U.S.

Stocks recorded solid gains in the quarter after overcoming a late-November sell-off in reaction to the global spread of the omicron variant of the coronavirus. The prospect of higher interest rates also periodically weighed on sentiment. Growth stocks outpaced value shares among large-caps, but value stocks generally performed better among mid- and small-caps. Most sectors of the S&P 500 Index saw double-digit gains, but the communication services sector was flat for the period.

Fed Takes First Step Toward Tightening

The rate outlook and persistent high inflation signals weighed on fixed income returns, which were also flat overall for the month. In late November, Federal Reserve Chair Jerome Powell told a congressional committee that he no longer thought it was appropriate to refer to inflation as “transitory” following a series of upside inflation surprises. Indeed, data were soon released showing that consumer prices rose 6.8% in the 12 months ended in November, the biggest increase since 1982. Producer prices jumped 9.6%, the most in records going back to 2010. In November, the Fed took its first step toward tightening by cutting its monthly asset purchases in half, and it accelerated the pace of tapering in December. Policymakers now expect a median of three rate hikes in 2022, followed by five more hikes over the next two years, lifting the median expectation for the federal funds rate to 2.1% at year-end 2024.

Inflation clearly worried consumers as well. In November, the University of Michigan’s consumer sentiment index tumbled to its lowest level in a decade, with many respondents citing rising prices. Evidence also emerged that consumers were pulling back in response, with retail sales falling in November on an inflation-adjusted basis. Supply shortages were one factor in rising prices, and Powell noted that concern about them may have also pulled some of November’s holiday shopping into October.

Job Openings Highest on Record

Powell also stated that he remained confident in the strength of the consumer, however, and most of the quarter’s data indicated that economic growth was accelerating again after the slowdown in the third quarter. Nonfarm payrolls grew at a healthy clip through October. Payroll growth then decelerated in November, but the slowdown appeared to be due to a labor supply shortage rather than demand—job openings hit 11 million, the highest on record, and the unemployment rate fell to a pandemic-era low of 4.2%. In December, weekly jobless claims fell to their lowest level since 1969.

The pandemic loomed large over sentiment throughout the quarter, particularly following news of the omicron variant. As the quarter came to an end, however, investors seemed reassured that the variant appeared to cause milder illness and seemed to have peaked rapidly in South Africa, where it was first discovered. The approval of two new pill-based treatments for those seriously ill with COVID-19 also seemed to calm fears, as did the Centers for Disease Control and Prevention (CDC) announcement that the agency was cutting its quarantine guidance from 10 days to five days.

Finally, investor sentiment alongside corporate profits seemed to remain resilient in the face of higher input and wage costs. Corporate profit growth slowed from its blistering pace in the second quarter but remained robust, and roughly four out of five companies in the S&P 500 beat consensus earnings estimates—the fourth-highest percentage since FactSet began tracking the data in 2008.

Europe

Shares in Europe posted strong gains, as investors took the view that monetary policy would only be tightened gradually. Fears about the highly infectious omicron variant of the coronavirus eased, as data suggested it may be less severe than other strains. In local currency terms, the pan-European STOXX Europe 600 Index ended the quarter about 7.25% higher and gained more than 22% on the year.

Governments Clamp Down as Omicron Spreads

The rapid spread of the omicron strain and record numbers of infections in several countries prompted governments to tighten social restrictions for the end-of-year holiday season. These measures included travel bans, mandatory vaccination for health workers, and the use of passes reflecting the bearer’s vaccination status for access to entertainment venues. The Netherlands and Austria introduced lockdowns in November. Austria lifted its lockdown mid-December; the Netherlands extended theirs until mid-January.

Market fears eased toward the end of December, after early studies indicated omicron was less severe than the delta variant of the coronavirus and resulted in shorter hospital stays, fewer intensive care cases, and fewer deaths.

