A Tough Act to Follow?
Although it didn’t always feel like it, 2021 was a banner year for financial markets. The S&P 500 returned 28.7% in 2021, ranking as the 21st best year since 1926. Further, the S&P 500 made 70 record highs, the second-best year in history trailing only 1995. Investors weren’t forced to confront much volatility either (at least at the index level), as 2021 saw the fourth-smallest drawdown (5.2%) since 1987. This certainly feels like a tough act to follow. Interestingly, however, history tells us that years following especially strong performances are generally like any other year. Following 20%+ return years, the S&P has returned 11.3% the following year on average, with about 70% of readings positive. This is not materially different from stock market data over the last 200 years – stocks are up about 70% of years.
2021 was a year of recovery, exceptionally strong growth, and beating expectations. As the calendar turns, we foresee a shift in these primary themes – a year of economic expansion, strong but slowing growth, and expectations more in line with reality. Overall, we remain optimistic about the prospects for the economy and financial markets, but this subtle shift will create challenges (and opportunities) which we cover in the following commentary.
Politics and Policy – Impact on Your Investments
United States: Mid-Term Elections in Focus
The recent uptick we have seen in economic growth has served to stabilize President Biden’s approval rating in the low 40’s. This is good news for Democrats heading into a mid-term election year, but inflation continues to erode real income gains, creating a challenging environment for the administration. Mid-term elections are always referendums on the current president, with results historically tied to the sitting president’s approval rating. Republicans need five seats to take the House, and Biden’s approval rating is consistent with a loss of 40. Interestingly, although mid-term election years can be more volatile (with average corrections of 19% versus a typical year of 13%), the S&P 500 has not declined in the 12 months following a mid-term election since 1946.
A Key Global Trend: Countries Turn Inward
Hyper globalization was the dominant trend throughout the 1990s and 2000s. During this period, companies developed intricate supply chains, outsourced labor, and relied heavily on trade to support their operations. This trend peaked during the last decade, with COVID-19 further accelerating the movement toward more centralized/protectionist production. Companies are warier of supply interdependencies, and frictions associated with trade have increased. As said by BCA Research, “countries are increasingly fearful of each other’s strategic intentions and using fiscal resources to increase economic self-sufficiency”1. The relationship between the U.S. and China is a perfect example of geopolitics leading to more regionalization versus globalization.
A reimagination of supply chains will have a direct economic impact. For example, we recently initiated a position in Applied Materials (AMAT) in BMT’s Multi-Cap and Large Cap equity strategies. There are several reasons for this purchase, but the decentralization of the semiconductor supply chain is part of the story. As production facilities become more regional (and numerous), equipment companies like AMAT stand to benefit from additional demand for their products.
Build Back Better: Legislation Spotlight
It is now clear that the bill will not pass in its current form. Even as currently written, the key for financial markets is the removal of direct increases to both individual and corporate tax rates. Based on previous versions, we thought the bill would reduce 2022 S&P 500 earnings by about 5%. With consensus earnings per share growth estimated at 8-9% in 2022, initially proposed corporate tax increases would have been a material headwind. Although the market had yet to factor in an increase in the corporate tax rate, we think that a recalibration of earnings based on tax policy is no longer a risk to stocks.
In our view, this creates both positive and negative dynamics for the market – with a net positive result. On the positive side, the lack of additional spending should reduce upward pressure on inflation, allowing the Federal Reserve to move more slowly when increasing interest rates. For the markets, this might be the key factor. However, the loss of $100 billion in additional child tax credits and $50 billion in increased state and local tax deductions could have a negative impact on certain segments of consumer spending.
U.S. Economic Outlook – Slow(er) but Steady
Waning fiscal stimulus, rising prices, and higher global interest rates have the potential to negatively impact the pace of economic growth, particularly in the second half of the year. There are countervailing forces at play, but unlike 2021, we think investors must now at least recognize the possibility of slower growth.
