In today’s bi-weekly review, we will look at what happened in the past twelve months in the markets and some of the year’s major headlines.
In the Macro
- Interest rates to rise in 2022 following a year of elevated inflation
- How did inflation impact the fixed income markets?
In the Micro
- The stock market rally of 2021
- What drove index outperformance?
- Expectations for the equity markets in the new year
In the Macro
Interest rates to rise in 2022 following a year of elevated inflation
Inflation has been one of, if not the top stories of the past year. At first, the Federal Reserve claimed it was a result of economic reopening and that rising prices were transitory. Eventually, though, the Fed moved away from the term and has accepted inflation as an ongoing risk.
The November consumer price index (CPI) showed a year-over-year increase of 6.8%, a record for the quickest growth in prices since the 1980s. Following their latest meeting, the Fed announced accelerated tapering and prepared the markets for subsequently raising interest rates. Projections from Fed officials now outline three interest rate hikes in 2022.
In Canada, November’s CPI showed a jump in prices of 4.7% year-over-year. While the pace of inflation has not run as hot as in the United States, it still marks the fastest growth in almost 20 years. The Bank of Canada “expect(s) inflation to ease in the second half of 2022,” though the timing of any interest rate hikes is still uncertain.
Source: Financial Post
How did inflation impact the fixed income markets?
Just 12 months ago, the 10-year Treasury started the year with a yield below 1%. On March 31, it reached its high for the year, paying a yield of 1.75% in a notable change for such a short time. In just under a few months, it rose 80 basis points, becoming one of the quickest increases recorded.
Following its March peak, the yield on the 10-year bounced around, clawing its way back to 1.5% in late December. The Treasury note, also known as the “risk-free rate,” ended the year just above that number, with the yield curve flatter than it was at the beginning of the year. Analysts suggest that we may see a further flattening of the yield curve in the year ahead.
Corporate debt levels are also retreating after a spike in 2020 due to the pandemic. As of Q2 2021, debt levels are approaching their long-term average. In fact, as of late October, there were more credit rating increases in 2021 than there were decreases, a reversal from what we saw the year before.
Source: RBC Wealth Management
When it comes to corporate bonds, the price of investment-grade (IG) bonds should fall in a rising rate environment. This is because IG bonds see their yields closely follow those of the Treasury note. On the other hand, speculative bonds have the potential to outperform with rising interest rates. Credit risk is more impactful for these investments than interest rate risk, and, as outlined, corporate balance sheets remain strong.
Regardless of the fixed-income investments in your portfolio, an important point for bond investors is to consider not only the credit risk but the real return on the investment. With strong inflationary forces, you may be losing more in the bond market than you think. For example, if you earn 3-4% on investment-grade bonds, you are not coming out ahead after considering inflation’s impact on your purchasing power. Bond investors should proceed with caution should we continue to see negative real interest rates as we did this past year.
In the Micro
The stock market rally of 2021
It was, at times, unthinkable, but the stock markets rallied in 2021, with North American equities ending another year of solid performance.
The S&P500 had an outstanding year, to say the least. The index closed at a record 70 times during the year, with the last few all-time highs reached in the final couple of weeks. Following a solid finish, the index saw an annual return of 26.89%.
The Nasdaq, known for a higher concentration in the technology sector, closed 21.4% higher for the year. While the double-digit return is still significant, this is the first time since 2016 that the tech-heavy index underperformed the S&P500.
With a greater portion of the index allocated to the energy sector, Canada’s S&P/TSX benefited from a surge in oil and gas prices, the top-performing sector this year. The S&P/TSX Capped Energy Index outperformed the broader market, ending the year 80% higher, while the S&P/TSX finished the year with a return of 21.74%