ECB Signals End of Emergency Program; BoE, Norges Bank Hike Rates

The European Central Bank (ECB) left its main policy rates unchanged but said it would stop buying assets under its Pandemic Emergency Purchase Program in March while temporarily expanding another bond-buying program to smooth the transition. The ECB signaled that any exit from ultra-easy monetary policy would occur slowly due to the economic uncertainty caused by the pandemic. ECB President Christine Lagarde said later that an interest rate increase in 2022 was “very unlikely.” Official data released before the ECB’s policy decision showed inflation had hit its highest level since the single currency was introduced in 1999. Surging energy costs were a big driver of inflation.

The Bank of England (BoE) unexpectedly raised its bank rate 15 basis points to 0.25% as a first step to controlling inflation, which in November hit the highest level in a decade. Norway’s central bank lifted its key rate by another 25 basis points to 0.50% and said that additional increases could follow.

New Government in Germany; Portugal to Hold Snap Election

Social Democrat (SPD) leader Olaf Scholz became chancellor of Germany after forming the first coalition government to combine the Greens and the liberal Free Democrats (FDP). FDP Chairman Christian Lindner, a fiscal conservative, was appointed finance minister. The alliance said its main aims are to upgrade infrastructure to modernize the economy, accelerate measures to combat climate change, and increase the minimum wage and social housing.

Portugal’s President Marcelo Rebelo de Sousa called a snap election for January 30, 2022, after lawmakers rejected the 2022 budget bill of the minority Socialist government.

Italy and Spain Approve Budgets

The Spanish and Italian parliaments approved 2022 budgets that include funds disbursed under the European Union’s recovery program. In Spain, spending plans totaled EUR 240 billion—the largest in the country’s history—and were made possible by an agreement to reform the labor market. Italy’s EUR 32 billion budget included income and business tax cuts and the creation of a climate fund.

Japan

Japan’s stock markets generated negative returns over the quarter, with the Nikkei 225 Index down 2.24% and the broader TOPIX Index falling 1.86%. Sentiment early in the quarter was dampened by political uncertainty in the lead up to the October 31 general election. New Prime Minister Fumio Kishida’s ruling Liberal Democratic Party (LDP) held on to its majority in the powerful lower house of parliament; despite losing some seats, the outcome for the LDP was better than opinion polls had suggested. In November, concerns about the global spread of the omicron variant of the coronavirus, and Japan’s subsequent closure of its borders to foreign nationals, weighed on sentiment. December was a stronger month for Japanese markets. While other major central banks took steps to normalize policy, the Bank of Japan (BoJ) said it’s ready to take additional easing steps as needed to support the economy through the pandemic, boosting investor sentiment.

Against this backdrop, the yield on the 10-year Japanese government bond was broadly unchanged on the quarter at 0.07%, while the yen weakened to around JPY 115.08 against the U.S. dollar, from about JPY 111.28 at the end of September. The BoJ remains among the world’s most dovish central banks, contributing to yen weakness. BoJ Governor Haruhiko Kuroda commented that its policy stance is contingent on Japan’s economic situation and independent of the decisions of other central banks, many of which, across the developed world, are tightening monetary policy.

Kishida Signals Policy Continuity

The early signs are that Japan’s new prime minister will pursue policy continuity; he has identified the “three arrows” from economic plans developed under his predecessor Shinzo Abe—aggressive monetary policy, fiscal consolidation, and sustained structural reform—as the key tenets of his administration’s macroeconomic policy management. Kishida’s government approved a larger-than-expected stimulus package, with record fiscal support of JPY 55.7 trillion (USD 490 billion). By carrying out the stimulus package with a sense of urgency, Kishida hopes to rebuild Japan’s pandemic-hit economy and put it on a growth path as soon as possible. The large-scale economic measures will include assistance to individuals and business operators, as well as an injection of funds to address the challenges of digitalization and climate change.

Japan’s Economy Contracts by More Than Initially Estimated in Third Quarter

Revised figures for economic growth released by Japan’s Cabinet Office showed that gross domestic product contracted by an annualized 3.6% in the third quarter, more than suggested by the preliminary estimate of 3.0%. Private consumption fell more than expected, due primarily to a surge in coronavirus cases over the summer. Meanwhile, Japan’s industrial production grew by a seasonally adjusted 7.2% month-on-month in November amid easing supply-side pressures, with the motor vehicle; plastic products; and iron, steel, and nonferrous metals industries the main contributors to the increase, according to Ministry of Economy, Trade and Industry data. The ministry upgraded its assessment and now expects production to increase in December 2021 and January 2022, having previously indicated that production is pausing.

