COVID, crypto, and inflation, oh my! Each year significant events occur and may impact our lives, economy, and the investment markets. That, as they say, is life. 2021 was no different.
Despite COVID waves and COVID seemingly becoming endemic to our lives, investors continued to pour money into assets like stocks, real estate, and crypto currency. These assets have been bid up as investors flush with cash seemingly felt that they had little opportunity in safer assets due to low interest rates. Earnings growth was undoubtedly strong with S&P 500 earnings projected to be up about 45% versus 2020.
Fixed income markets were jolted by some of the highest inflation data in over 30 years, reporting a 6.8% annual increase through the end of November. About half of this increase was from energy prices, which cratered in 2020.
The U.S. stock market posted its third straight year of double-digit returns. As usual, when looking under the hood of the broad market, returns within the stock market were not equal. Small growth stocks returned just 2.8% while small value and large blend stocks returned a whopping 28%. Value stocks outperformed growth stocks for the first time in years. However, growth stocks are still priced at a level above value stocks not seen since the Tech Bubble, as is the broad U.S. market.
Foreign stocks were harmed by an appreciating U.S. dollar and again underperformed domestic stocks. Yet, they still managed to gain 11.3% as measured by the MSCI EAFE Index. Not accounting for currency swings, these stocks gained 18.7%. Emerging Market stocks struggled, posting a 2.5% loss for the year.
Fixed income investments, as measured by the Bloomberg US Aggregate Bond Index lost 1.5%, as interest rates began to climb.
Real estate rebounded sharply after certain segments like retail and office were hard hit during shutdowns in 2020.
The spike in inflation and low unemployment numbers is expected to push the Federal Reserve to increase the federal funds rate three times next year to a rate between 0.75%-1.00% — still quite a bit lower than the long run estimate of 2.50%. Investors need to navigate the fixed income market carefully as rising rates would continue to put pressure on bond prices.
Earnings growth will be more difficult moving forward as wage pressure and other cost increases will begin to eat away at company profit margins. If interest rates increase more than expected and in a swift manner, this too would likely stifle stocks returns, especially higher growth sectors such as technology.
With high valuations and low-interest rates, investors will likely see lower returns within both stocks and bonds over the next 5-10 years versus the past 5-10 years. Favoring assets that are more attractively priced should help bolster things a bit.
Foreign stocks have underperformed U.S. stocks by 275% over the past 14+ years – the longest streak in history. There was a period in the last 1980’s where foreign stocks outperformed the U.S. by over 370% (remember when Japan was going to take over the world?). Perhaps 2022 will begin a reversal.
While no one has a working crystal ball, you and should have reasonable expectations for investment outcomes. Unreasonable expectations may lead to poor investing decisions, poor retirement planning and spending decisions, and a lack of peace of mind for starters.
And don’t forget diversification. As Nobel winner Merton Miller has said, “Diversification is your buddy and the closest thing to a free lunch.”