We painted two contrasting pictures at end of last quarter: a threatening story of high valuations, rising bond yields, stubborn inflation, energy price rises and persistent COVID problems; alongside a happier tale of robust corporate profits, easing supply issues, consumers still spending freely, and central banks keeping a pro-growth tilt even as they start to shift policy. In reality, there may be little to choose between these pictures: differences may be as much to do with the investors’ sentiment and interpretation of the landscape. It doesn’t take much for optimism overgrowth to tip into concerns about overheating. We have seen periods of swinging investor sentiment and should expect more, given the current trajectory of the economy and central bank policy.

There is no real economic or market precedent for what we saw in 2021: this is clearly not a normal business cycle. We may think of it as a restart, not a recovery, after the pause button was pressed in early 2020. Growth has surged as activity has resumed, boosted by massive government and central bank support. Household spending patterns have shifted with reopening in the second half of 2021, for example towards leisure and travel services that were off-limits in lockdown, and inflation has spiked and stayed stubbornly high. Corporate profits have also surged, rebounding from the 2020 lows by around 50% (in the US) to reach record levels. Household incomes, underpinned by furlough schemes in 2020 and early 2021, may now benefit from a tight labour market, with firms forced to pay up to recruit and retain staff.

After the explosive growth as lockdowns ended, there is a clear market consensus for GDP growth to slow from very high levels towards more normal trend levels in 2023, with 2022 as something of a transition year. After close to 6% global economic growth in 2021 (that number won’t be confirmed by statisticians for several months yet!), economists expect perhaps 4.5% this year, and closer to 3% in 2023: a continuing recovery, but with momentum easing.

Of course, there is much that could challenge this smooth glidepath: new restrictions in the face of Omicron or the next threatening variant could test the flexibility and resilience of the global economy again, and disruptions to global supply chains and labour markets have still not been fully resolved. For example, the shortage of semiconductors as supply was diverted to personal electronics during lockdown, has wrought havoc on global car manufacturers, and is still some way from normalising.

So far, the global economy remains robust and adaptable in the face of these challenges. Corporate surveys in December confirm that growth is moderating, but the global economy continues to expand and companies remain quite optimistic about the future. Services are still outperforming manufacturing, although the global spread of Omicron could change that: in Europe and the UK, where Omicron hit early and hard, surveys point to a more abrupt slowing of services, as leisure and tourism were affected by new protective measures. The $1.2tn US Infrastructure Investment and Jobs Act was passed with bipartisan support, bringing in further fiscal support for growth, although the hoped-for $1.7tn package in the broader ‘Build Back Better’ campaign looks unable to gain enough support to pass. Despite that, a resilient jobs market and high levels of consumer savings provide a tailwind for growth. Concerns persist about inflation pressures across components and raw materials, energy, transport and staffing, although some surveys point to gradual easing of bottlenecks and supply chain issues.

The market narrative on inflation has evolved markedly through the year. Initial concerns centred on a transitory inflation spike being driven by a narrow range of goods and services when the economy emerged from lockdown in the spring and early summer, from second-hand cars to flights. Economists argued that sudden but temporary shifts in consumer spending patterns, combined with bottlenecks in supply chains disrupted by the pandemic, would lead to a temporary surge in inflation, but that it could pass quickly. But signs of inflation have become clear across a much broader swathe of the economy, and that inflation has proved much stickier than initially expected: while acknowledging that supply bottlenecks will be resolved, central banks have understandably moved away from characterising inflation as “transitory”.

Markets are uncertain how aggressively policymakers will react to inflation. It’s possible that we are within a couple of months of the peak of inflation pressures: food and energy prices may still be a factor well into 2022, but supply chain bottlenecks will be relieved, and firms will adapt to meet shifting patterns of consumer demand. Many emerging market central banks have already increased interest rates, some quite aggressively. Among the majors, the Bank of England has joined Norway and New Zealand in starting hiking rates, and Canada and the US Federal Reserve have signalled that rate rises will come in early 2022, and the Fed has brought forward the end of QE bond purchases. Progress will be slower in Europe and Japan, where QE will continue, but it is clear that the policy backdrop for 2022 will look very different to the last two years.

Markets fear a heavy-handed response, but inaction risks deeper problems; runaway inflation, demanding a more aggressive rates policy later. So far, policymaker shifts away from emergency pandemic support and towards a tighter policy have come with enough reassurance for markets, and calm has prevailed. Bonds fell in 2021, but not by much; certainly not by enough to rattle equity markets.

