It Was Better Than It Felt
From the violent insurrection at the US Capitol on January 6th through the rapid spread of the Omicron variant at year-end it felt like the bad news never stopped coming in 2021. Hopes for political calm after over four years of turmoil and for an end to the pandemic with the arrival of vaccines were dashed. Even as the economy continued to re-open and growth was strong supply chain blockages and other issues led to inflation at a 40-year high. Consumer confidence fell and the public was in a grim mood.
But yet the US stock market was practically euphoric, posting the third straight year of double digit returns and closing at near-record highs. The S&P 500 rose an impressive 28.7% for the year, 11.0% of that in the fourth quarter. New companies arrived on the stock market at a record pace, with 1,000 initial public offerings (IPOs) raising $1 trillion from investors. If the public had just focused on the stock market – as it often does – it would have been in a much better mood.
Does this mean that the stock market was disconnected from reality? Not at all. The US economy boomed in 2021, corporate earnings rose and the job market was strong, with wage growth the highest in years. The Economist magazine estimates that the US economy grew 5.5% in 2021, the fastest rate in decades. By December unemployment had fallen to its pre-pandemic level: 3.9%. Estimates collected by Factset forecast that US companies will have seen profits grow 45.1% for the year. These impressive numbers alone have been very positive for the stock market. In addition, the Recovery Act passed by Congress in the spring pumped substantial amounts of money into a then much weaker economy while the Federal Reserve did not begin to withdraw its extraordinary monetary support until late in the year. Just as happened in 2020 there was plenty of cash while stocks were the most attractive option with interest rates at rock bottom. Once again, the US market did much better than international markets, which rose only 8.0% (MSCI All Country World Index ex-US).
The stock market hardly went up in a straight line, however, and the continued rally hid some less positive trends. In the first half of the year optimism about the prospects for growth and an end to the pandemic led investors to buy riskier investments such as smaller companies and IPOs. And who can forget the frenzy surrounding “meme stocks” like GameStop and the excitement over highly speculative SPACs (“Special Purpose Acquisition Company”)? When inflation first spiked in the spring investors were not soothed by the Federal Reserve’s assurances that it was “transitory” and the stock market retreated. As the Fed got tougher, investors were reassured and started buying again but this time they were much more cautious and did not return to the indiscriminate buying seen in the first quarter. Shares of relatively safer big companies did best, with those of smaller companies lagging well behind them. The SPAC excitement started dying down when the SEC began taking a tougher line on these speculative investments. Half of the record number of IPOs ended up below their initial price by year-end.
In contrast to the exuberance in stocks, bonds had their first year of losses since 2013. US interest rates had been on a long-term downward trend since the early 1980s and by the end of 2020 they appeared to have gone as low as they could. The benchmark Ten-Year US Treasury yield rose from 0.93% at the beginning of 2021 to 1.52% at the end.
Not all bonds were bad investments in 2021, just like not all stocks were good investments. The safest bonds – US Treasuries - were the worst place to be in the bond market since their prices had nowhere to go but down. The riskiest corporate bonds – less sensitive to higher interest rates and benefiting from strong growth did especially well. Municipal bonds also did well with the Recovery Act and the Infrastructure Bill both directing federal government money towards local governments. Inflation-linked government bonds also did very well, of course.
US investors in foreign bonds lost money as well because of the stronger dollar. The booming economy and the expectation of higher interest rates drew more money into the US, leading the dollar to strengthen against most other currencies.
If your portfolio consisted largely of the biggest US companies and a mixture of inflation-linked, municipal, and high yield corporate bonds, you just had a very good year.
So much for “Transitory” Inflation!
Inflation kept on rising all year after first spiking in May and by year-end had reached 7.0%, the highest level since 1982. The problem is not limited to the US: inflation has been rising across developed economies as voracious consumer demand for goods (spending in services remains well below pre-pandemic levels) has run straight into manufacturing shortages and supply chain constraints. This is the downside of the strong economic rebound.
The Federal Reserve has long since stopped promising that the spike in inflation is “transitory” and is now talking tough. In his recent reconfirmation hearings Fed Chair Jerome Powell pledged to “keep higher inflation from becoming entrenched.” The minutes of the Fed’s December meeting made it clear that monetary policy is likely to become tighter sooner. The Fed has accelerated the pace of its withdrawal from bond purchases and is now expected to raise rates three or four or even five times this year.
Treasury Secretary Janet Yellen has gone out on a limb and predicted that inflation will be back to the 2% range by year-end but few others seem ready to say that inflation has peaked. The supply chain issues that have been largely responsible have not gone away and have, in fact, been worsened by the rapid spread of the Omicron variant. While energy prices have retreated some, rents, and prices of used cars and food are rising. The bond market is forecasting that inflation will fall again, as reflected in longer-term interest rates, but the distortion caused by the Federal Reserve’s vast bond holdings make this signal unreliable.