China

Chinese stocks recorded a mixed performance in the fourth quarter. The MSCI China Index lost 6.1%, but the MSCI China A Onshore Index gained 3.4%. The yield on the 10-year Chinese government bond peaked above 3.0% in mid-October, then declined 10 basis points to end the quarter at 2.79%. The renminbi appreciated 1.4% against the U.S. dollar over the quarter to close at 6.373 per dollar. The currency was Asia’s best performer in 2021, gaining 2.6% against the greenback as most currencies in the region recorded losses.

Easing Monetary Policy

China’s monetary policy took a dovish turn as the government sought to cushion the economy amid a nationwide property market slowdown. The People’s Bank of China (PBOC) cut its reserve requirement ratio, or the amount of cash that banks must hold in reserve at the central bank, by 50 basis points, effective December 15, its second such move this year. Toward month-end, the PBOC cut the one-year loan prime rate for the first time since April 2020.

Hopes for a thaw in U.S.-China relations following a November virtual summit between U.S. President Joe Biden and his Chinese counterpart Xi Jinping were dashed as both sides escalated investment restrictions on each other. In November, the Biden administration said it would extend a Trump-era ban on U.S. investments in Chinese companies that it deems are owned or controlled by China’s military, then added a dozen Chinese companies to its trade blacklist later in the month. In December, President Biden signed a bipartisan bill that effectively bans U.S. imports from Xinjiang province. For its part, China issued a flurry of new regulations on overseas share sales by domestic companies.

Mixed Economic Signals

External trade performance was strong over the final quarter, though exports slowed in November due to currency strength and weaker global demand. December indicators showed that factory output grew faster than expected, but growth in retail sales and fixed asset investment lagged forecasts. In a separate release, official purchasing manager indices for manufacturing and services both rose more than expected in December. Next year, China’s economy is forecast to expand about 5.3% compared with an estimated growth pace of 8% in 2021, the government think tank Chinese Academy of Social Sciences wrote in its annual report.

Turmoil in the property sector continued as developers China Evergrande Group and Kaisa Group Holdings, two of the mainland’s biggest issuers of offshore debt, entered restructuring talks with creditors after defaulting on their bond payments. Both companies’ restructurings follow a wave of defaults among smaller developers in recent months. Meanwhile, liquidity problems also emerged at Shimao Group, a higher-rated developer seen as one of China’s stronger developers.

Other Key Markets

Turkish Equities Plummet Along With the Lira

Turkish stocks, as measured by MSCI, returned -11.13% versus -1.24% for the MSCI Emerging Markets Index.

Equities performed well in local currency terms for most of the quarter, but bonds and the lira were pressured by various factors. These included President Recep Tayyip Erdogan’s mid-October removal of three members of the central bank’s Monetary Policy Committee, one of whom was dismissed specifically because he voted against the central bank’s interest rate cut in September, three central bank interest rate cuts in the fourth quarter that reduced the one-week repo auction rate from 18.0% to 14.0% despite year-over-year headline inflation that recently exceeded 20%, and S&P Global Ratings’ decision to lower its credit outlook for Turkey from “stable” to “negative,” which is a possible prelude to a future downgrade of the sovereign rating.

Turkish stocks fell sharply in the second half of December, and the lira plunged to new all-time lows versus the U.S. dollar, as President Erdogan spoke in defense of what he called Turkey’s “new economic model.” T. Rowe Price sovereign analyst Peter Botoucharov believes that the intention of this new economic model, while not yet clearly defined by Erdogan, is to allow the lira to depreciate in an orderly manner so that exporting companies will be more competitive in international markets. He believes that exports could also be supported by new structural measures, such as the issuance of cheap credit, as well as central bank credit facilities. The downside of this model, however, is higher inflation and currency weakness that will likely be suppressed by the government’s close monitoring of currency speculation and by price-setting behaviors.

