A brief recap of the risk and return environment in the fourth quarter and full year of 2021
Markets continued to decouple from one another in the fourth quarter, as COVID and its “beneficiaries” continued to drive the prices of some stocks higher, while economic and policy issues, such as inflation and central bank activity, loomed large for others. Expected volatility of the US market rose, and it is now one of the riskiest among the major markets we cover (only Japan is expected to be more volatile over the near term).
With similar return trajectories, the US and Canada saw the biggest increases in major-market risk during the fourth quarter (Exhibit 1). But while the US has moved up several notches in terms of its riskiness relative to other markets, Canada remained among the lowest in volatility. Japan’s market struggled in Q4 and its risk also rose. Risk forecasts for Europe and the UK were flat during the quarter, while Developed Asia ex-Japan saw a sharp decrease.
Exhibit 1. Return and short-horizon risk, selected markets
When we analyze the changes in risk over the past three months for these markets, from the standpoint of our country or regional short-horizon fundamental factor models, we note that rising risk was driven by higher factor volatilities and vice versa (Exhibit 2). But when we drill down into an asset-asset covariance matrix, we see the important impact of asset correlations. While asset volatilities rose in five of the six markets, the increase in Europe and the UK was offset by falling asset correlations (both volatility and correlation were down in Asia ex-Japan). Higher asset correlations in the US, Canada and Japan accelerated the increase from higher stock volatility.
One source of the difference in correlations may be the actions of central banks. The US Federal Reserve has been clear in its mission to shift its focus from employment (which seems to be recovering) to fighting the high and rising inflation figures that have been reported most of this year. US markets appear to be pricing in a high probability of a rate hike by the middle of next year. In Europe, however, where the European Central Bank (ECB) has suggested it will keep monetary conditions accommodative (despite also higher reported inflation), the expectation is that no interest rate move will occur until at least 2023. Rate hikes will likely have some impact on all stocks, thereby causing their prices to move in the same direction, whereas the lack of a concerted effort by the central bank leaves investors to focus more on the merits of each individual company.
Exhibit 2. Decomposition of the change in risk, three months ending December 9, 2021
Attribution on various STOXX equity indices using our WW4 Macroeconomic Projection Model (‘macro model’) also shows that economic concerns—particularly carbon emissions pricing, inflation and steepening term spreads—once again emerged as equity-return drivers, after taking a breather in the third quarter. For example, macro factors in aggregate accounted for about 45% of the return of the STOXX® USA 900, and more than 60% of the return of the STOXX® Europe 600 (Exhibit 3).
Almost all factors in the macro model contributed positively to US and European market returns. Most notable were positive exposures to the newly added Carbon Emissions Price factor, US and GB Break-Even Inflation, and Commodity prices, all of which produced positive returns, and a negative exposure to GB Term Spreads, which narrowed. Only the positive exposure to the US Term Spread, which narrowed (thereby producing a negative return), was a significant detractor.
Exhibit 3. Return Attribution, Q4 Through December 9, WW4 Macroeconomic Projection Model
Exhibit 4. Individual macro factor contributions to US and Europe returns, Q4 through December 9, WW4 Macroeconomic Projection Model
All that said, let us get back to the headline of this post: The Pandemic Profiteers. We chose 20 US stocks that seemed to benefit the most from the pandemic, most of which would come as no surprise to anyone who has been stuck at home for at least some, if not most, of the past 21 months or so. These names were clearly the only stocks driving the US market higher in the fourth quarter. In fact, without them, the market would have been roughly flat, and a portfolio that was underweighted by these names likely would have lagged the market substantially (Exhibit 5).
These stocks also likely contributed to the increased risk in the US market. Back in June, these 20 names comprised about 27.6% of the weight of the USA 900 Index, and 31.8% of the risk. By December 7, their weight had increased by about three percentage points, and their risk contribution was up to 36%.
Exhibit 5. Cumulative total and active return, “Pandemic Profiteer” Portfolio and USA 900 Index excluding the Profiteers
Conclusions and a look ahead
What are the implications for next year? Based on the emergence of Omicron, along with the continued havoc wrought by the Delta variant, it seems likely the Profiteers could continue to profit from the pandemic. Reported inflation has hit a 40-year high, and although break-even inflation has remained much more stable it, too, could rise if the reported numbers start to seem more permanent. The question is whether investors will continue to believe higher inflation is a signal of a stronger economy or if it has reached a point where it is harmful to profits and will drive the Fed, ECB and other central banks to act more boldly1. If market exposure to inflation variables turns negative, that could be bad news, indeed. And the correlation issue that drove predicted risk of some indices higher could remain if economic concerns turn cautious as monetary policy is tightened. Overall, at current readings, the outlook for equities looks okay, but these pesky concerns that have been around for some time could turn from benign to malignant fairly quickly.
 See the recent blog post from my colleague Christoph Schon for a more detailed set of stress-test analyses linking inflation to returns of equity and other market variables.