As worrying as inflation is, the Federal Reserve’s response to it has investors just as worried. Bringing down inflation without triggering either a recession or trouble in the bond market can be a delicate balancing act. The Fed seems to have been caught by surprise by the persistence of inflation and is now under pressure to act quickly, which increases the risk of an “accident”. This is always a concern when the Fed begins to hike interest rates but this time the concern is magnified by the fact that the Fed aggressively bought bonds to keep the economy afloat in the depths of the pandemic and now has a vast bond portfolio that it is expected to start selling as it raises interest rates. Getting back to normal is going to be very tricky. The market is likely to remain worried about these questions for some time.
A simple and low risk way to help reduce inflation would be to roll back the Trump tariff increases. This would also reduce tensions between the US and its trading partners in Canada, Europe, China and elsewhere. Unfortunately, this move does not appear to be under consideration.
Sustainable Investing under Scrutiny
Sustainable investing has been continuing to make its way into the mainstream, attracting large inflows from investors of all types. Prominent investors including the head of the Norwegian sovereign wealth fund and Larry Fink, CEO of giant fund manager Black Rock have been vocal supporters of the trend. Naturally a backlash has set in.
In keeping with the politicization of practically everything in the US, sustainable investing is now being called “woke capitalism” by some on the political right. Climate change denialism is a key element of this backlash but it is far from the only issue that is rallying opponents of sustainable investing. Recently the Governor of Texas has signed two anti-ESG laws. The first of these turns the idea of divesting from carbon on its head by banning state investment in firms that won’t do business with the oil and gas industries. The second forbids the state or local governments from doing business with banks that that do not lend to gun manufacturers. This has already led some of the large banks to pull out of the municipal bond business in Texas.
On the investing side of things new ETFs (Exchange Traded Funds) have been created that are designed to appeal to right -wing investors, including one whose ticker symbol is “MAGA”. These ETFs invest in oil and gas stocks, gun manufacturers and other companies perceived to be sympathetic to right wing views or at least “unwoke”. It remains to be seen how well they will perform. Politically driven investments do not have a very good track record.
A more serious challenge to the sustainable investing movement was revealed in an investigation of MSCI’s ESG ratings by Bloomberg Businessweek:
MSCI is the world’s leading creator and provider of stock market indices, a business that has boomed along with ETFs in recent years. It also has an arm that provides ESG ratings that are widely relied on by investors seeking to invest sustainably. Bloomberg Businessweek’s investigation found that MSCI does not rate companies according to their impact on the world – the standard way of doing ESG analysis – but instead according to the world’s impact on them. For example, Bloomberg cites the case of McDonald’s, a major contributor to climate change due to its vast consumption of beef which also generates a great deal of packaging, of course. MSCI rates McDonald’s highly on carbon emissions because the company is not directly exposed to the risk of increased regulation of carbon and gives it credit on waste management for instituting a recycling program in certain markets where it has become mandatory. This turns one of the supporting arguments for sustainable investing – that it helps investors avoid ESG risks – on its head. The article is very much worth reading in full as it exposes the hollowness of MSCI’s ESG ratings and shows how “greenwashing” puts the credibility of sustainable investing at risk.
The news was not entirely surprising to White Pine Advisory. As mentioned in a previous report, our investigation of Black Rock’s MSCI ESG Aware suite of funds revealed that they only exclude the most extreme cases of carbon emissions such as oil sands while holding large oil companies and no attention at all is paid to social and corporate governance issues. This is another useful reminder that investors who care about sustainability need to look carefully at their investments.
Now What?
Those of us who were cautious on the markets back at the beginning of the fourth quarter were clearly a few months too early. So far 2022 has seen the concerns we expressed in October driving negative performance by both stocks and bonds. The outlook for inflation and anticipation of the Federal Reserve’s moves to bring it back down seem likely to continuing being top of mind for investors, at least until the path to 2% inflation is clearer. As interest rates rise, stocks will no longer be the only attractive investment available as they have been for the last two years of rock bottom rates. In the past stock markets have often rallied as the Fed embarks on an expected rate hiking cycle. It remains to be seen if that will happen again later this year.
In addition to inflation and the Fed, investors have to worry about the continued pandemic (what’s next: yet more variants or does it gradually fade out?) and increased geopolitical risk, given Russia’s troop buildup on Ukraine’s borders. A further concern is China’s zero tolerance COVID policy, which has led to entire cities (including their port facilities) being locked down, causing severe disruptions to trade.
On the positive side, US corporations are in very good shape. Most are coming off a year of impressive earnings growth. The corporate sector as a whole has paid down substantial amounts of debt and is well positioned to weather higher interest rates. Tighter monetary policy and supply chain improvements have a good chance of leading to lower inflation by year end. Maybe, just maybe, after a few more months of volatility 2022 will be the year that things get back to normal.
Urban Larson
Principal
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