United States

Markets were resilient in the face of elevated inflation and Omicron headlines

Investors were rattled by the evolving headlines surrounding the Omicron variant, and the Federal Reserve’s (Fed’s) clarification on its views about current elevated inflation levels. However, U.S. equity markets have continued to show resilience. 

The S&P 1500® marked new all-time highs in December, rebounding from its November decline to return 4.5%, the third-best monthly performance for the year. 

Market performance was driven by large capitalization, and value-oriented stocks. The S&P 1500 finished the year with a 28.4% gain.

The S&P 500® also rose in December, gaining 4.5% during the month to close the year with a 28.7% gain. Performance was led by value- and defensive-oriented stocks in the Consumer Staples and Utilities sectors amid a backdrop of concerns regarding the Omicron variant and expectations for rising interest rates. The Russell 2000 also posted a gain of 2.2% for December and 14.8% for the year, as rising short-term interest rates supported Financials and Real Estate stocks.

The CBOE Volatility Index fell throughout December; however, we believe this is largely due to starting the month at the highest level since January 2021. The futures curve also went into backwardation at the start of the month, a rare formation for volatility futures where current prices are higher than longer-dated futures contracts, indicating significant volatility expectations. We believe that while volatility futures settled during the month, elevated volatility will persist as the pandemic lingers, economic data moderates and global fiscal and monetary stimulus fades.

The Consumer Price Index hit its highest level since 1982, climbing 6.8% on a year-over-year basis. Energy-related commodities, food and some durable goods such as autos continue to see high price levels (Figure 1). We believe continued elevated inflation is due primarily to labor shortages and supply chain constraints that emerged from the pandemic, whereas consumer demand has not slowed. We maintain the view that while inflation may spike in the short term due to pandemic-related effects, elevated inflation will not persist over the long term. In-line with inflationary pressures in consumer prices, the U.S. Producer Price Index recorded its largest increase in November, up 9.6% year-over-year due to the impacts of supply chain bottlenecks.

Figure 1. Consumer Price Index, YoY 
Consumer prices hit highest level since 1982

Source: Bloomberg, L.P.

View accessible version of this chart.

The November payroll report missed expectations by a wide margin, adding 249,000 jobs versus the consensus expectation of 550,000. The December payroll report also disappointed, adding 199,000 jobs versus estimates of 450,000. Consumer demand remains resilient with consumer sentiment increasing during the month as seen in the University of Michigan Sentiment and NFIB Small Business Optimism indices, although both remain below their pre-pandemic levels. Overall, while the current accelerating expansion phase of the business cycle is showing signs of exhaustion, the growth outlook for 2022 remains positive, just at a decelerating rate compared to 2021. 

The Federal Open Market Committee held its final meeting of 2021 in December. Meeting notes signaled an expected acceleration in the Fed’s asset purchase tapering schedule; it is set to begin in January 2022 and complete by March 2022. Fed Chairman Jerome Powell stated he expects tapering to conclude before increasing the fed funds rate, so an acceleration in the tapering schedule may point to rising rates sooner than initially expected. PNC Economics expects the Fed may raise its policy rate as early as September with a second hike later in the year. We believe that despite the Fed’s move to accelerate the tapering of its asset purchases, monetary policy is expected to remain accommodative and thus supportive of markets.

The U.S. Treasury (UST) yield curve ended the month slightly higher, with maturities six months and beyond rising in reaction to the Fed’s accelerated tapering schedule and revised dot plot. As of year-end, the 10-year UST was 1.51% and the 2-year UST rose nearly 17 basis points (bps) to 0.73%. The breakeven yields at both the 5- and 10-year level ended higher in December, moving above their 50-day and 200-day moving averages, indicating investors’ expectations for inflation have increased.

Equity valuations remain high relative to history, with the S&P 500 forward price-to-earnings ratio (P/E) ending December at 21.0 times (x) compared to the 10-year average of 16.6x. The Russell 2000 P/E also traded lower to 23.4x and is now just above its 10-year average of 23.1x. The exception is the S&P 400 MidCap®, due in part to its composition, which tilts toward lower-valuation sectors like Industrials and Financials; its forward P/E of 15.8x is below its 10-year average of 16.7x. We do not expect to see meaningful multiple expansion given current high levels of inflation, thus equity returns will be more reliant on earnings growth.

