During 2021, all three of the major financial markets provided an extraordinarily good year for equities, with the Dow Jones Industrial Average, Nasdaq and S&P 500^® Index finishing the year at or near all-time highs. Several events led to these record highs, including the rollout of Covid-19 vaccines, unprecedented U.S. government fiscal and monetary support, strong consumer balance sheets, sturdy consumer spending and robust corporate earnings. Building in the background on the domestic front, however, were some potentially unfavorable trends, especially by year-end: the highly contagious Omicron variant of Covid-19, tighter monetary policy, the highest inflation in 30 years, the failure to pass more fiscal stimulus, and modest earnings growth in the equity market. Mutual of America Capital Management LLC looks at the impact these issues had on the economy and financial markets in 2021 and explores how they may influence market movements in early 2022.

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Strong Year in Equity Markets

Even in the face of accelerating headwinds last year, the equity markets rallied. For example, the S&P 500 increased by 4.5% in December and finished 2021 up 28.7%—easily outpacing its 18.4% rise in 2020. During the year, the S&P 500 set 70 record highs, which is the second-most ever, behind the 77 in 1995. It was also the third-highest annual gain on record; and there was only one pullback of 5% in September. In the last three-year period, the S&P 500 doubled, something the Index had not achieved in a three-year period since the 1995–2000 stretch of the Technology Bubble, also known as the Dot-Com Bubble. Over the most recent two-year period, U.S. equity markets outperformed international equity markets, reflecting the earlier vaccination adoption success in the United States. Value stocks, both large and small, achieved much better returns than in 2020. This was especially true in the first half of 2021, given their high operating leverage to the reopening of the economy.

The 10-year U.S. Treasury bond yield was on a roller coaster most of the year as investors debated whether inflation in the economy was transitory or more of a long-term problem. To recap, yields began the year at 0.91%, hit a one-year high of 1.74% on March 31, 2021, fell to 1.17% by August 3, 2021, and rose once again to 1.51% by December 31, 2021. At this point, the 10-year Treasury is back to pre-pandemic levels and, given the outlook on inflation, yields appear likely to trend higher. For the full-year period, the 10-year Treasury was down 3.7%, the 30-year Treasury declined 4.7%, the Bloomberg U.S. Corporate Bond Index declined 1.0%, and the Bloomberg U.S. Aggregate Index declined 1.5%.

Inflation Concerns Grow

Inflation continues to be problematic, and its rise is being caused by a variety of factors, including increases in global commodities, rising consumer demand, wage pressures and supply-chain bottlenecks. By November of last year, all three well-known inflation gauges showed heightened and increasing levels well above the U.S. Federal Reserve's average target of 2.0%: 1) the Bureau of Economic Affairs' Personal Consumption Expenditures (PCE)—the Fed's preferred inflation gauge—was up 4.7% year-over-year; 2) the Producer Price Index, which sometimes predicts the direction of consumer prices, was up 9.6%; and 3) the Consumer Price Index (CPI), the most widely recognized gauge, was up 6.8%—its highest level since June of 1982. The CPI provides a statistical measure of the average change in prices in a fixed market basket of consumer goods and services. The December CPI came in at 7.0%, marking the 10th consecutive month that inflation was above the Fed's target rate.

The ongoing effect of inflation has directly impacted consumers' purchasing power. Gas prices jumped nationwide during 2021, with an average of $3.38 per gallon on December 27, 2021—an increase of more than $1.00 per gallon from December 2020. Food prices jumped 6.1% over the year, while used car and truck prices increased 31.4%. Home prices surged, as well. The most recent S&P/Case-Shiller U.S. National Home Price Index, from October 2021, reported a 19.1% annual gain. While down slightly from 19.7% in September 2021, these are very strong numbers that will continue to keep the CPI elevated in the coming months.