The Expansion Continues, but the Pace Slows
Mid-cycle economic slowdowns and reaccelerations are common. As measured by Manufacturing PMI (a commonly used leading economic indicator), between 2008 and 2020, the U.S. economy experienced two growth deceleration/reacceleration periods…and a third reacceleration was underway before the pandemic. The recent increase in interest rates is forecasting a growth deceleration in the second half of the year. Markets will likely have to contend with a compression in price-to-earnings (P/E) multiples. Slowing growth is usually associated with falling P/E multiples as investors become more risk-averse, willing to pay less for every dollar of company earnings.
Risks Skewed to the Upside – Corporate Earnings & the Consumer
Incredibly, 2020 proved to be the first recession in history to see total household income increase. Combined with COVID-19 related supply chain issues, there is a certain level of pent-up demand that we think will continue to support growth this year. Companies will still be rebuilding depressed inventory levels while consumer demand remains robust amid a very healthy jobs market. Also, as inflation eases this year, the pressure on real wages will decrease, increasing consumers’ purchasing power. So, although economic growth is likely to moderate, it is also likely to remain above trend. Furthermore, a marked increase in capital spending after the pandemic could lead to an increase in productivity, which would help to protect corporate profit margins, in turn lifting earnings expectations beyond the current 8-9% growth consensus.
Investors will be well served to eschew the typical value versus growth debate, instead focusing on profitability and earnings growth. Even in 2021, whether in value, growth, small-cap, or large-cap, the common factors in stock outperformance were quality and profitability. We think this trend will intensify in 2022 as the economic expansion continues but slows. We believe stocks will outperform bonds, and we prefer credit risk to duration risk in fixed income portfolios, given our view that, although growth will slow, the economy will continue to expand.
Global Economic Outlook – Higher Risks to Growth
Based on research conducted by Cornerstone Macro, Global Manufacturing is expected to trend lower during 2022. International equities are more economically sensitive and tend to underperform when Manufacturing PMI falls, which is exactly what occurred in the back half of 2021.
Although relative equity market valuations continue to point to strong returns over time for regions like Europe and Japan, the near-term economic outlook continues to favor the United States, in our view. Growth in Europe, for example, will be relatively challenged from Omicron-related lockdowns (and any future pandemic-related restrictions), while even slower growth in emerging markets (EM) will impact the more export-oriented economies of the region. Also, the European Central Bank has yet to remove any monetary policy accommodation. Although tightening is unlikely in 2022 (a positive for growth), markets will need to begin to digest the possibility of a shift in policy later in the year.
The macroeconomic picture is further complicated for EM economies given current vaccination rates and higher leverage to commodity prices for certain EM countries. In addition, short-term rates have been rising as many EM central banks are taking steps to rein in worrisome levels of inflation. China, given its size within emerging markets, is particularly important. Tightening credit standards, a slowdown in the property sector, and non-free market regulation will weigh on the Chinese economy. The Chinese Communist Party’s willingness to impose stringent COVID-19 restrictions is also a potential headwind to growth. Current levels of internet penetration (44% vs. 87% in developed markets) mean less capacity to sustain output when activity restrictions are implemented. That said, the possibility remains that Chinese policymakers will implement stimulus measures or modestly curtail regulatory crackdowns to promote “stability” in advance of the 20th National Party Congress meeting – a consortium of elite CCP officials that will ultimately determine President Xi Jinping’s fate as leader of the country.
Stock market valuations are far more attractive in developed international and emerging markets. For that reason, we believe it is important to maintain exposure within equity portfolios, knowing we will never be able to pinpoint the precise turn-in relative performance. Our concerns are greater within emerging markets; therefore, we will likely reduce exposure as we move into 2022.
Outlook for U.S. Stocks – Overweight
The current consensus estimate for 2022 S&P 500 earnings per share (EPS) is $225. This would represent an 8% growth rate from 2021. In our view, this might prove conservative as operational leverage and productivity gains should enhance profit margins and propel earnings growth into double-digit territory. Share repurchases alone could add one or two percentage points in 2022 if they continue at the same pace as 2021.
