Q4 2021
January 9, 2022
2021 was another year of strong stock market returns, the third in a row. In fact, for four of the last five years, the stock market has delivered performance well in excess of the long-term average. Since 2017, only 2018 delivered below-average stock market returns.
Each quarter, I provide commentary discussing market performance, trying to highlight for you what is driving the stock and bond markets. Today, I thought it might be useful to provide a broader look back at the markets and what they might tell us about where we sit today.
I’ll start with the bond market as its story is straightforward. The context for the bond market today has its roots in the “Great Recession” of 2008/2009. If we roll back to 2007, before the recession, we find that interest rates paid on the 10-year Treasury bond hovered around 5%. For those of us with more than a 15-year perspective on bond yields, earning 5% to 8% on a high-quality bond sounds like “normal” yields.
When real estate markets collapsed in 2008, the Federal Reserve implemented policies that, at the time, were considered extraordinary. The Fed slashed interest rates and began buying bonds in the open market. The policy, known as “quantitative easing”, had the Fed competing with investors to buy available bonds in the market. Given the unlimited buying power of the Fed, the impact was to push bond prices up and bond yields down to the 2% range. At the time, that was thought to be extremely low.
The intent of this policy was twofold: First, it was meant to help stabilize the housing market. By buying mortgage-backed bonds, the Fed was providing liquidity to the mortgage market. They kept the mortgage finance business from collapsing. Second, by lowering interest rates, several interrelated objectives were accomplished. Property owners were able to refinance and lower their mortgage payments. This made property more affordable. Lower interest rates also helped increase the value of other investments. All other things equal, a decline in interest rates increases the value of most all investments. Lower interest rates certainly helped the stock market find a bottom and quickly recover.
The problem with quantitative easing is it becomes almost impossible for policymakers to reverse course. Allowing interest rates to rise is resisted politically.
So, when real estate markets stabilized (2011/2012), the Fed continued quantitative easing, and simply changed its objectives for the policy. Its purpose morphed from a temporary emergency action to the ongoing policy of the Fed. As a result, lower interest rates have been supporting higher investment values for over a decade.
The only exception was 2018 when Fed Chairman Powell started raising interest rates and indicated the Fed would continue to raise interest rates well into 2019. The stock market collapsed. The Fed’s action stands as the reason 2018 was the only “bad” year for stocks over the past 5-years.
Many in Congress, along with President Trump, complained about raising interest rates. The Fed relented and stocks recovered.
When the pandemic struck in 2020, the Fed redoubled the quantitative easing effort and pushed interest rates to near 0%. The effect was the same as in 2008/2009, markets stabilized, and stock prices (along with other assets like housing) soared.
In a nutshell, the bond market has been captive to quantitative easing for more than 10 years. Interest rates have been low and gotten lower. All investment classes have benefited.
Over the same period, the stock market’s performance is more difficult to boil down. We know that low interest rates have helped stock prices, but low rates are not the singular reason for a strong stock market. Sustained good stock performance also requires good earnings and growth.
Over the past 10 plus years, as over most decades, there have been many things going on in business that have helped drive good performance. Two easy ones to highlight are:
Apple and the rollout of the iPhone. It may seem like it’s been longer, but the iPhone was introduced in June of 2007.
Amazon and the move to online shopping.
These two companies alone have had a significant positive influence on the stock market over the past 10 years.
Another key event in driving the strong market since 2017, is the corporate tax cuts implemented that year. As I’ve noted many times in the past, those tax cuts were positive for stocks at many levels. They eliminated the incentive for corporations to hold cash overseas. They strengthened the case for companies to invest in their U.S. operations. They stopped companies from reincorporating in other countries. Most importantly, in most cases, they provided a windfall of cash flow that could be reinvested in the business (or distributed to shareholders).
Some may feel the economic multiplier effect of government spending is on par with private spending, but the market does not.
The corporate tax cuts of 2017 were a windfall for the market raising the trajectory for expected economic growth and with it, the stock market.
Now, as we sit here at the beginning of 2022, can we make the case that stocks will continue to do well?
In the short term, I am concerned.
The emergence of inflation is forcing the Fed’s hand; they intend to start raising interest rates this year. Rising rates are going to be a headwind for stock prices.
Worker shortages are a problem. Higher wages will squeeze profitability and earnings. A lack of willing workers also diminishes economic growth opportunities.
The pandemic continues to be a headwind for stock prices. Whether you personally believe we need to get on with life despite COVID or that COVID, in any form, requires collective action, overall people are still responding to the virus. It continues to influence activity and decisions. Until that ends, COVID will impact the economy, earnings, and stocks.
Despite these headwinds, there are plenty of reasons to be hopeful for the stock market. Without passing judgment on Biden’s spending plans, I believe the failure of the plan, as it pertains to rolling back some of the tax cuts, eliminates risk to economic growth and with it, the long-term performance of the stock market. The positive effects of the 2017 tax cuts remain in place.
We still have a robust economic recovery ahead. 2021 was to be the year of economic recovery, and in many ways it was. But the persistence of the virus and the emergence of bottlenecks in the supply chain kept growth below what was possible. Over time, these growth impediments will be resolved and help support economic recovery.
I think it is fair to summarize our view today by stating it’s going to be difficult for the market to maintain its recent strength. Despite this, once we adjust to higher interest rates and resolve some of the issues that have arisen during the pandemic, the longer-term outlook remains quite favorable for stocks. As for the bond market, we welcome higher rates on fixed-income investments. The Fed has for too long been penalizing investors looking to earn a yield on safe investments.
We all wish you a wonderful New Year!
Mark Hoonsbeen, CFA
Principal
Nicollet Investment Management
800 North Washington Ave, Suite 150 Minneapolis, MN 55401
Phone: 612-915-3033
Email: markh@nicolletinvest.com