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Economic Growth & Inflation
Despite moderating growth during the second half of 2021, the economic recovery in the U.S. has proven to be resilient to ongoing challenges from the COVID-19 pandemic. Household spending is likely to grow at the fastest pace since World War II. The U.S. consumer has been supported by record-high household wealth, ongoing fiscal assistance programs and tight labor markets helping to fuel wage gains.
Even though real gross domestic product (GDP) moderated during the third quarter, nominal GDP registered the strongest increase in decades. Inflation pressures are lasting longer than Federal Reserve (Fed) policymakers expected and have spread across key economic sectors such as food, energy and housing. Supply chain bottlenecks appear to be easing but demand drivers have kept price pressures elevated. Inflation for the full year of 2021 is likely to register the highest rate in nearly four decades.
Despite a strong rebound in labor market conditions, Fed policymakers remain focused on the nearly 4 million jobs lost since the onset of the pandemic. Labor-force participation remains well below the pre-pandemic level, with women and older workers disproportionately affected. Sharp declines in women’s labor-force participation coincided with the start of the school year twice during the pandemic. A wave of early retirements has created outsized declines in labor-force participation for workers over the age of 55.
Widespread labor shortages have left nearly half of all firms in the U.S. unable to fill open positions. The record-high quits ratio and new labor agreements reflect a shift in the balance of power from employers to employees. Companies are beginning to react to the new environment by raising prices, increasing the likelihood that inflation will become more self-reinforcing.
Monetary & Fiscal Policy
During the November Federal Open Market Committee (FOMC) meeting, the Fed announced the beginning of the end for its ultra-accommodative monetary policies, starting with a plan to wind down its government bond purchases by $15 billion per month. This plan was quickly revised at the December FOMC meeting following new economic and inflation data coming in stronger than expected. The Fed doubled the pace of tapering to $30 billion every month and is now on a path to end new net asset purchases by the end of the first quarter.
Despite mounting criticism that policy was getting too far behind the curve on inflation, Fed Chair Powell stayed the course with his dovish bias until his December congressional testimony, when he surprised the market with an abrupt U-turn in outlook. His hawkish pivot included retiring the word “transitory” from his inflation forecast.
The immediate and historic fiscal policy response in the U.S. to reduce the economic and human damage from the COVID-19 pandemic continued into 2021. The $1.9 trillion American Rescue Plan was signed by President Biden in March. This package contained numerous financial support measures for individuals and businesses hit hardest by the economic shutdown. Schools and state and local governments also benefited from the new spending package.
After facing disagreement within the Democratic Party over tying passage of the bipartisan infrastructure and social infrastructure bills together, the House of Representatives passed the Infrastructure Investment and Jobs Act in early November. However, concerns started to mount in Washington, D.C., that additional fiscal spending would only add to the recent spike in inflation.
After the House passed the Biden administration’s Build Back Better plan, Sen. Joe Manchin derailed the bill in the Senate. A slimmed-down package of so-called social infrastructure spending remains a primary focus for President Biden, who is looking for another legislative victory prior to the midterm elections.
Interest Rates & Credit
Treasury yields moved higher and the yield curve steepened materially during the first quarter as the economic recovery and inflation shifted into high gear. A disastrous 7-year Treasury auction in late February led to an abrupt spike in yields. The bond market volatility spilled over into the stock market, with large-cap technology names such as Apple and Alphabet taking the brunt of the damage.
The sell-off in Treasury bonds was short-lived, as investors shifted their concerns to the COVID-19 delta variant and an economy that was approaching peak growth rates. Investors also started to buy into the Fed’s view that higher inflation was likely transitory. The 10-year Treasury rate moved below 1.25% by mid-July, more than 50 basis points below its first-quarter close.
Interest rates resumed their march higher in September as supply shortages and tight labor market conditions showed no signs of easing. Despite the increase in nominal Treasury rates, yields for Treasury Inflation-Protected Securities (TIPS) continued to move deeper into negative territory throughout 2021. Yields on 10-year TIPS reached a historic low of -1.21% in early November.
Following a year of historic credit-market volatility, credit spreads held steady with a modest tightening bias for the majority of 2021. Investment-grade corporate bonds traded in a relatively narrow range this year, near the tightest levels witnessed since the global financial crisis.
Despite a weak close to the year, the high-yield bond market also exhibited relative calm during 2021 as spreads grinded tighter. The less interest-rate-sensitive high-yield market witnessed less price volatility and higher returns throughout the year relative to the investment-grade corporate bond market. High-yield default rates trended lower throughout 2021 and closed the year near the lowest levels on record.
Exhibit 1. Bond Market Performance (1-Year as of 12/31/2021)
Source: Bloomberg
Equity Markets
Equity markets continued to climb higher this year despite a growing wall of worry: inflation running at the hottest level in nearly four decades, new COVID-19 variants threatening the economic recovery and central bank policy likely to turn less accommodative. Investors have instead remained more focused on the strong corporate earnings picture and the lack of attractive alternatives across the fixed-income markets.
Earnings and revenues have consistently exceeded estimates across all sectors. Full-year S&P 500 Index earnings are expected to register a nearly 50% gain over 2020, which was negatively impacted by the COVID-19 pandemic.
2021 started with investors moving away from growth stocks toward more economically sensitive reopening sectors, including cyclicals, energy and banks. However, the long-anticipated “great rotation” was short-lived. The first-quarter interest rate spike quickly reversed course, helping to bring growth stocks back into favor for the remainder of the year.
Developed market global equity markets also rallied this year but again failed to keep pace with U.S. market performance. China’s regulatory crackdown on a wide range of businesses weighed heavily on emerging market index performance. In sharp contrast to their U.S. counterparts, large-cap technology names in China such as Alibaba and Tencent were especially hard hit by the country’s policy actions.
Exhibit 2. Financial Market Performance (1-Year as of 12/31/2021)
Source: Bloomberg
As we enter a new year, what can investors expect in 2022? Be sure to check back next week for our 2022 Capital Markets Outlook!
Index Definitions:
Bloomberg Barclays U.S. Aggregate Bond Index – An index that is a broad-based flagship benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency).
Bloomberg Barclays U.S. Corp High Yield – An index that measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded.
S&P 500 Index – An index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe.
MSCI EAFE Index – An index that is designed to measure the equity market performance of developed markets outside of the U.S. & Canada.
Russell 2000 Index – An index measuring the performance of approximately 2,000 small cap companies in the Russell 3000 Index, which is comprised of 3,000 of the largest U.S. stocks.
MSCI Emerging Markets Index – A free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.
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Disclosures:
The views expressed in this material are the views of PMAM through the year ending December 31, 2021, and are subject to change based on market and other conditions. This material contains certain views that may be deemed forward-looking statements. The inclusion of projections or forecasts should not be regarded as an indication that PMAM considers the forecasts to be reliable predictors of future events. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate. Actual results may differ significantly.
Past performance is not indicative of future results. The views expressed do not constitute investment advice and should not be construed as a recommendation to purchase or sell securities. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed. There is no representation or warranty as to the accuracy of the information and PMAM shall have no liability for decisions based upon such information.