At the end of 2021, S&P 500 investors were paying about 23x estimated full-year 2021 EPS of $207. The trailing price-to-earnings ratio has hovered between 23-29x since the fourth quarter of 2020. As the economic cycle matures, P/E ratios could face headwinds as interest rates rise and growth decelerates. Should the S&P 500 grind higher, we believe it will be driven by earnings growth, not P/E expansion. For perspective, applying a 21x trailing P/E multiple to 12% earnings growth (which we believe is a reasonable upside case) would produce an index price return of 4-5% for 2022. Uninspiring on the surface, this level of return would equate to an average annual price return for the S&P 500 of more than 18% over the past four years. Over the past 30 years, the average annual return on the S&P 500 is 9%, with only three rolling four-year periods exceeding 18%. Company balance sheets are strong, which could offer some downside protection to valuations in the event of heightened market volatility. In the third quarter of 2021, cash held at S&P 500 firms (excluding Financials, Real Estate, and Utilities) was up over 35% from the same quarter in 2019, according to Bloomberg data.
Sector & Industry Leadership
On the back of strong earnings momentum, companies in cyclical industries such as mining, chemicals, energy, financials, and autos could see their stocks climb higher in the first months of 2022. However, by mid-year, economic momentum may decelerate. If so, growth stocks could once again regain market leadership. Large capitalization stocks could outperform relative to small-capitalization firms, given their size (i.e., liquidity) and relative earnings stability. The U.S. would also have an advantage over non-U.S. stocks in such an environment.
As we move into the slowing expansion phase of the business cycle, investors often pay a premium for profitability and earnings growth. Investors tend to seek firms with low debt loads, or even net cash, as well as companies with unique competitive advantages. For example, firms with limited competition and/or the ability to pass on higher costs to customers should prosper. In our view, companies that focus on software services and healthcare are uniquely advantaged in this environment. Of late, highly profitable companies, as measured by higher return on investment capital, are outperforming across all market segments – value, growth, small-cap, large-cap, and across sectors. In general, this profitability bias may drive outperformance in the technology sector, given its high concentration of profitable companies. We will be looking for opportunities in stocks that fit this description while also making small adjustments to our broad asset allocation preferences to reflect this evolution in the economic cycle.
Outlook for Developed International Stocks – Market Weight
Last year, we expected an acceleration in the global recovery to disproportionately benefit more cyclically oriented companies. This logic would also dictate a positive view on developed international stocks, whose sector composition is decidedly more cyclical than the United States.
While this logic was sound, it was more than offset by the massive stimulus ($1.9 trillion in 2021) that the U.S. Government applied to its economy in the form of the American Rescue Plan. As a result, the U.S. economy grew far more quickly than other developed economies, and not surprisingly, the S&P 500 index outperformed developed international stocks (MSCI EAFE index) by a wide margin.
Looking to 2022, we believe cyclically-oriented companies will face increasing headwinds as the year unfolds. This will come from a natural deceleration of stimulus-driven demand, along with central banks reducing the unprecedented measures introduced during the depths of the COVID-19 pandemic.
We are not forecasting a recession, just a deceleration in growth, which will have investors paying a premium for high-quality companies that exhibit continued earnings growth in what will be a more challenging environment. This view is supported by our expectation that PMIs2 will decline in 2022, thus weighing on the industrial sector and other more cyclical areas of the market. The charts below highlight classic macroeconomic variables that forecast this slowdown. Intuitively, as higher interest rates and prices work their way through an economy, growth usually slows.
We are not outright negative on developed international markets but believe a more nuanced approach is warranted for investments in 2022. Like our domestic strategy, we will be looking to reduce our current cyclical/value bias, likely sometime during the first few months of 2022. We will be shifting toward a more neutral posture and possibly a modest growth bias, which should better position portfolios for the decelerating growth environment we believe will occur over the course of the year.
