December 2021 Market Commentary

January 5, 2022

“Here come Santa Claus, here come Santa Claus, right down Santa Claus Lane…”

Despite the popular notion that Santa Claus is only for children, investors would tell you otherwise. While St. Nick’s arrival is not the guaranteed event for investors that it is for children, in 2021 investors once again benefitted from the arrival of everyone’s favorite elf. A “Santa Claus” rally, as it is popularly known, is the idea that markets typically enjoy positive performance in the latter part of December. A stricter definition is that the rally occurs during the last five trading days of December and the first two trading days of January. In 2021, the S&P 500 returned 3.1%, in the last two weeks of December, helping push full month returns to 4.4%. Various theories as to what causes a Santa Claus rally have been offered- the completion of tax-loss harvesting, year-end bonuses, a general sense of optimism during the holiday season- with little agreement. This year, headlines that Omicron isn’t as severe as previous variants likely aided the rally. December’s strong market returns were not limited to large caps. Small caps (Russell 2000) gained 2.1%. International markets also generated positive returns, led by developed markets (MSCI EAFE) which gained 5.1%. Emerging markets (MSCI EM) gained 1.6%.

Omicron wasn’t the only headline challenging markets during the month. Monetary policy, inflation, and Congress were also prominent. After a slight deceleration in the third quarter, inflation re-intensified during the fourth quarter. November data, released during December, showed headline inflation at its highest level in nearly 40 years, while the “core” measure, excluding more volatile food and energy prices, reached its highest level in 30 years. In response to the sustained upward pressure on prices, the Fed announced an acceleration of its tapering plans at its December meeting. As it now stands, the Fed will conclude its pandemic-era bond buying program by March 2022, three months earlier than previously planned. In addition, the Fed revised its “dot plot” projections for interest rates to show an expected three rate increases by the end of 2022. In general, markets took the tapering news and rate hike projections in stride suggesting that investors were prepared for both.

In addition to the Fed, other central banks also announced tightening measures during the month. The Bank of England surprised markets by raising its benchmark interest rate for the first time since the start of the pandemic, while the Bank of Norway raised rates for the second time in three months. Though seemingly more cautious than other central banks, the European Central Bank (ECB) announced that it would conclude its pandemic-era bond buying program by the end of March 2022. However, bond buying under a different program will be accelerated in order to continue to provide the regional economy with significant amounts of stimulus. Contrary to other central banks, the Bank of China announced new stimulus measures to help support economic growth impacted by the country’s strict zero-Covid policies and slowing real estate sector.

In the US, Congress eschewed it typical 11th hour approach to important decisions by passing a short-term government funding bill and raising the debt ceiling with days, not hours, to spare. However, fundamental disagreements within the Democratic party about the size and scope of President Biden’s Build Back Better Act, resulted in the bill’s demise. Though there remains a chance that some version of the bill, or select pieces of it, will be passed in 2022, the current version lacks the necessary support for passage. That led several economists to lower their 2022 US GDP forecasts due to the lack of additional stimulus.

Despite higher inflation readings and the Fed’s decision to accelerate its tapering plans, fixed income returns were quite muted. The Bloomberg Aggregate Bond index, the broadest measure of the US bond market, fell 0.3%. High yield, demonstrating its greater correlation to equity markets, was the best performing sector, up 1.9% for the month. Long-dated Treasuries were the worst performing sector with the 30-Year Treasury falling 2.2%.

Interestingly, thus far, interest rates have largely been immune to rising inflation. One would be forgiven for expecting otherwise. Though headline inflation reached 6.8% in November, interest rates as measured by the 10- Year Treasury yield ended December at 1.51%. That was up just 0.08% from the start of the month and well below the 2021 high of 1.74% recorded in March when headline CPI inflation stood at just 1.7%. The disconnect has been vexing for economists, fixed income investors, and likely the Fed as well. One explanation is that despite the Fed retiring the use of the word “transitory” to describe current inflation, the bond market continues to believe that will be the ultimate outcome. Another explanation is Fed rate hikes in 2022 will slow economic growth thereby putting downward pressure on rates. Another possible explanation, and one that has been prevalent for a number of years now, is the massive amount of negatively yielding global debt. While a 1.5% 10-Year Treasury yield is not overly attractive to US investors, it is far better than what investors can earn on similar bonds elsewhere, with German, Japanese, and UK 10-Year rates currently at -0.18%, 0.07% and 0.97%, respectively.

Taking a closer look at interest rates, most of the activity in the Treasury market during December occurred at the short-end of the curve as Fed commentary became more hawkish than at any other point since the onset of the pandemic. The hawkish tone was driven by inflation data that continues to be more persistent than originally projected. Following the Fed’s tapering announcement and increased rate projections for 2022, yields at the short end of the curve spiked, with the 12-month and 2-year Treasury notes touching 2021 highs in the final week of the year. Longer-dated bond yields moved only slightly higher as concerns over the Omicron variant subsided somewhat on preliminary evidence suggesting that symptoms may be mild. If that proves to be correct, it would lessen the threat to economic growth, potentially pushing investors into more of a risk-on mode to start 2022.

The municipal market closed the year on a very quiet note, with little movement across the curve. Two-year muni yields stayed at 22 basis points throughout the month, while the 10-year municipal yield fell just one basis point over the month. December is typically a muted month for munis as most issuance is taken care of before the year- end holidays. This year did not prove to be an exception.