By: Jim Picerno
Director of Analytics, The Milwaukee Company
U.S. real estate investment trusts and commodities were 2021’s big winners while US bonds and stocks in emerging markets retreated last year. The MSCI US REIT Index regained 2020’s loss several times over by surging 43.1% on a total-return basis, lifting the benchmark to a record high at December’s close.
In addition to the stellar gain for US REITs, the asset class continued to offer a relatively attractive yield. Using Vanguard Real Estate ETF (VNQ) as a proxy, securitized real estate’s payout rate is 2.56% for the trailing 12-month period, according to Morningstar.com. That’s more than a full percentage point above the 10-year Treasury Note’s 1.52% yield, as of December 31.
Commodities also delivered an impressive performance in 2021. Fueled by demand born of a strong expansion in the global economy, along with heightened anxiety over the sharp increase in inflation, the CRB Commodities Index rose more than 38% last year.
Stocks in developed countries also posted solid advances last year, led by American shares. The S&P 500 Index rallied nearly 29% on a total-return basis – one of the best calendar-year performances on record for this widely followed yardstick of US equities. In fact, the S&P has been on a tear for each of the past three calendar years, posting an astonishing 23.9% annualized total return over that time window.
International diversification for equities was a mixed bag in 2021. Developed markets ex-U.S. posted a solid 11.8% total return, based on the MSCI EAFE Index. But emerging markets lost ground last year: MSCI Emerging Markets Index shed 2.2%.
US bonds endured a losing year in 2021 too. Thanks to modestly higher interest rates, bond prices (which move inversely to yields) fell. The Bloomberg Aggregate Bond Index, a broad measure of investment-grade fixed-income securities, lost 1.5% last year as the benchmark 10-year Treasury yield rose more than 50 basis points for the year to 1.52% by 2021’s close.
A notable exception to bond market losses: inflation-indexed Treasuries, which gained 6.0% in 2021, according to the Bloomberg US Treasury Inflation-Linked Index.
Market risk factors to monitor in 2022
The year that just ended was kind to most risk assets, but markets face several risk factors in 2022 that could bring choppy results or worse. At the top of the list: inflation.
Pricing pressure jumped sharply in 2021 and proved to be more persistent than expected. The Federal Reserve back-pedaled on its inflation-is-transitory narrative and decided to accelerate plans to wind down its bond-buying program that’s intent on keeping interest rates lower for longer. As a result, there are widespread expectations that interest rates will rise this year.
Fed funds futures are estimating a roughly 60% probability of a rate hike at the March 16 FOMC policy meeting, according to CMEGroup.com. The expected 25-basis-point increase to a 0.25%-0.50% range for the Fed funds target rate would still leave interest rates near zero, but if the forecast is accurate the change in directional bias would mark the first round of policy tightening since the pandemic started two years ago.
Rising rates cast a negative outlook for bonds, but the stock market may be able to weather higher yields if the economic expansion stays healthy. Much depends on how the efficacy (or not) of Fed policy in nipping inflation pressure in the bud. If price trends continue to surprise on the upside (or remain elevated), the Fed may be persuaded that several rate hikes are needed in 2022. How the stock market reacts may be largely determined by how the economy is impacted by inflation and higher rates.
Another critical variable to watch is the evolution of the Omicron variant of the coronavirus. There’s cautious optimism as the year kicks off. Preliminary data suggest that the current wave of infection will be relatively brief and mild, based on the experience in South Africa, where the variant was first detected. Even if that’s true, the healthcare system could be overwhelmed, largely because a significant portion of the population is either unwilling or unable to be fully vaccinated. In some states, the percentage of people fully vaccinated was still under 50% at 2021’s close, according to one estimate.
“As you get further on and the infections become less severe, it is much more relevant to focus on the hospitalizations as opposed to the total number of cases,” says Dr. Anthony Fauci, the US government’s primary infectious disease expert.
The main risk for the economy is how federal, state and local governments react. Another round of widespread shutdowns, ill-advised or not, would take a significant bite out of growth. In other words, political risk remains a real and present danger for the expansion.
Even if the pandemic begins to wind down and inflation eases, elevated market valuations are becoming harder to ignore. Professor Robert Shiller’s Cyclically Adjusted PE Ratio (CAPE Ratio) is at the second-highest level in 150 years. High valuation for US equities can persist for years without a market correction, but the lofty CAPE ratio suggests that the market is priced for perfection and therefore unusually vulnerable to negative surprises.
For now, the economic outlook remains upbeat. Recession risk is low and the blowback from Omicron and inflation appear limited. If and when macroeconomic conditions deteriorate and trigger a warning sign, an early clue is likely to show up in the Treasury yield curve.
The spread between the 10-year and 3-month Treasury yields was solidly positive at 2021’s close – nearly 150 basis points. For much of last year, this rate gap trended up, which is a bullish forecast for the economy. In the fourth quarter of 2021, however, the upside trend stalled. It’s unclear if this is noise or an early warning of trouble ahead.
The yield curve has a reliable history of signaling recession risk when it inverts (long rates below short rates). The spread is long way from going negative as 2022 begins, but investors should keep a close eye on this indicator. A clear and persistent reversal of last year’s upside trend would be widely regarded a caveat for the economy and the stock market. By contrast, a persistent increase in the spread would signal an improving economic outlook.
A third possibility: the yield curve remains stuck in a tight range of roughly 120-to-180 basis points. For now, that looks like the path of least resistance as long as there’s room for debate on the outlooks for inflation and Omicron risk.