Quarterly Review - Q4 2021: Market Continues to Climb the 'Wall of Worry'

US Powers Through Market Concerns; Emerging Markets Still Struggling


  • Stocks ended the year strongly, overcoming headline concerns, in our view.
  • We remain overweight stocks going into 2022, with a preference for the US.
  • While we expect positive returns, we anticipate higher volatility.

A popular investor adage during mature bull markets is “Climbing the wall of worry.” This is used when the market rises as bearish investors gradually shift their views and add to equity positions even in the face of uncertainty. The second half of 2021 brought uncertainty in the form of COVID-19, inflation, and Fed policy. However, the fourth quarter once again proved the adage correct, as markets climbed these multiple “walls of worry” to close the year near all-time highs.

The First ‘Wall of Worry’, October-November

The fourth quarter opened with the passage of the bipartisan Infrastructure and Jobs Act in early November, and the Fed’s effective communication around tapering, which initially calmed fears of runaway inflation. The perception of strong, sustainable earnings buoyed equities, and a period of relative geopolitical calm supported the upward climb of stock markets, particularly in the US.

This rally was temporarily halted in late November by fears around a new COVID-19 variant – Omicron - and the impact of increasing inflation. Headline US consumer inflation for October crossed 6% for the first time since 1990. This inflation spike forced the Fed to taper bond purchases faster than expected and to move up their rate hike probabilities in 2022. This spike also had the indirect effect of delaying the passage of a second phase of fiscal stimulus, called the Build Back Better plan, through a deeply divided Congress.

Climbing the Second 'Wall’ in December

We believe the second “climb” is currently underway, reflecting investors’ increasing comfort with the Fed’s slightly hawkish shift to combat higher inflation. Investors are also settling into life with COVID-19 variants – milder outcomes, more testing, shorter quarantines, and lower likelihood of prolonged shutdowns. Markets ended the year with a rally that erased losses from early December, netting +11.0% for the S&P (Standard & Poor), +2.7% for Developed International, and small losses in Emerging Markets (-1.3%), with Bonds flat (.01%) for the quarter.

Performance: A Closer Look

Source: RiverFront, Morningstar Direct. Past performance is no guarantee of future results. Shown for illustrative purposes. It is not possible to invest directly in an index. Returns through December 31, 2021. See disclosures for asset class definitions. Index returns are provided for informational purposes and are not indicative of RiverFront portfolio performance.

From an asset class perspective, the fourth quarter’s performance themes resembled the year that preceded it. Most broad stock market indexes rose apart from emerging markets. Gains by far were the largest in the US, as international markets were acutely affected by geopolitics and COVID-19. Russia massed troops on the Ukraine border, and US/Chinese tensions escalated, with rumors of the US government delisting Chinese ADR’s. In addition, China’s economy was negatively affected by the government’s stringent “Zero COVID” policy, and European economies were also impacted by more draconian lockdown responses than the US.

“Bonds that look like stocks” - aka High Yield Bonds - outperformed all other fixed income asset classes both in Q4 and for 2021. Gold, despite a strong Q4 recovery on the back of inflation fears, was the lowest returning asset class we track in 2021, as longer-term inflation expectations have stayed anchored.

Looking at US sectors a little more closely, Q4 favored Growth and Defensive Equity themes over cyclicals, with Real Estate and Technology leading for the Quarter. While Energy was the best sector of 2021, it lagged on faltering oil demand and stagnant prices. Financials also underperformed as profit margins were hurt by falling long-term interest rates in the final month of the year.

Positioning for 2022: Stocks Over Bonds; Still Prefer US Over International

At RiverFront, our process is grounded in active management and the ability to be flexible, helping us navigate through periods of uncertainty. Interest rates are too low to offer attractive returns in all but the worst environments, which continues to point us towards stocks over bonds in our broad asset allocation. Heading into 2022, our process continues to favor US equities over international, with three distinct themes. The first theme consists of a mix of growth industries that benefit from the work-from-home environment and lower interest rates. The second is comprised of value stocks that stand to benefit from elevated levels of government stimulus, rising inflation, and higher levels of nominal GDP (Gross Domestic Product). The final theme is to incorporate covered call strategies (See 07.19.2021 Weekly View: The Search for Income), which can help generate additional income in a potentially volatile and range-bound equity market. For a more thorough explanation of covered call strategies see disclosures.

Within international markets we prefer developed markets to emerging ones. We see some selected opportunities in developed international if global economic growth continues to expand as we expect, given their more attractive valuations relative to the US. In contrast, we remain cautious on emerging market equities, particularly China, given the increased scrutiny and regulation of the corporate sector on the part of the Chinese government.

Given the challenges identified above around rates and inflation, we remain underweight fixed income in our balanced portfolios. We are also using a barbell approach to security selection here, owning shorter maturity corporate bonds (stronger economy to limit defaults) on one side and longer maturity Treasuries on the other. As a result, we have less bonds in the intermediate (7-15 year) part of the curve. We expect the slow path to higher rates to have a lot of volatility as policy shifts and equity market pullbacks occur and so will seek to buy long-term Treasuries when we feel their yields are at the top end of the range.

‘Process over Prediction’ – What We are Watching

The last four months of the year reinforced the importance of having a long-term plan (to stay invested through turmoil) as well as a tactical discipline (to identify times to make selection changes or pull back on equities after a market run). Our mantra of “Process Over Prediction” helped us remain overweight stocks despite these negative headlines since our three tactical rules remained positive (See 12.13.2021 Weekly View: Looking Through the Windshield), although we are now more cautious with regards to Fed policy. Historically, equity markets can go higher in the face of a new rate hike cycle (See 12.20.21 Weekly View: 2022 Outlook Summary – ‘Riding the Recovery’), but overly hawkish actions from the Fed can damage investor sentiment.

We believe the US economy remains the strongest of the major world economies, and we would like to see evidence of earnings momentum improve overseas before we invest more internationally. We will also continue to seek opportunities to diversify our sources of return in the portfolio as rates move up or down and shift to Treasuries when market sentiment is near optimistic extremes.

Implications for Different Investor Outcomes

  • Accumulate: The good news for Accumulate Investors is that the macroeconomic backdrop still favors equities. However, we think forward returns will be lower than in the last decade and volatility will be greater. As discussed above, we continue to seek opportunities in regions and sectors that have underperformed their peers in recent years.
  • Sustain: At current bond yields, traditional sources of safety, like bonds, are likely not as effective as their historical results might suggest. We believe that stable growth-oriented equities will prove useful in this environment – the sustainable nature of their earnings and cash flows have proven to be a safer haven than more cyclical companies’ earnings. We also believe covered call strategies will provide downside protection from transitory corrections.
  • Distribute: With interest rates so low, it can be tempting to reach for yield. However, low risk-free rates have also driven up the prices of more risky income assets (high yielding dividend stocks and bonds, preferred stocks, and MLPs) increasing their risk should a meaningful correction occur. With this in mind, we have become more tactical in our security selection and have a total return focus. A total return focus helps Distribute Investors supplement income through systematic withdrawals rather than reaching for yield. We are also incorporating covered calls more heavily for Distribute Investors.