corporate earnings growth is anticipated to moderate in 2022. This is to be expected considering the rate of economic expansion will likely slow and its comparative period, 2021, established such a high bar. For 2022 Wall Street analysts are projecting an 8.8% jump in corporate profits. While this is a substantial slowdown from 2021, it still represents healthy growth from a high watermark and should companies exceed these expectations, it may help support higher valuations.
Another important market influence may be a slowdown in China’s economy. A deceleration in the growth of the world’s second largest economy may translate into lower consumption of imported consumer goods or production of manufactured goods, representing a potential risk to the global economy.
Possible rate hikes, higher inflation, and moderating economic growth may sound like a recipe for a tepid stock market, but history tells us that stocks are more likely to rise in a rising interest rate environment and during periods of moderate economic deceleration. While past performance is not a guarantee of future returns, it suggests that markets may advance under less-than-optimal circumstances.
Additionally, while the post-COVID recovery peak may be behind us in the U.S., our positioning overseas should benefit from the continuing rebound in earnings and economic recovery abroad.
1. Trading Economics, January 1, 2022
2. Conference Board, December 15, 2021
3. The Balance, December 23, 2021
4. Federal Reserve Bank of St. Louis, December 3, 2021
5. Yahoo! Finance, December 21, 2021
6. CNN Business, March 11, 2021
7. USA TODAY, December 15, 2021
8. Reuters, December 22, 2021
9. International Monetary Fund, January 1, 2022
10. Business Insider, December 23, 2021
11. Bloomberg, December 1, 2021
12. Wall Street Journal, January 1, 2022
13. Barchart.com, January 1, 2022
14. CNBC, December 30, 2021
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