2021 in Review: Higher Inflation Leads to Cautious Outlook
Last year, including the fourth quarter, was a rewarding period for investors, especially U.S. stock investors. The most straightforward explanation for this is the positive economic landscape during the year. Consumers benefited from government stimulus, rising employment and wages, and spent freely as a result. Corporations produced and sold record amounts of goods and services. And despite cost pressures, they were more profitable than ever. This combination yielded higher stock prices in almost all categories, but U.S. stocks again far outpaced the rest of the world. Here are the investment returns for the major asset classes over the last quarter, one, three, and 20 years:
Let's dig deeper into some of these figures. The International Monetary Fund estimates that U.S. and Global GDP growth for 2021 was about 6%, the fastest growth in nearly 40 years. Much of this was a rebound from the 2020 pandemic-induced contraction. Headlines focused on volatile job numbers and a record number of resignations. Still, the big picture is that the U.S. economy added 6.4 million jobs in 2021, more than ever before (a typical year sees 2 - 3 million jobs added). Unemployment (3.9% in December) remains slightly above pre-pandemic levels but is at just about the lowest level ever. The flip side of the Great Resignation is that new business formation surged in 2021. In short, the economic backdrop for the year was quite supportive for most businesses.
While the strong performance of stocks was widespread, it's also important to note some critical and pronounced trends within the stock market. At the very opposite end of the size spectrum from those millions of startups mentioned above, there has never been a time in history when a few large corporations dominated the economy and stocks markets so thoroughly. We can reference the S&P 500 (an index with, you guessed it, 500 components), but that name obscures the outsized importance of just a handful of global technology behemoths.
Apple just recently made headlines for surpassing $3 trillion in market value (it has since declined some), about on par with the GDP of the United Kingdom and easily exceeding the GDP of Canada. (This comparison of market value to GDP is intended to provide a sense of scale, recognizing the two figures measure different things. Apple’s market value is the market’s assessment of all future earnings; GDP is a measure of one year’s production of goods and services.) As of the end of 2021, according to JP Morgan, the top 10 companies in the S&P 500 comprised 30.5% of the index. Because the S&P 500 is market-weighted (meaning the size of each component's contribution to index performance is proportional to its market value), the bottom 400 companies in the index (i.e., 80% of the total) have about the same impact as these largest 10.
We are not arguing here that this represents a market, or valuation, bubble. These companies are so commercially successful and so dominant in important, growing areas of the economy that it is at least arguable that they deserve to be as richly valued as they are. Instead, we make the point for two other important reasons relevant to how we think about investing. First, the history of capitalism yields few examples of companies that remain at the tip-top of the competitive heap from one generation to the next. Second, the very essence of the technology sector is to disrupt the status quo. While today's market seems to bet that these current giants will only be ever more successful, it doesn't seem an especially wild guess to foresee that some future entrepreneurs will imagine a way to disrupt the current landscape.
In a similar vein, and directly related to the massive market size of these American technology giants, we believe U.S. stocks represent a disproportionately high share of the global market. The U.S., no doubt, enjoys the world's largest economy, and we'd argue that it's not just a coincidence that the U.S. has been the breeding ground for the world's most successful companies. But we also see limits to that line of thinking.
The U.S. economy represents about 24% of global GDP, but U.S. stocks today comprise a record high 61% of the worldwide stock market value (in the MSCI All Country World Index). Referencing the asset class returns table above, you can see that 2021 was another in a long string of years in which U.S. stocks trounced other developed market stocks. This means the valuation gap between U.S. and international stocks, which was already high going into 2021, is even larger.
In a U.S. market where the focus is increasingly on a small set of gargantuan tech leaders and a global market where U.S. companies are currently punching way above their weight, we think we'll be well served by casting a wider net to find investment value.
Large Cap Value Review
(Not all clients of Bristlecone are invested in our Large Cap Value Equity portfolio strategy, depending on the size of the overall portfolio, and the client's objectives and constraints.)
Value stocks enjoyed a brief period of outstanding relative performance between the 2020 election and roughly the middle of 2021. In the second half of 2021, and especially during the fourth quarter, the market seemed to return to narrowly favoring large growth companies. We won't speculate much on why this might have been. It was not because the brief period of value ascendancy materially closed the valuation gap between growth and value stocks. It likely had more to do with the perceived short-term economic effects of a resurgent virus (in the form of the Omicron variant) on more economically sensitive value stocks. Our large-cap value portfolios ended 2021 with solid absolute performance and outperformed the Morningstar Large Value index, but lagged the S&P 500 for the whole year.
The largest positive contributors to Large Cap Value performance during the fourth quarter were Johnson Controls (which sells HVAC, fire, and security controls, predominantly to commercial buildings), Amerco (operator of the UHAL brand), and Howard Hughes (which owns a diverse real estate portfolio). In terms of price performance, the best performer in the quarter was Pfizer. Pfizer stock has gotten relatively little benefit from the financial impact of its Covid vaccine (which is not seen to be a durable source of profits) but did benefit from the bump in vaccine uptake during the Omicron surge.
