Research Review: Fourth Quarter 2021

The ongoing global economic recovery that occurred throughout 2021 was accompanied by historically elevated returns across most risk-oriented corners of the market, particularly domestic sectors. The concluding quarter of the year presented risk-seeking investors with notably strong returns, despite the initiation of quantitative easing (QE) tapering by the Federal Reserve (Fed) in November. Global equity performance for both the fourth quarter and calendar year strongly favored domestic large cap, while smaller cap and internationally based indices lagged. Emerging market equities, as reflected by the MSCI Emerging Markets Index, underperformed domestic (S&P 500 Index) by more than 30 percentage points in 2021, representing the second sharpest calendar year underperformance, behind 2013, in at least two decades. Fixed income performance for both the fourth quarter and calendar year overwhelmingly favored credit-based sectors versus those of a more rate-sensitive nature, as rising inflationary pressures helped drive nominal interest rates higher. Real asset performance, in aggregate, was robust throughout the year, buoyed by a continued global expansionary bias, inflation rates at a multi-decade high, and expectations for a continuation of these tailwinds to performance over the near term.

Economic Update

Risk Assets Shrug off Elevated Inflation, Fed Tapering, with Strong 2021 Performance

Against a complex backdrop of an overall expansionary bias and continued historically accommodative monetary and fiscal policy on one hand and sharply rising inflation rates pressing policymakers to rein in the pace of accommodation on the other, risk-based asset classes and categories generated elevated total returns in 2021.

The multi-year theme of domestic assets broadly outperforming their international peers remained firmly in place throughout most of the year, particularly when viewed through the lens of domestic versus emerging market equity relative performance. Relatedly, the U.S. dollar (USD) appreciated meaningfully against a broad basket of liquid emerging market currencies in 2021, placing some commonly referenced emerging market currency index gauges at multi-decade lows versus the USD.

In the second half of the year, a relatively robust domestic economic recovery called into question the continued need for near-zero policy rates and the previous COVID-era pace of monthly Fed asset purchases, which stood at $120 billion per month before the initiation of Fed QE tapering in November.

Throughout 2021, the Fed was presented with ample evidence pointing to the need for a less accommodative posture. Their preferred inflationary gauge, for example, accelerated to a more than 30-year high through November, to a rate nearly 300 basis points ahead of their stated 2.0% targeted level.

With realized inflation running at a multi-decade-high pace, combined with significant improvement across headline measures of unemployment that have coincided with strong upward pressure on risky asset valuations, the Fed shifted gears to reflect a less accommodative stance in late 2021. In a widely telegraphed move, the Fed initiated the tapering of asset purchases in November by announcing a $15 billion monthly reduction in their monthly pace of asset purchases, which pre-taper stood at $120 billion per month in purchases.

With more timely employment and inflationary data available for their mid-December meeting, the Fed acknowledged the need for an even quicker pace of marginal policy accommodation removal and announced the doubling of the pace of QE tapering to $30 billion, in addition to making upward revisions to the Fed’s “dot plot” estimate of where committee members expect the policy rate to be in the coming years.

Market participants reflect comparable sentiment for tighter monetary conditions, with current market implied measures continuing to point to at least six 25 basis point Fed rate hikes in the coming 24-36 months, based on early 2022 data.

In the absence of wage growth on pace with the inflation rate, consumer sentiment may continue to decline, the potentiality of which would presumably serve as a headwind to economic growth fundamentals in the coming quarters without a reversal of the current inflationary trend.

To conclude, market performance in November was broadly negative, with positive returns generally witnessed among the highest-quality sectors of the bond market and within the domestic large cap growth equity space. Despite being only 18 months into the ongoing economic expansion, realized inflation rates meaningfully above trend have pulled forward the bond market’s expectation for increases to the Fed’s primary policy rate, which has been discounted to occur in mid-2022. Moreover, nominal employee wage growth stood below the inflation rate through November, resulting in eight consecutive months of negative employee wage growth in real terms, the recent trend of which has likely dented U.S. consumer sentiment, which deteriorated to a 10-year low on the month.

Market Returns

Global Equity

• Global equity markets rose during the fourth quarter of 2021 due in part to strong earnings. Volatility increased in November as the highly infectious COVID-19 Omicron variant began spreading globally. Volatility quickly subsided, however, as emerging data suggested the new variant was less severe than previous COVID-19 strains.