Supply-chain issues also added to the heightened concern about inflation over the last year. These issues include global chip shortages due to supply-chain disruptions caused by the Covid-19 pandemic, a sharp rise in demand for electronic goods because more people are working from home, and a lack of investing in chip manufacturing capacity. Industries most hurt by the chip shortage include automotive and technology (especially computer, cell phone and video game manufacturers). Shipping and transportation also were affected by mounting supply-chain issues, due to a shortage of dockworkers and truckers. At the end of November, there were 94 ships waiting to dock at the ports of Los Angeles and Long Beach, California. The delays in shipping increased costs for consumers and continued to affect the availability of goods during the holiday season and into the new year.

The Powell Pivot

With such increases affecting consumers, it's no surprise the Fed is keenly focused on curbing inflation. The December 2021 meeting of the Federal Open Market Committee (FOMC), which included seven members of the Board of Governors of the Federal Reserve System, made it clear that the Fed's inflation goals have been achieved and that Chairman Jerome Powell had signaled a hawkish pivot. Part of that pivot included an accelerated pace of tapering, and the Fed now anticipates their program of quantitative easing will be concluded by March of 2022. The Fed also released a revised schedule of economic projections, which now indicates that they anticipate at least three 25-basis-point interest-rate increases during 2022. The Fed also projects that the labor market will continue to improve, with the unemployment rate declining to 3.5% by the end of 2022, which is well below its longer-run rate of 4.0%. The Fed is sending a clear message to the market that it is concerned about inflation, and it will use the tools at its disposal to keep the economy from derailing as a result of inflation.

Build Back Better Act

As for major legislation by the federal government, President Joe Biden and Democratic leaders have already twice scaled back their ambitions for the social-spending and climate-change bill known as the Build Back Better Act—first by reducing its cost from $6 trillion to $3.5 trillion, and then down to $1.7 trillion. While West Virginia Senator Joe Manchin's opposition in December ended his party's hopes of passing the $1.75 trillion bill before the end of 2021, some Democrats hoped they could get Manchin to support an even smaller version in 2022, or pass popular components of the bill as separate, stand-alone measures. Although Manchin said he has not restarted talks with party leaders yet, it does not mean negotiations have ended. Democratic leaders see the bill's passage as critical in helping their party to gain political momentum going into the midterm elections this November. If a bill does come together, it would probably include these Democratic priorities: major climate-change provisions that include generous subsidies for green energy, enhanced child tax credits, Medicare expansion, childcare and universal preschool. These priorities would be financed with tax increases and drug price controls. The child tax credit remains the biggest sticking point, and meeting Manchin's demands would mean dropping several other major Democratic priorities.

A Challenged Labor Market

With consistent job growth every month in 2021, the economy added 6.45 million jobs, the highest aggregate calendar-year gain on record going back to 1940. This represents 84% of the jobs lost at the start of the pandemic, leaving the total employment level 3.6 million jobs shy of where it stood in February of 2020. The unemployment rate of 3.9% in December 2021 represented a decline of 0.3 percentage points from 4.2% in November. This marked the first time that unemployment has been under 4.0% since the pandemic began, and the largest-ever one-year drop in the unemployment rate on record. As a point of comparison, in February 2020, before the outbreak of the pandemic in the U.S., the unemployment rate was at a 50-year low of 3.5%, and the number of unemployed persons was 5.7 million.

Even with strong job growth and a low unemployment rate, there are some indications that the labor markets may be challenged going forward. First, the U.S. Bureau of Labor Statistics' Job Openings and Labor Turnover Survey (JOLTS) for November showed that the number of job openings nationwide was still above 10 million for the fifth month in a row. Second, the labor force participation rate in the U.S. was 61.9% in December 2021, remaining 1.5 percentage points lower than in February 2020 (63.4%) before the pandemic started—and thus representing a labor force that is nearly 2.4 million smaller. The workforce has shrunk for a number of reasons, including that: 1) many people close to retirement decided not to return to work, due to healthcare concerns and lifestyle changes; 2) childcare issues, as there is a lack of caretakers to meet demand, and the cost of care has increased; and 3) more recently, workers are hesitant to reenter the workforce due to the emergence of the Omicron variant. Another indication is that average hourly earnings continued to climb in December and were up 4.7% year over year. All told, millions of job openings, fewer people in the labor market and rising wages could exacerbate the already high levels of inflation.