It’s unusual for a calendar year to see bonds deliver negative returns and stocks positive; 2021 is only the fourth time since the late 1970s that we have experienced this. In fact, it was a vintage year for stocks: we ended the year with global equities close to record highs, returning over 22% for the year. The US market was the driving force, up almost 29% after a very strong final quarter, but Continental European equities were also strong, up 25% for the year in local currency terms. UK equities made good absolute gains, though underperformed slightly (+18% for the year), but Japan was the laggard among developed markets, gaining less than 7%. Emerging markets struggled, with a slightly negative return for the year, dragged down by a 21% fall in Chinese shares and an 8% fall in Latin America. Indian equities (+29%) bucked the negative trend in Emerging Markets.

Style and size trends were mixed. Large-cap stocks outperformed small-caps significantly in the US, but small-caps led in the UK and Japan. For the year as a whole, there was little to choose between Value and Growth: in the US, Growth slightly outperformed, but for the rest of the world, Value was slightly stronger. More notably, 2021 saw the most significant decoupling of US Value stocks vs US Growth since at least 2000, as measured by their daily correlation of returns: we have long been used to much of the market moving up or down together; 2021 saw Value and Growth stocks moving increasingly independently of one another. This may help to explain the low volatility for the market as a whole: sometimes when Value zigged, Growth zagged, helping dampen volatility at an index level.

There was money to be made in every global industry sector: Energy stocks led the way (+42%), fuelled by sharply higher oil and gas prices, but the Information Technology, Real Estate and Financial sectors each gained around 30%. Defensive and bond sensitive sectors made more modest returns: Utilities gained 11%, Consumer Staples 14% and Communications 15%.

Global equities screened for ESG (Environmental, Social and Governance) characteristics outperformed again: this is especially striking when oil company shares have surged. ESG equities have now outperformed conventional equities over one, three, five and ten years - with slightly lower volatility too - an eye-catching result for investors.

The performance of US equities has been particularly remarkable however we look at it. It’s clearly not all about the post-pandemic recovery: US equities have now delivered a return of 84% over the past three years, including the pandemic sell-off and subsequent recovery. Over the past 10 years (2011-21), only four country stockmarket indices have beaten the global index: of these, the US was the strongest (and in the others, Denmark, Taiwan and Netherlands; arguably a single high-performing growth stock has had an outsize effect on each market). This leadership is particularly remarkable when we note that over the previous decade (2001-2011) the US was one of the weakest performers in the global index, 39th of 45 countries. Market trends can play out over very long periods, but it’s clearly been a losing proposition to bet against the US market - and especially large-cap tech and growth stocks - for a very long time.

Recent performance has been driven by earnings, rather than valuations. Equity markets (especially the US) struck many as expensive at the start of the year, but such has been the surge in corporate earnings - going well beyond pre-pandemic levels - that US equities appear cheaper now, relative to earnings, than they did before 2021’s gains. Valuation clearly isn’t everything.

Even more remarkable is the low level of volatility seen in the equity market in 2021. Even in strong bull markets, it’s quite usual to see significant pullbacks or market corrections. Since 1980, the average pullback in US equities has been a little over 14% in any given year. Even in the last ten years, where volatility has generally been lower (with the notable exception of the initial panic around Covid-19), we have seen market corrections on average over 10% per year. For 2021 - a year of inflation scares, central banks shifting towards tighter policy and new Covid variants, against a backdrop of apparently elevated equity valuations - a bout of market alarm or a few bumps on a volatile path would not have been at all surprising. But the biggest peak-to-trough correction we saw in US equity in 2021 was just 5.2%. We have only seen calmer years three times before in the last forty: investors will be questioning whether this calm can continue.

Global bonds delivered a rare negative year (2021 is only the sixth time we’ve seen this since the late 1970s) with total returns of -1.5% for the global aggregate index. US Treasury yields hit their highest levels for the year in March, hitting 1.75% for the 10yr bond as the inflation scare emerged. The damage was done by then, with yields falling a little through the rest of the year as central banks moved towards the end of QE and the first rises in interest rates, ending around 1.5%. Ten-year gilt yields ended the year at 1%, having peaked at 1.2% in October.