• Small cap stocks underperformed large cap stocks during the quarter due to a fear of weaker future growth prospects in the small cap universe. The Fed’s signaling of rising rates concerned investors who worried increased rates could adversely affect small cap companies that do not have strong balance sheets and need access to cheap lines of capital for growth.

• Although high beta was the best-performing factor within the S&P 500 Index in 2021, its opposite factor, low volatility, was the best-performing factor for the quarter, which returned just below 10% for December.

• Europe faced an energy crisis during the quarter as the limited supply of Russian gas began to dwindle. As a result, gas and electricity prices rose sharply across the continent, coupled with falling investments in thermal energy and maintenance work on nuclear power plants.

• Chinese equities significantly under-performed global equities due in part to the continued growth of COVID-19 resurgence concerns, as well as market participants digesting the ramifications of China’s regulatory push. Renewed geopolitical tensions also weighed heavily on the country’s market. In turn, given China’s significant weight within the index, the Chinese market’s underperformance weighed on the overall emerging market index.

Fixed Income

• Heightened interest rate volatility led to opposing movements along the yield curve. The 10-year U.S. Treasury yield remained unchanged for the fourth quarter at 1.52%. However, the 10-year/2-year Treasury spread decreased 45 bps to 0.79%. Movement on the front end of the curve was driven by hawkish Fed policy—specifically the Fed increasing the pace of the taper from $30 billion per month to $60 billion per month and hot inflation prints. This accelerated timeline will allow the Fed to raise rates as early as March 2022. Chair Powell has communicated that the Fed will not raise interest rates until the taper is complete. Long rates decreased for the quarter as the onset of the COVID-19 Omicron variant increased doubts over long-term growth.

• Economic data releases gave reason for concern for those with dovish sentiment during December. November’s read of the Consumer Price Index (CPI) rose 0.8% on a month-over-month basis and 6.8% for the trailing 12 months, the fastest pace in nearly 40 years. Although November’s non-farm payroll reading of 210,000 printed below expectations, the unemployment rate fell from 4.6% to 4.2% as the labor force participation rate ticked up 0.2% to 61.8%. The JOLTS survey identified more than 11 million job openings. Both inflation and labor readings suggest hawkish monetary policy should be a central theme in 2022.

• Despite spread volatility, below investment grade corporate bonds outperformed their investment grade counterparts. December’s return of 1.9% was the strongest monthly return of 2021. Technical factors contributed to performance. Since mid-December, a lack of new issue supply led to a supply-demand imbalance as investors looked to take advantage of Omicron-induced spread widening. December saw only $8.8 billion in new issues, significantly lower than November’s $29 billion.

• For the first time, 2021 CMBS sales were dominated by single-asset single-borrower (SASB) loans, as investors were willing to buy single-name single assets due to relatively more straightforward underwriting versus conduit securities. Full-year SASB issuance totaled $77.8 billion, compared to $31.2 billion for diversified conduits. Due to these factors, the maturity wall for SASB securities has been extended past that of conduits. The market’s appetite for SASB relative to conduit new issue will likely be a key theme in the future. Furthermore, CRE CLOs saw a staggering 371% increase in issuance versus 2020, with over $45 billion of supply.

Real Assets

REAL ESTATE

• Despite concerns around the COVID-19 Omicron variant which emerged late in the year, U.S. REITs ended fourth quarter 2021 up 16.2% and finished the year with a gain of over 40%. Property sector trends remained consistent relative to previous quarters, while sectors tied to the “re-opening trade” (e.g., lodging, healthcare, and office) underperformed. In contrast, sectors considered defensive or experiencing supply-demand imbalances, such as industrial and single-family rentals, continued to have strong performance into year-end 2021.

• Self-storage continues to attract capital, returning almost 80% for the year. The sector is viewed as a hedge against inflation because of its lower operational costs compared with property types that are more capital and labor-intensive. Month-to-month leases offer owners the ability to raise rents more frequently than properties with multi-year leases. Finally, the continued improvement in domestic employment has resulted in worker migration, driving demand for storage. As such, self-storage REITs have experienced attractive supply-demand dynamics, resulting in increased pricing power across the U.S.