Quarterly Review and Outlook - December 2021
"Every Rose Has Its Thorn"
A Look Back
The above title is a famous proverb generally used to teach an important fact about human nature—nothing is perfect. “From a thorn comes a rose, and from a rose comes a thorn.” It is also the title of hit song by the band Poison and lead singer, Bret Michaels. The power-ballad was released in 1988 and reached number one status later that year. It was the band’s only chart-topper. I heard the song recently and thought it was a pretty good reminder in our current economic and market environment. The last two years in the market have really been quite remarkable. We have seen patient investors rewarded as we dealt with a health and economic situation that none of us have ever seen before. Dealing with a global pandemic and all that has meant over the last two years, the large-cap bellwether stock index S&P 500 has delivered returns of over 18% and 28% in 2020 and 2021, respectively. Further, over the last three calendar years, the index is up 100% in total…that is right…it has doubled since the end of 2018! Other stock indexes didn’t fare nearly as well, as we saw some huge differences in performance. Smaller-capitalization stocks did worse, as Mid-Cap stocks were up 22% and Small-Cap up 14.8%, only around half of the S&P 500. The gap grows more when we examine international equities in 2021. Developed countries had a positive return of 11.2% in 2021, as the Emerging Markets Index, which is dominated by China, was actually negative for the year, returning -2.5%. International stocks are typically added to the portfolio because they diversify the allocation and increase the overall investable universe for investors. Over the last couple of decades, the correlation has increased…what was generally good/bad for one, was the same for the other. The argument for an increasingly global economy was becoming more evident…until last year. You just don’t typically see the magnitude of return volatility as we saw last year, where there was a 30% difference between the S&P 500 and Emerging Markets.
The chart on the next page shows the cycles of equity performance between U.S. and International Developed countries. The purple shading represents when international stocks have outperformed, and the gray shading shows when U.S. stocks have fared better. There has really been a growing out-performance from U.S. stocks since the onset of the Great Recession timeframe of 2007-08. Over the 14 years from 2007 through 2021, the U.S. has enjoyed a cumulative outperformance of 275%. They call these rotations of winners and losers cycles for a reason…yesterday’s losers tend to be tomorrow’s outperformers and vice versa.
The difficult part is determining when the worm is going to turn, but charts like the one above are useful in at least saying that it has, indeed, been a long run of U.S. dominance, and it is probably sooner rather than later, that international stocks have a chance to do better. The trend is your friend…until it isn’t…and those prickly thorns show themselves.
We believe the asset class table above is especially revealing now. It shows how different asset classes weave in and out of favor over time, and how a more conservative balanced allocation, denoted in white, has performed. REITs and Commodities did particularly well in 2021. Commodities, specifically, have a long way to go to make up for a decade of severe underperformance. Typically, that asset class does not do well in periods of low or lower-trending inflation like we have had in the U.S. over the last 15 years. If inflationary pressures that we see currently in the U.S. persists, then Commodities have a real chance to continue their turnaround.
Importantly, what has happened in the core Fixed Income world has affected traditional asset allocations across the spectrum. The Bloomberg Aggregate was down -1.5% last year. It was a reminder to investors that bonds can have negative returns in the short-run. The table below shows how rare that occurrence has been over the last 50 years. 2021 marked just the fourth time in those fifty years where core bonds have been negative, with the worst year being 1994 returning -2.9%.
So, why hold bonds in this environment? Well, the truth is they still provide a significant diversification from traditional stocks and can help to cushion the blow from stock declines…even in a potentially rising short-term rate scenario
Rising Rates Can Have A Silver Lining For Bond Investors
When the Fed raises short-term interest rates in a measured way (Fed tightening), this can be good news for long-term investors exposed to bonds.
- Bonds remain a critical component of a diversified portfolio as they help dampen the volatility of stock exposure.
- During periods of rising interest rates, regular coupon payments and reinvestment in new higher-yielding bonds help cushion the impact of declining prices for existing bonds and can boost total return over time.
- During past periods of Fed tightening , total returns for bonds (as measured by the Bloomberg Barclays U.S. Aggregate Bond Index) were fairly benign, and any loss was limited to one year.
A Look Forward
So far, January has been a real clunker for stock investors. The continued wave of the Omicron variant weighed on global economies, along with the continued pressures of persistent inflation across many sectors, stubborn supply chain disruptions, and an increasingly picky workforce that has left many employers struggling to fill positions just to name a few. We have talked for some time about our concerns about stretched valuations in the stock market and concerns over the idea that inflationary pressures were “transitory.” Those concerns still remain in the short to intermediate term. The S&P 500 just recently, and finally, hit a technical correction territory of being down -10% from a peak. We had not seen such a move since mid-2020, when we typically see these corrections around twice a year. We believe that the current volatility might be around for a bit as investors digest the impending rate hikes and increasing inflation numbers. However, as we have discussed, core fixed income has its own obstacles in the short-term. Other asset classes like Commodities and those that have fared well in times of rising inflation may very well do better. We have a slight overweight to stocks over bonds right now, and have introduced allocations to other non-traditional asset classes as we continue to navigate these headwinds. History is comforting in that we have been here before. Yesterday’s losers often become today’s winners. Patience in a thoughtful, diversified asset allocation program works over time, while taking advantage of short-term price fluctuations. And, realizing that, while roses remain beautiful, they still have their thorns.