Falling bond yields at a time when investors expect interest rates to rise is not as counterintuitive as it may first seem: central bank action to tackle inflation increases interest rates and usually pushes up the yields of shorter-maturity bonds. Such steps may reduce the risk of much larger policy steps being needed later, or of inflation spiralling out of control. This can lead to “curve flattening”: long-dated bond yields falling, or rising less than interest rates and short-dated bond yields. There can be opportunities in bond markets even as investors look ahead to rising interest rates: a buyer of long-dated US Treasuries at the peak of inflation concerns in the Spring, when the US 30yr Treasury yield nudged close to 2.5%, could have made a double-digit return by yer-end, as yields fell back to 1.9%.

It paid off again to own inflation protection (US TIPS gained 6%, UK linkers 4%) or to own riskier bonds with shorter maturities (US High Yield gained 5%), while government bonds lost money: US Treasuries lost around 2%, UK Gilts (which have a much longer average maturity profile and are therefore more sensitive to rising yields) lost 5%. Higher quality corporate bonds were caught in the middle: not enough additional credit income to offset losses from rising yields. Emerging market bonds suffered, especially local currency bonds, hit by both currency weakness and higher borrowing costs for weaker debtors. Emerging market debt overall has perhaps become riskier through the pandemic as the level of indebtedness among EM governments has increased, in some cases quite substantially, and this may explain poor performance.

The US Dollar strengthened against all major currencies except the oil-sensitive Canadian Dollar and Norwegian Krone. Dollars gained most against Yen (9%) and Euro (5%), boosted by the prospect of higher interest rates in 2022. Sterling had a poor start to 2021, with Brexit exacerbating supply strains in the economy, but ended the year down only 1% against the Dollar, supported by the Bank of England’s first rate hike of this cycle. Almost all emerging market currencies weakened against the Dollar, with the Turkish Lira falling 24% and significant falls for several Latin American currencies. It may have been a strong year for equities and high yield bonds, but investors clearly did not embrace risk in all its forms, as the dismal showing of Emerging Market assets - equities, bonds and FX - makes clear.

Sharp rises in many commodity prices underpin the sticky inflation that central banks are focused on. Steep climbs in energy prices have made headlines: crude oil ended the year up 58% at almost $76/barrel, but gasoline futures rose a similar amount and natural gas ended the year up 45% at $3.73, having topped $6.30 in October. High energy costs will continue to affect transport and distribution costs into 2022 and natural gas prices in particular will feed into household gas and electricity bills over the coming months. But we have seen marked rises in a range of other commodities, as demand has recovered ahead of supply: prices for industrial metals like copper, zinc and nickel rose by 25-30%, aluminium by more. Futures prices for agricultural commodities like wheat, corn and cattle rose by 20-25%, cotton and coffee by much more; these will also feed into household bills over the coming months, potentially impacting discretionary spending. Precious metals were rather disappointing by comparison, with gold edging 4% lower over the year, and silver falling 12%. Many investors like to hold gold as a potential hedge against inflation, but on this occasion it has not worked. Some now favour cryptocurrencies instead: Bitcoin enjoyed the wildest of rides, ending the year up 105% at over $46,000, but well down from its peaks above $60,000.

Carbon Permit prices in the EU emissions trading scheme saw an even stronger rise, up 140% over 2021, with much of that price surge coming in the wake of the UN COP26 conference. Progress there perhaps didn’t live up to the more optimistic expectations, but markets took some heart from commitments in coal, methane and deforestation (bolstered by further climate commitments in the subsequent US-China summit).

We approach 2022 conscious of the risks and the enormous gains made by stocks over the past 18 months or so. The rapid recovery has given investors a relatively easy ride: growth underpinned by fiscal and monetary support, an environment of low or falling interest rates, surging profits, and rising asset valuations. As growth decelerates and policy support fades, many strategists expect more modest returns and more frequent or intense periods of volatility. But such predictions rarely capture reality, and investors need portfolios that can cope through a range of unexpected outcomes - whether another year of low volatility and surprisingly strong equity returns, or a more serious bear market. When drawdowns come, recoveries might be slower than the extremely rapid rebounds we have seen in the last 18 months, but investors can use time and well-constructed portfolios to their advantage, sticking to their plan and letting the passage of time drive investment returns.

N.b. All content is based on data at the time of writing on 10 January 2022.