Toward the end of December, the lira bounced sharply from its lowest levels of the month, as President Erdogan announced new measures that seem intended to reduce household demand for foreign exchange (FX) and to support domestic savings that are denominated in lira. While details are incomplete, one of the measures seems to be the creation of a new FX-indexed deposit instrument that pays either the lira deposit interest rate or the FX return, whichever is greater. This measure would transfer the risk—and any potential costs of lira depreciation above the lira deposit rate—from the household and banking sector to the public sector balance sheet.

Political Developments Drive Decline in Chilean Stocks

Chilean stocks, as measured by MSCI, returned -9.04% and underperformed the MSCI Emerging Markets Index. Political developments were significant drivers of Chilean financial markets. For example, investors were concerned for much of the quarter that a new bill allowing for pension system withdrawals—the fourth such legislation since the beginning of the pandemic—would soon become law. While the lower house of Congress barely passed the legislation, the Senate was just one vote shy of the three-fifths majority needed for approval. The bill went to a mixed 10-member committee that revised and returned the bill to Congress for a final vote. However, the bill died in the Chamber of Deputies in December because it was four votes short of the required three-fifths majority.

Also, Chile held elections on November 21. In the legislative elections, right-leaning political parties fared better than expected—they won 70 out of 155 seats in the Chamber of Deputies and 25 out of 50 seats in the Senate. As for the first round of the presidential election, far-right candidate Jose Antonio Kast did slightly better than far-left candidate Gabriel Boric, though neither received more than 30% of the ballots cast. As a result, there was a second-round runoff between them on December 19, which Boric won with approximately 56% of the votes. According to T. Rowe Price emerging markets sovereign analyst Aaron Gifford, Boric’s advantage was that his platform was more in line with what Chilean voters want, such as a larger state, a new constitution, and greater social rights. However, Gifford also believes that the strong support for Boric is probably conditional on him being moderate.

Monetary policy was another significant factor during the quarter. In response to rising inflation, the central bank raised its key short-term interest rate from 1.50% to 4.00% in two 125-basis-point steps. (A basis point is 0.01 percentage points.) According to Gifford, central bank officials highlighted in their mid-December post-meeting statement that economic growth was strong—mostly due to robust private consumption on the back of high household liquidity. The statement also mentioned household and business sentiment declining recently, likely a reflection of political uncertainty and inflation concerns. Given strong growth and high inflation, however, central bank officials expect the policy rate to continue increasing in the near term.

What We’re Watching Next

After back-to-back years of strong performance across most equity and credit sectors, global markets face more uncertain prospects in 2022. Investors will need to use greater selectivity to identify potential opportunities. Higher inflation, a shift toward monetary tightening, and new coronavirus variants all pose potential challenges for economic growth and earnings—at a time when valuations appear elevated across many asset categories.

The bearish economic case now centers on monetary and fiscal policy. Many believe that as governments and central banks withdraw the massive stimulus applied during the pandemic, economic growth inevitably will slow sharply. But slower growth doesn’t necessarily mean low growth. A number of tailwinds should sustain the recovery in 2022:

• Consumers are in a strong cash position, especially in the U.S., where over USD 2 trillion is sitting in checking accounts and other short-term deposits.
• Asset appreciation has boosted household wealth both in the U.S. and globally.
• Pent-up demand for housing should continue to fuel new home construction.
• Corporate balance sheets generally are in strong shape, with high liquidity and low debt ratios.
• Transportation bottlenecks appeared to ease in late 2021, as seen by a sharp drop in global seaborne shipping costs.

Unless pandemic conditions deteriorate significantly, improving global supply chains and factory reopenings could ease the upward pressure on prices in 2022. Much of the 2021 inflation surge was concentrated in specific products—such as used cars and gasoline—that were particularly hard hit by supply/demand imbalances. The hefty price hikes in these goods seen in 2021 are unlikely to be repeated in 2022.

In terms of equity valuations, much will depend on the strength of earnings growth in an environment where the spread of coronavirus variants and the potential for rising interest rates both pose significant—if contrary—risks to the global economic recovery.