Credit spreads in both investment grade and high yield corporate debt narrowed in December, remaining near record lows. Investment grade ended the month lower by 7 bps, while high yield tightened by 54 bps, reversing much of the widening that occurred in November.

As a result, the Bloomberg U.S. Corporate High Yield Index posted a positive return of 1.87% in December, its best monthly return of the year. While credit spreads should in fact decline in the accelerating expansion phase of a business cycle, we continue to believe fixed income valuations are more stretched than equities at these low interest rate levels.

Volatility remains high in cryptocurrency markets, with Bitcoin declining 19%, a 31.6% decline from its all-time high reached in November. December was the second month of 2021 with a double-digit decline. Despite its volatility, Bitcoin still posted a 60% return for the year. However, relative to the total crypto market, which now has a market capitalization of more than $2.5 trillion, Bitcoin represents just 39.5% of that total, its lowest level since May 2018. Other cryptocurrencies have continued to increase their own market share as decentralized finance gains increasing adoption among investors. A key theme going into 2022 will be adoption of new blockchain use cases such as non-fungible tokens (NFTs) and decentralized applications found in Web3. 

Developed International Markets

Developed markets get a “Santa Rally” along with a spike in COVID-19 cases

Developed international equities outpaced their domestic counterparts during December, with the MSCI World ex USA Index up 5.1% compared to 4.5% for the S&P 500. Some of the strongest returns came from countries experiencing the sharpest rise in COVID-19 cases, such as the United Kingdom and Switzerland, up 7.3% and 7.8%, respectively. Cyclical stocks in Financials, Materials and Consumer Staples rallied, as did the Energy sector after declining more than 9% in November.

Although vaccination rates are relatively high in Europe, the 7-day moving average of new COVID-19 cases in the region is now more than 500,000 — more than double the rate from a month ago (Figure 2). It is important to remember that even before Omicron, some European governments had begun implementing another round of economic and travel restrictions to curb case growth. In our view, the impact to the region’s tourism industry will depend largely on just how long the current acceleration in cases lasts and policy restrictions stay in force.

Figure 2. COVID-19 Daily New Cases, 7-day MA, Europe
COVID-19 cases spike in Europe due to Omicron

Source: Bloomberg L.P.

View accessible version of this chart.

As we noted in our 2022 Outlook Coming Down the Mountain, in an economy built on globalized supply chains, when just one section goes offline, it sends shockwaves across the entire system, leading to higher prices. Alongside a rapid rise in COVID-19 cases, the U.K. for example saw its inflation rate reach 5.1%, a 10-year high. As a result, the Bank of England announced its first pandemic-era rate hike, one of the first among developed markets. European Central Bank leaders have taken a more dovish approach, suggesting a mere slowdown in asset purchases. In either case, considerable focus will likely remain on the impending normalization of global monetary policy and any potential missteps that may arise in the process.

Economic data depict an uphill battle for the Eurozone’s ongoing recovery. In our view, the region is facing a relatively broader scope of macro risks than the United States which has already worked past the initial steps to recovery, largely characterized by easy comparisons from last year. 

From a consumption standpoint, November retail sales in the U.S. grew by 18.2% from the previous year, versus just 1.4% in the Eurozone. Additionally, a variety of sentiment indicators such as the ZEW Survey of Economic Expectations have slumped notably, returning to its longer-term average after reaching a 21-year high in June 2021. While our outlook for developed international markets is positive, we believe a considerable number of issues need to be addressed to further the region’s economic recovery.

The German federal government officially appointed Olaf Scholz its new chancellor, marking a new era in German politics. While COVID-19 will likely dominate the new administration’s focus for the first few months, other broad initiatives on the horizon include a push toward green energy and a more digitized world. Considering the DAX German stock index lagged the developed market index after Scholz was confirmed as chancellor, consumer confidence metrics will be key investor indicators of the new era of German politics.

Emerging Markets

China weakness weighed on performance as we head into the Year of the Tiger

The MSCI Emerging Markets Index underperformed its developed market counterparts in the month, ending down for the year by 2.5%. Two sizeable index constituents, China and Russia, both posed headwinds to performance for the month. China’s regulatory policies weighed on sentiment as they has been a headwind throughout 2021, while investors also contended with heightened geopolitical risk in Russia, the sixth-largest country in the index by market capitalization.