Outlook for Emerging Market Stocks – Underweight
For 2021 we were neutral on Emerging Market equities as we expected the global economic recovery to provide support, but the less-cyclical MSCI Emerging Market (EM) Index kept us from increasing the exposure. Not going overweight this asset class was the right call for 2021, but for the wrong reasons. China’s clampdown on technology companies with the goal of “Common Prosperity” through the redistribution of wealth sent the China technology-dominated MSCI EM Index lower throughout the year, massively lagging both the S&P 500 and MSCI EAFE indexes.
Although we believe cyclical stocks face greater headwinds throughout 2022, and the more growth-focused (read technology) EM index could be a beneficiary, we will still be looking to reduce our exposure to these geographies. As we previewed in our recent publication on China in our view, the risk profile for investors has changed when investing in China – – – translating to a higher equity risk premium (lower P/E) than in the recent past.
Then too, while Emerging Market risks are higher due to China’s recent policy shift, valuations are not particularly inexpensive on an absolute basis when looking at the last ten years. The chart below graphs the next 12-month price-to-earnings ratio for the iShares MSCI Emerging Markets ETF, which is lower than levels seen at the end of 2020 but far from offering a significant discount based on historical valuations. We should acknowledge that EM valuations remain relatively cheap versus U.S. markets, but we believe this discount is less likely to fully mean revert given China’s policy shift.
As a result of the EM Index’s large exposure to China & Taiwan, approximately 50%, we will be dialing back our exposure to emerging markets, going to an underweight stance. On a more granular level, the exposure that we do have is likely to look very different than the benchmark. Positioning within any Chinese exposure is likely to include a bias toward small to mid-cap companies, which, given their size, should have a greater possibility of flying beneath the radar of Chinese government intervention. To date, most of China’s steps to pressure corporations have been focused on large companies and high-profile industries.
To be sure, we believe maintaining some exposure to emerging markets, including China, makes sense within a well-diversified portfolio. It is possible that China backtracks on some of its regulatory shifts during 2022, in addition to the fact that China is still a large/growing economy. We find it prudent to retain EM exposure and remain invested, even if our base case is that EM stocks will not be near-term top performers.
Inflation – The Key Variable for 2022
Inflation’s future path is the key variable for 2022, as it will impact interest rates, economic growth, and asset prices across both stocks and bonds. In short, we believe the unusually high inflation of 2021 will trend significantly lower throughout the year.
Importantly, there was a tremendous amount of fiscal stimulus directed towards consumers in 2020 and 2021 that contributed to high excess savings and subsequent consumer demand. Additional spending was targeted towards good sectors, including furniture, computer equipment, and appliances. Even residential real estate prices rocketed higher. Simultaneously, the pandemic wreaked havoc on global supply chains – supply and demand were pushed way out of balance.
In 2022, we believe the critical balance between supply and demand will be restored. Waning effects from substantial fiscal stimulus, a gradual shift in consumer spending preferences from goods to services (i.e., – restaurants and travel) should exert downward pressure on goods prices this year. On the supply side, ship/truck-related bottlenecks appear to have peaked while companies are rebuilding inventory levels.
Additionally, this year’s abnormally high prices didn’t lead to abnormally high inflation expectations. In fact, when looking at TIPS five-year forward breakeven rates, a market-based measure of future inflation, annual inflation beginning five years from now is expected to be roughly 2.10% as of mid-December. To be fair, the rate was about 30 basis points (0.30%) higher earlier in the quarter but still within range of the Federal Reserve’s 2.0% target. With this in mind, we expect inflation expectations to remain well-anchored, a positive for price stability.
Productivity is another factor that will likely keep prices from accelerating higher. Companies have finally started to increase capital investments, which should result in higher productivity. Increased productivity refers to workers producing more product per unit cost of labor. Intuitively, this puts downward pressure on prices over the long term. Productivity was trending higher during the years leading up to the pandemic, and this uptick in capital spending should accelerate this trend.
