Q4 2021 Insights
Global financial markets delivered mixed performance in the fourth quarter, finishing off a year that saw strong gains for U.S. equities, respectable returns for developed markets, and small declines for emerging markets and core bonds. Investors grappled with the uncertain economic effects of the highly contagious (though less fatal) Omicron variant of Covid-19, continuing global supply chain disruptions, and rising inflationary pressures. Reflecting the varied global experiences fighting Covid-19, in the fourth quarter decisionmakers around the world began unveiling divergent strategies regarding the eventual normalization away from low interest rates, record fiscal stimulus, swollen central bank balance sheets, and episodic restrictions on travel and other social activity. Investors shrugged off many of these concerns and uncertainties, and continued to put more capital into risk assets, especially in sectors with already stretched valuations (e.g., large-cap growth and real estate stocks in the U.S.).
As we entered the new year, market volatility suddenly intensified as investors had to digest a series of negative developments – record inflation in the U.S., a more hawkish Federal Reserve aiming to accelerate rate hikes and balance sheet tapering, rising geopolitical tensions, and disappointing earnings guidance citing higher costs and ongoing supply chain disruptions. Prices of the most speculative assets (particularly shares of unprofitable firms and digital currencies) fell sharply in December and January as investors revalued their true growth potentials against higher discount rates and the unwinding of easy-money support to capital markets.
That said, amid all this revaluation, market volatility (as measured by the VIX Index¹) remains near its long-term historical average and far below the extremes witnessed in 2020 or 2008. As we commented in our previous letter, the mid-stage of the business cycle is typically when markets are the most turbulent – this cycle is no exception. It is these moments when volatility picks up that the virtues of prudence, patience, and discipline are the most valuable to investors.
Our message to clients is simple: do not attempt to time the local peaks and valleys of markets (it is almost always a fruitless endeavor) – active managers are topping up high-conviction positions on your behalf as markets decline. Avoid the urge to blindly buy the dip in a company’s stock just because it had a headline-making bad day in the market – some stocks may be oversold, yet others may be re-rating lower for a reason. Do not overload portfolios with alternative asset classes that are marketed as guardians against inflation – over the long term, many are not value-adders when compared to holding diversified equities. At the same time, do not fear entering or staying in the market. Volatility is a normal phenomenon and is the risk one must take in order to achieve a higher return over risk-free assets. Investors should rely on broad diversification to protect their wealth against the risk of permanent loss of capital, especially in choppy markets.
 The VIX Index is a calculation designed to produce a measure of constant, 30-day expected volatility of the U.S. stock market, derived from real-time, mid-quote prices of S&P 500® Index (SPX℠) call and put options.
Financial Market Performance
In the final three months of 2021, U.S. stocks recorded strong gains (see Exhibit 1). The fear of the fast-spreading Omicron variant and the prospect of higher interest rates periodically weighed on sentiment, yet a still dovish Fed and news of the relatively benign nature of the variant reinforced the strong upside momentum. Large-cap stocks outperformed small caps by a wide margin, and growth stocks beat value (but only among large caps). Investors were betting that large-cap growth stocks would be less susceptible to rising rates (vis-à-vis small-cap growth). Most S&P 500 sectors delivered double-digit returns, with real estate and technology shares adding the most, advancing 46.2% and 34.6% in 2021, respectively. Energy and financials delivered only slight gains for the quarter but ended the year as the best-performing sectors, up 54.7% and 35.0%, respectively.
Performance for developed market equities outside the U.S. was mixed for the quarter. European shares gained 5.7% in U.S. dollar terms as the European Central Bank (ECB) signaled it would tighten monetary policy very gradually despite inflation hitting its highest level since the euro was introduced in 1999. Other contributors to the region’s positive return were the formation of a new governing coalition in Germany with a mandate to upgrade infrastructure and modernize the economy, as well as the approval of expansionary budgets in Italy and Spain. Meanwhile, Japanese stocks declined 3.9% in U.S. dollar terms over the same period, pressured by political uncertainty earlier in the quarter and the spread of the Omicron variant in November. Waning global demand continued to pressure economic growth, and export-sensitive Japanese GDP contracted in the third quarter. However, signs of a turnaround were emerging by November, as easing supply-side pressures helped local industrial production expand.
Emerging market equities lost additional ground during the quarter to end the year in negative territory. Chinese stocks, by far the largest component of the emerging market investment universe, declined 6.1% despite strong external trade performance. Investors fretted that a strict zero-tolerance Covid-19 policy would have dire implications for growth, even as policymakers pivoted towards easing on the back of moderating inflation. Furthermore, an escalation in investment and trade restrictions between China and the United States weighed on sentiment. Meanwhile, Russian and Brazilian shares were also down as geo- and domestic political uncertainties weighed.
¹The VIX Index is a calculation designed to produce a measure of constant, 30-day expected volatility of the U.S. stock market, derived from real-time, mid-quote prices of S&P 500® Index (SPX℠) call and put options.