A Strong Finish to the Year… With a Few Caveats

The S&P 500 Index and the S&P TSX index both ended the year 2021 with a robust total return of ~28.7% and ~25.1%, respectively. Underpinned by continued easy monetary policies of the central banks and tailwinds from a reopening economy, companies reported better-than-expected earnings in general which helped investor enthusiasm throughout the year. Fixed Income markets did not share this enthusiasm, however, and the Canadian bond markets declined by ~-2.53% and US bond markets declines by -1.54% over the year.

Looking beneath the hood, we estimate that only about 15 of the ~500 companies in the S&P 500 Index and about 11 of the ~250 companies in the S&P TSX Index were responsible for about half the total returns for 2021. (See Charts). Similarly, within the fixed income asset class, inflation protected securities as measured by the Bloomberg US Treasury TIPS 0-5 Years Total Return Index and floating rates loans as measured by the S&P/LSTA Leveraged Loan Index CAD TR Hedged returned ~+5.34% and +5.11% for the year.

A few names contributed a major chunk of the index returns in 2021

While we do not think that concentration of market performance alone is enough reason to worry given that the same measure looked even worse at the end of 2020, we do note that one of the reasons that promoted concentration of performance in few areas over the last few years, i.e., low interest rates, is on the brink of change. Several years of accommodative monetary policies and record low interest rates have supported sky-high valuations of several high growth names with promise of earnings farther into the future. Consequently, it is likely that a large chunk of the overvaluation driven by low interest rates is concentrated on the high performing names of the previous years with little to no current earnings.

As the economy transitions into a rising interest rate environment, it is reasonable to expect that some of the overvaluation will get taken out in 2022. At the end of October/early November, the Bank of Canada and the US Federal Reserve signaled that interest rate hikes are coming in 2022. The following two months witnessed rotation out of high-growth and high-valuation stocks to value-oriented and high dividend paying stocks. Looking ahead, we think the price action of the last two months of 2021 is a harbinger of things to come in 2022.

December in Review

1. The S&P 500 and S&P TSX started the month on a cautious note, however, a bullish sentiment prevailed towards the end as the last trading of the weeks ensured the indices ended the month in green.

2. The concerns on ‘Omicron’, the new variant of Covid-19 virus faded towards the end of the month on reports that the variant was not causing as many hospitalizations as expected.

3. The headline inflation number for November came in at +6.8% for the US.

4. After the Federal Open Market Committee (FOMC) meeting on December 15th, the US Federal Reserve Chair, Jerome Powell, announced that the Fed will double the rate of tapering of its bond buying program with a conclusion of the program coming in March 2022.

5. The FOMC committee projections indicated the committee now expects three, 25-basis point interest rate hikes in 2022.

6. The Canadian government renewed the Bank of Canada’s 2% inflation target, however, added language that gives it flexibility to temporarily overshoot the target to achieve employment objectives.

7. The unemployment rate in Canada declined to 6.0% in November from 6.7% in October, indicating a healthy job market.