Chinese internet-based companies were generally down during December due to ongoing regulatory concerns that have plagued these stocks throughout the year, which weighed on overall index performance. In fact, if just two stocks — Alibaba Group Holding Ltd and Tencent Holdings — were removed from the index, the calendar year return would have been positive!

Economic data reported in December showed China may be slowly turning a corner; however, there are still material headwinds to contend with. For example, exports rose only 22%, which surprised to the downside and was lower than the 27.1% jump in October. A primary driver of the miss was due to weaker-than-expected demand from Europe. On the domestic front, retail sales fell short of expectations, growing just 3.9 % in November, compared to the consensus estimate of 4.7%. However, PMI data was positive for December, with both manufacturing and services PMI coming in above estimates. In the case of manufacturing PMI, it was also the highest level since July 2021 and the first time in eight months that its rolling six-month average did not decline.

Despite the challenges in 2021, we believe certain year-end events in China suggest a promising outlook for Chinese equities. 

For example, signs that Chinese policy makers are shifting focus toward economic growth was made clear at the Central Economic Work Conference (CEWC), which concluded in mid-December. We believe the CEWC is a reliable indicator of policy change in China, and the 2021 conference slogan was “allow capital to play a positive role while effectively controlling its negative impact.” Such rhetoric does not imply outright policy reversals, but it does point to more balanced enforcement.

Additionally, the People’s Bank of China lowered its banking reserve requirements twice in the second half of 2021 followed by cutting the 1-year loan prime rate, a proxy for corporate borrowers. While these easing measures are encouraging for Chinese equities and emerging markets in general, signs of accelerating private credit growth will need to follow as private credit growth has been a strong guide for equity performance (Figure 3). 

Figure 3. Private Credit Growth in China versus MSCI China (rolling quarterly returns)
Credit growth in China remains weak

Source: Morningstar, St. Louis Fed, PNC.

View accessible version of this chart.

Russia struggled in December as geopolitical concerns continued to mount regarding potential conflict with Ukraine. 

While the natural gas crisis in Europe has been acting as a slight tailwind for the Russian Energy sector, inflation remains elevated, with the latest reading at 8.7%. 

As a result, the Bank of Russia increased its policy rate for the seventh time in 2021 in December, up to 8.5%, the highest level since 2017.

For more information, please contact your PNC advisor.



Figure 1: Consumer Price Index, YoY
Consumer prices hit highest level since 1982 (view image)

Date Consumer Price Index (% Change, YOY)
9/30/1982 5.0%
9/28/1984 4.3%
9/30/1986 1.8%
9/30/1988 4.2%
9/28/1990 6.2%
9/30/1992 3.0%
9/30/1994 3.0%
9/30/1996 3.0%
9/30/1998 1.5%
9/29/2000 3.5%
9/30/2002 1.5%
9/30/2004 2.5%
9/29/2006 2.1%
9/30/2008 4.9%
9/30/2010 1.1%
9/28/2012 2.0%
9/30/2014 1.7%
9/30/2016 1.5%
9/28/2018 2.3%
9/30/2020 1.4%
9/30/2021 5.4%

Figure 2: 
COVID-19 Daily New Cases, 7-day MA, Europe
COVID-19 cases spike in Europe due to Omicron (view image)

Date Cases
2/5/2020 4
4/5/2020 33,916
6/5/2020 16,741
8/5/2020 19,769
10/5/20207 74,081
12/5/2020 232,410
2/5/2021 174,699
4/5/2021 241,825
6/5/2021 53,700
8/5/2021 144,448
10/5/2021 168,588
12/5/2021 399,589

Figure 3: Private Credit Growth in China versus MSCI China (rolling quarterly returns)
Credit growth in China remains weak (view image)

Date MSCI China, LHS Private Credit Growth, RHS
2012-04-01 9.92 5.7
2013-04-01 -4.54 15.9
2014-04-01 -5.86 12.0
2015-04-01 8.12 10.0
2016-04-01 -4.80 13.5
2017-04-01 12.93 3.6
2018-04-01 1.82 -2.1
2019-04-01 17.69 1.2
2020-04-01 -10.22 17.8
2021-04-01 -0.43 -4.8