Despite numerous twists and turns this year, equity markets are closing out 2021 with double-digit returns as the cyclical recovery continues. While COVID remained a major driver of the market in the 1st half of the year, the progressive weakening of the Delta and Omicron variants reduced its impact in the 2nd half. Strong profits supported by robust consumer spending and effective cost management have continued to drive the market higher. This occurred even as supply chain and inflation pressures took hold and the Federal Reserve began unwinding its historic monetary easing.
A big driver of this was consumers’ raw appetite and corporations’ ability to leverage technology and scale to protect margins in the face of higher costs. Indeed, through the 3rd quarter, the operating margin on the S&P 500 increased a whopping 50%, from 10% to 15%, despite all these headwinds. This occurred in tandem with rising retail sales, higher GDP, and lower unemployment. This flow of strong economic data provided the market with the fundamental basis to rally.
Seasonal factors were also strongly at work as a “Santa Claus” rally took hold in December. This seasonal effect often happens as consumers spend going into the holidays, investment managers finish selling tax losses, and the market broadly goes “on vacation”. This occurred even as fears about the Omicron variant caused a little bout of volatility in early December. Despite higher prices, consumers aggressively spent this holiday season, with a nearly 10% increase over last year. This robust spending provided further fuel for the market to continue its rally in the final weeks of the year.
Heading into 2022, the market has set some strong expectations for itself, and the pressure will continue to be on earnings to deliver. Cost pressures have already caused estimates for the 4th quarter to moderate and the verdict is still out as to whether these factors reverse. This will be especially important with the Federal Reserve taking its foot off the pedal and eventually raising interest rates. So far, markets have taken the Fed’s shift in stance in stride, with markets cheering the “Powell Pivot” which resulted in rapid revisions to guidance after economic data came in stronger than expected. Markets in particular are still buying the notion that the Fed will successfully reign in inflation. Whether or not that holds, and to what degree they ultimately have to hike rates, will be key drivers of the market in 2022. Strong economic fundamentals continue to have us looking into next year with cautious optimism, but of course we will be ready as always to act if market volatility presents itself.
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