The Fed is projecting core inflation to drop from 4.4% in 2021 to 2.7% this year. We believe these factors collectively will lead to much lower prices this year, in line with Fed expectations. If correct, the Fed will increase interest rates less than currently expected, generally a positive for economic growth and asset prices.
Monetary Policy – Rate Hikes are Likely, but Less than Forecast
In 2021, the Fed remained committed to accommodative monetary policy to promote a continuation of the economic expansion. Policy rates remained near zero while the Fed was adding additional liquidity via its monthly bond purchasing program.
Last year, abnormally high inflation was tolerated by the Fed. However, as 2021 was coming to an end, the Fed wavered regarding the temporary nature of price increases. Higher and longer-lasting inflation coincided with continued labor market improvements. The unemployment rate ended November at 4.2%, almost a full percentage point below the Fed’s Summary of Economic Projections recorded in December 2020. As a result, the Fed increased the reduction of monthly bond purchases while simultaneously projecting three rate hikes in the latter part of 2022.
The number of rate hikes, in our view, will be highly dependent on the future path of inflation. We continue to believe the Fed will err on the side of caution and will be patient when tightening policy. Before any rate hikes are initiated, we expect the Fed to have ended its monthly bond purchases, with perhaps a few months in between to fully prepare markets for the first rate-hike – perhaps June of 2022.
It’s important to recognize that although inflation may be stubbornly high in the short term, we believe the trend will be lower throughout 2022. Further, as discussed in previous sections, we think a deceleration in economic growth later in the year will also necessitate a more deliberate rate hike cadence than currently forecast. We believe the Fed will want to keep monetary policy accommodative so that the labor market continues to improve, and waning inflation will allow them to do just that.
Lastly, the Fed monitors financial conditions in accordance with their policy decisions. As rate hike expectations have increased for 2022, the yield curve started to flatten. As all investors do, we will monitor the yield curve for signs about the future path of interest rate hikes. As the curve flattens, the market is pricing in slower future economic growth, often the result of rate hikes. An inverted curve (shorter-term rates higher than longer-term rates) has almost always been an accurate signal of recession. The Fed is keenly aware of this and will go to great lengths not to invert the yield curve. In that sense, the Fed is somewhat beholden to the market’s ultimate interpretation of their policy stance. A curve that becomes dangerously flat would make it difficult for the Fed to execute the number of rate hikes (three) currently projected.
Treasury Yields, Corporate and Municipal Credit
U.S. Treasury Yields Higher in 2022
Regardless of the shape of the curve, we are anticipating higher yields across the maturity spectrum in 2022. This expectation is consistent with positive economic growth, a tighter labor market, and a more benign inflationary environment. BMT strategy construction and positioning will focus on a shorter duration relative to benchmarks.
Credit Spreads are Tight but Still Compelling
Investment-grade and high-yield credit spreads are trading below their prior 10-year average as investor demand remains strong. Although we acknowledge the potential for substantial spread tightening this year is limited, the additional yield compensation over U.S. government securities is notable.
Corporate fundamentals will likely continue to improve this year, coinciding with economic growth and increasing corporate profits. According to the Fed’s projections, the U.S. economy will grow at 4.0% this year, well above the trend.
Increasing revenues and cash flows will support already healthy corporate balance sheets and liquidity positions. Corporate leverage improved last year as many companies focused on paying down debt, while others refinanced into longer-dated maturities at attractive rates. Default rates were below average in 2021 and expected to trend even lower this year, according to Moody’s Investors Service.
We believe fundamentally sound corporate balance sheets, and above-average growth expectations justify current valuations and the potential for credit spreads to grind tighter this year. BMT taxable strategies will continue to favor investment-grade credit over U.S. government securities this year, as well as more modest exposure to high yield, bank loans, and emerging market debt.
Healthy Issuer Fundamentals Drive Strong Municipal Demand
Multiple fiscal packages have injected billions of dollars of financial aid to states and certain municipal sectors which have supported issuer fundamentals and municipal bond valuations. We believe this will continue to be the case as we move through 2022.