The biggest detractors from performance during the quarter were Medtronic, Liberty Broadband, and Qurate Retail. Medtronic received an FDA warning letter concerning one of its device manufacturing facilities. It was likely also hurt by the surge in hospitalizations from Coronavirus cases, which displaced other hospital procedures. Qurate Retail, which operates the QVC shopping network, reported an unexpected sales decline in the third quarter, which resurfaced doubts about the transition of its sales model from cable television to online (including mobile). We believe its low valuation compensates for these uncertainties.
Bonds and Inflation - A Tough Year. Tougher Times Ahead?
First, it's been relatively rare over the last five decades for investment-grade, intermediate-term bonds to generate a negative annual return. 2021 was just the fifth time it has occurred since 1980. And the worst year for the Aggregate Bond index during that period was -2.9% (in 1994), so it's fair to say that 2021 was one of the worst years for bonds in a long time. We've been expecting a rise in interest rates for a while now (rising rates correspond to declining bond prices), so we weren't caught off guard by the increase in rates that occurred in 2021. The rise seems to us quite modest in a historical context. Rates for the benchmark 10-year U.S. Treasury bond increased from 0.93% at the start of the year to 1.52% by year-end. Still, that shift was enough to generate a negative total return for the aggregate bond index, which has seen its sensitivity to rate changes increase over the last several years. The bond portion of our clients' portfolios was generally positioned with rising rates in mind, so it fared better than the index and eked out a barely positive return.
Even more significant than the slight negative return in nominal terms for bonds was the more dramatic loss in real terms (i.e., after considering the effect of inflation). Indeed, the return of a material level of price inflation was probably the most important financial story of 2021.
Investors in bonds want capital preservation. Ideally, a bond investor wants a high probability of getting all their principal back along with enough interest such that their real spending power is preserved. That was decidedly not the case for bond investors last year.
After averaging about 1.7% in the decade ending in 2020, the Consumer Price Index (CPI) shot up to a 7% annual rate by the end of 2021. This was the highest yearly inflation figure since the early 1980s. Here's a look at the CPI over the last 50 years.
The chart below shows the combination of (still) low interest rates and the current high inflation rate. Bond investors are not being compensated sufficiently to cover recent price increases.
Inflation-protected bonds (TIPS), whose principal adjusts with increases to the CPI, did their job well in 2021 and offered the best returns within the capital preservation portion of your portfolios. While TIPS did well enough to offset nearly all the effects of inflation, they still lost value in real terms due to the broader rising rate environment.
Inflation, interest rates, and stock price returns are all intimately connected, if not in entirely predictable ways. If higher inflation persists for any length of time, interest rates will surely need to rise further to offer bond purchasers sufficient incentives. That process has accelerated in the first month of 2022.
The link between inflation and stock returns is less obvious. Speaking broadly, we know that low inflation and declining interest rates contributed to excellent stock returns over the last four decades. Before that, higher inflation and rising interest rates were a significant headwind for stocks in the 1970s, which featured a major bear market from 1972 - 1974, followed by contracting valuations for another eight years.
It's helpful to remind ourselves that stocks represent pieces of businesses, and management can adapt to changing economic conditions (unlike a typical bond, where the best case return is fixed at issuance: the return of principal with an annual coupon). Companies might pass on price increases to their customers (depending on their competitive position) or become more efficient by deploying technology, for example. While this is no guarantee that business fundamentals will overcome the effects of inflation in any short-term period, this adaptability is the main reason we believe stocks offer a higher probability of beating inflation over the long term.
The return of inflation worries is an unwelcome change for investors and makes the current environment challenging. While this development will likely lead to short-term volatility, it is in more difficult times that sticking with a well-thought-out, long-term plan is most important.
As always, if you have questions or concerns about your situation, please reach out to discuss.
One of Bristlecone Value Partners’ principles is to communicate frequently, openly, and honestly. We believe that our clients benefit from understanding our investment philosophy and process. Our views and opinions regarding investment prospects are "forward-looking statements," which may or may not be accurate over the long term. While we believe we have a reasonable basis for our appraisals, and we have confidence in our opinions, actual results may differ materially from those we anticipate. Information provided in this blog should not be considered as a recommendation to purchase or sell any particular security. You can identify forward-looking statements by words like "believe," "expect," "anticipate," or similar expressions when discussing particular portfolio holdings. We cannot assure future results and achievements. You should not place undue reliance on forward-looking statements, which speak only as of the date of the blog entry. We disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. Our comments are intended to reflect trading activity in a mature, unrestricted portfolio and might not be representative of actual activity in all portfolios. Portfolio holdings are subject to change without notice. Current and future performance may be lower or higher than the performance quoted in this blog.
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