It’s been another remarkable year for domestic stocks, with large-cap U.S. stocks returning a stunning 28.7% as a handful of large-cap tech stocks dominated the market returns as the average stock struggled. This sector meaningfully outperformed U.S. small-cap stocks which were up 14.8%, developed international stocks up 11.3%, and emerging-market stocks down 2.5% for the year. Much of this outperformance occurred in the fourth quarter, with large-cap U.S. stocks gaining 11.0%, while the other market sectors were flat to slightly positive. A strong dollar, the renewed surge in COVID-19 infections late in the year (particularly in Europe and emerging markets), and China’s policy-induced economic slowdown and stock market decline drove the disparity of returns.
Turning to the bond markets, core bonds lost 1.5% for the year, as interest rates rose moderately. The benchmark 10-year Treasury bond yield ended the year at 1.51%, compared to a 0.92% yield at the end of 2020. Given the very sharp rise in inflation, most pundits would not likely have predicted such a mild increase in bond yields. Credit markets fared much better than core bonds in 2021. The U.S. high-yield bonds returned 5.4% and the floating-rate loans gained 5.2%. These returns were consistent with our expectations for a recovering and growing economy.
Our base-case macro and market scenario is cautiously optimistic: that the pandemic recedes (but doesn’t disappear), the global economy slows but still grows above trend, corporate earnings growth slows but is still solid, the U.S. rate of inflation remains elevated but begins to moderately fall, and U.S. interest rates rise moderately. That scenario (along with the average stock being reasonably priced, minus overvalued momentum stocks) would be a positive scenario for the economy and global equity and credit markets, although not for the core bond market. But even in the best case, it likely won’t be a smooth journey: The pandemic remains uncontained, domestic and global political and social tensions are elevated, the risks of an economic policy mistake have risen, and any number of other bumps in the road (or worse) may occur. And were we to see a sharply inflationary environment that is well above current consensus expectations, it would undoubtedly be damaging for stocks and bonds, as the Fed would more than likely raise interest rates aggressively and equity market valuations fall. This is a development that we will continue to monitor, but believe our portfolios are well positioned for this outcome and would adjust portfolios, as necessary.
All these considerations (and more) factor into our analysis and current tactical portfolio positioning. We would benefit nicely from our highest-conviction tactical shifts if our base case plays out, but our portfolios are also strategically balanced and well-diversified across a range of global asset classes, alternative strategies, and risk-factor exposures. This should enable them to be resilient should a risk scenario or shock outside our base case occur. Overall, our portfolios are positioned with (1) a small overweight to global equities, through our tactical overweight to emerging market stocks; (2) a large overweight to flexible, actively managed fixed-income funds and floating-rate loan funds; (3) positions in lower-risk and diversifying alternative and real estate strategies; and (4) a large underweight to core bonds (interest rate/duration risk).
Within our global equity allocation, we continue to maintain balanced allocations across the “value-blend-growth” style spectrum, as we do not have a high-conviction tactical view on individual sectors, styles, or factors. We do see potential for value and cyclical stocks to rebound (again) as COVID-19 recedes and interest rates rise. And value stocks in aggregate still look very cheap versus growth. But we also want to maintain exposure to high-quality, innovative growth companies with strong competitive advantages that are priced at not-unreasonable valuations – there are still some out there!
A noteworthy point on our tactical overweight to emerging market stocks is that we are actively evaluating the relative opportunity compared to European equities. This is somewhat of a moving target as relative valuations shift, but if our return outlook for European equities become sufficiently attractive, their lesser exposure to some of the risks faced by emerging markets could lead us to shift a portion of the overweight from emerging markets to European stocks. Evaluation of relative opportunities is a regular part of our ongoing portfolio management process.
Our fixed-income positioning reflects the poor return outlook for core bonds: the fact that they are starting from a low sub-2% yield and interest rates are likely to rise over the coming quarters. Our active, flexible fixed-income managers have a strong likelihood, in our view, of outperforming core bonds without taking imprudent risks. But we still maintain a meaningful core bond allocation in our more conservative balanced portfolios as ballast in the event of a recessionary scenario, which would hurt flexible, credit-oriented bond funds as well as stocks.
Finally, our allocations to alternatives and real estate are largely a substitute for some fixed-income exposure. Again, we believe these positions offer better return prospects plus beneficial diversification across a range of scenarios beyond a traditional recession where core bonds shine. In addition, historically these sectors have provided a reasonable hedge to higher inflation periods.
The last two years have been extraordinary. Amidst the COVID-19 pandemic and all the chaos it has wrought, there have been many reminders that markets commonly defy consensus predictions and confound investors in the short term. In the face of a deep drop in economic activity early in the pandemic, markets rebounded and have racked up remarkable gains since. More recently, as supply chain and labor market disruptions have been contributors to a spike in inflation, increases in bond yields have been surprisingly mild. Of course, surprises that defy prediction happen in both directions, and this is why we maintain broad diversification and focus squarely on the long term, which can be analyzed with much higher confidence—even while we continually work to understand how the never-ending stream of new developments will impact the portfolios we manage.
As always, we thank you for your trust and confidence.
The Water Valley Investment Team