Equity Valuations

The earnings recovery in 2021 was among the most remarkable in the modern history of the equity markets, with earnings increasing by an estimated 49%. This increase, which is the result of soaring revenue combined with a cost structure that was held flat through the pandemic, is similar to what happened after the financial crisis of 2008–09. Most macroeconomists estimate that the S&P 500 will earn $227 a share in 2022, which represents year-over-year earnings growth of 9%. Currently, the S&P 500 trades at a forward price-to-earnings (P/E) multiple of 21, which is elevated relative to the historic range of 14 to 15 times for forward multiples. Last year, the market became even more narrow, with a relatively small number of stocks driving returns. During the final week of December, while the S&P 500 was setting new record highs, 334 companies in the Index hit new 52-week lows, more than double the number that marked new one-year highs. This has happened only three other times, all in December of 1999, during the Dot-Com Bubble. Another take on this phenomenon is to look at the five largest names in the Index—Apple, Microsoft, Amazon, Facebook and Alphabet—they accounted for roughly 26% of the overall 28.7% return to the Index in 2021. In related news, on January 3, 2022, Apple became the first company to be worth $3 trillion. Apple's market value is greater than the $2.76 trillion Gross Domestic Product (GDP) of the United Kingdom, and it is approaching the $3.85 trillion GDP of Germany.

Outlook

As we begin a new year, there are a number of positives and negatives facing the U.S. economy and financial markets. On the positive side, the country has experienced strong jobs growth, robust corporate earnings, strong consumer spending and low interest rates. On the negative side, there are higher levels of inflation, created by a sluggish supply of labor participation and supply-chain issues. Additionally, the Omicron variant emerged, and infections surged. This variant appears to be more contagious but less lethal than previous variants, at least among the segment of the population who have been vaccinated. Therefore, it is less likely that widespread lockdowns will occur to hamper economic growth. However, this remains a risk. Finally, many stocks, especially the top names in the S&P 500, carry valuations that are potentially stretched. With this in mind, we continue to favor value-oriented stocks, which have better valuation support. We will continue to monitor these issues and other events that might impact our outlook in the coming months.

Jamie Zendel is EVP, Head of Quantitative Strategies, and Erik Wennerstrum is VP, Quantitative Research, at Mutual of America Capital Management LLC.

Past performance is no guarantee of future results. The index returns discussed above are for illustrative purposes only and do not represent the performance of any investment or group of investments. Indexes are unmanaged and not subject to fees or expenses. The index returns above reflect the reinvestment of distributions. It is not possible to invest directly in an index.

The views expressed in this article are subject to change at any time based on market and other conditions and should not be construed as a recommendation. This article contains forward-looking statements, which speak only as of the date they were made and involve risks and uncertainties that could cause actual results to differ materially from those expressed herein. Readers are cautioned not to rely on our forward-looking statements.

The information has been provided as a general market commentary only and does not constitute legal, tax, accounting, other professional counsel or investment advice, is not predictive of future performance, and should not be construed as an offer to sell or a solicitation to buy any security or make an offer where otherwise unlawful. The information has been provided without taking into account the investment objective, financial situation or needs of any particular person. Mutual of America is not responsible for any subsequent investment advice given based on the information supplied.

Mutual of America Capital Management LLC is an indirect, wholly owned subsidiary of Mutual of America Life Insurance Company. Securities offered by Mutual of America Securities LLC, Member FINRA/SIPC. Insurance products are issued by Mutual of America Life Insurance Company.