Market Commentary - Q4 2021 and 2022 Outlook
Don't fight the Fed is now don't fight the taper.
Summary
US stocks saw a third consecutive year of strong performance, with major indexes closing 2021 near record highs.
Even with the recent volatility from the Omicron variant, the S&P 500 posted a 26.9% gain for 2021. The Nasdaq Composite and Dow Jones Industrial Average have gained 21.4% and 18.7%, respectively, this year, helping send the major indexes to their best three-year performance since 1999.
Top performing sectors in the S&P 500 were energy (+47.7%), real estate (+42.5%), technology (+33.4%), and financials (+32.5%). The Stoxx Europe 600 gained 22.2% for the year, while the Bloomberg Commodity Index gained 27.1%, largely due to a surge in oil/gas prices and supply chain shortages.
Much of the broader market rally was also driven by a small group of massive stocks such as Apple, Tesla and Microsoft. Microsoft and Tesla shares have each risen around 50% this year, while Apple has gained more than 30%. In order for the market to continue its upward trend, we believe the rest of the market outside of mega-cap technology stocks will need to participate in the upside as growth stocks tend to underperform during periods of higher inflation and interest rates.
However, that market dynamic began to shift in December when the Federal Reserve turned up the dial on their plans for interest rate increases and balance sheet shrinking.
In response to surging COVID cases, increased tensions overseas in Russia/Ukraine and China/Taiwan, and the Fed’s roadmap for 2022, investors finally turned more defensive during December. They bought shares of utilities, consumer staples, and real-estate firms, pushing all three sectors up at least 9.4% over the month. Financials had a strong month as well, up over 4% in December. Technology and communication stocks saw more muted gains, while shares of consumer discretionary firms were flat.
S&P beats both the Dow and Nasdaq in 2021 by the widest margin in 24 years
The S&P 500 closed at a record high on 70 different trading days in 2021. That is more than 25% of all trading days in the year.
It is only the 6th time the S&P 500 beat the Dow and the Nasdaq in a year: 1984, 1989, 1997, 2004 and 2005. With the strong performance from the S&P 500 in 2021, it begs the question, what is to come in 2022? Although it represents a tiny sample size, gains have been healthy in the year following. In fact, all three benchmarks have continued to trend higher. The S&P 500 averages 12.6% returns, the Dow averages a rise of 11% and Nasdaq Composite averages a positive return of 12.8% in those instances.
History suggests that after a gain of at least 20% by the benchmark, returns are comparatively muted but not insignificant, with an average rise of 7.7%.
The year after a big rally also tends to be followed by a positive finish for the index in the subsequent calendar year over 70% of the time. Gains have occurred consistently the previous nine times that the S&P 500 has posted a 20% rise or better. Of course past performance is no guarantee of future results, and 2022, much like 2021, will come replete with idiosyncratic themes, including the struggle with the pandemic, the battle with inflation running at its highest level in 40 years, and Congressional midterm elections due in November.
Fed and Inflation
The single biggest headwind for equities is a longer period of elevated inflation than the Fed anticipates. According to Allianz Chief Economic Advisor Mohamed El-Erian, the Fed repeatedly calling inflation “transitory” is “probably the worst inflation call in the history of the Federal Reserve, and it results in a high probability of a policy mistake”. Being forced to tighten their balance sheet in order to combat potentially runaway inflation quicker than the market anticipates could kick-start a deep correction.
While we are not necessarily going to say it was the worst in history, we have been saying for months that the Fed’s reluctance to deviate from its script of classifying inflation as “transitory” was a huge mistake and we have been positioning client portfolios accordingly. We have reduced technology exposure by rotating from the Nasdaq 100 to the S&P 500, and adding sector specific ETFs/stocks in the utilities, financials, and energy sectors.
The minutes of the Fed’s December policy meeting, released on January 5th, indicated that officials might lift short-term interest rates as soon as March. US equities fell broadly after the minutes were released. Bond yields rose to their highest levels since early April.
The yield on the 2-year Treasury note, which often rises when investors anticipate tighter central-bank policies, reached its highest level since Feb. 2020. The 10-year Treasury yield rose to 1.7%, its highest level since April 2021. Bond yields rise as prices fall.
Despite the rising risks, many investors believe markets will power through the coming year, delivering returns that are solid as the best long-term protection against high inflation is equities.
We expect markets to hinge on every word from the Fed and to be volatile after meetings/minutes are released.
“If the Fed is looking to move that much faster, then that headwind is a little bit stronger than what the market was originally thinking about at the end of 2021,” said Principal Global Investors Chief Strategist Seema Shah.
While we believe that parts of inflation will subside when the supply chain bottlenecks are relieved, investors should be prepared for multi-year inflation levels north of 3%. Inflation in the ballpark of 3%-3.5% certainly is not overly harmful to markets, however the Fed must act swiftly in order to bring inflation down from November’s read of 6.8%.
Balance sheet runoff - The key headwind of the year
Minutes of the Fed’s December 14-15 meeting, released Wednesday, showed officials believed that rising inflation and a very tight labor market could call for lifting short-term rates “sooner or at a faster pace than participants had earlier anticipated.”
Some officials also thought the Fed should start shrinking its $8.76 trillion portfolio of bonds and other assets relatively soon after beginning to raise rates, the minutes stated. Investors would see the move as another way for the Fed to tighten financial conditions to cool the economy.
Stocks turned sharply lower after the minutes were released on January 5th. The blue-chip heavy Dow fell 1.1%, while the tech-heavy Nasdaq fell 3.3%. Meanwhile, government bond yields rose. After the minutes were released, trading in interest-rate futures markets implied a roughly two-thirds probability that the Fed would raise rates in March, according to CME Group.
“People expected rate hikes this year, and that was talked about, but I don’t think people were expecting the Fed to already be speaking about letting the balance sheet runoff, even as soon as the first rate hike,” said Chris Zaccarelli, chief investment officer for Independent Advisor Alliance.
“We expect growth to deflate as we go through the year. That will happen naturally. As the monetary, fiscal support fades, markets will have to stand on their own two feet,” said Hani Redha, a portfolio manager at PineBridge Investments. “It’s not a disaster, but it is a headwind at the same time that central banks are on the move.”
Markets in 2022 will look very different, investors need to apply fundamentals
US and global markets have been accustomed to an extended period of extremely easy monetary policy stemming from the 2008/2009 financial crisis. During this period, many investors and institutions have thrown traditional valuation metrics out the window and focused purely on growth prospects and total addressable markets of companies.
Over the past few years, we have seen the birth of new asset classes and investment vehicles like crypto, NFTs, Special Purpose Acquisition Companies (SPAC), Natural Asset Companies (NAC), to name a few. It is hard to believe that these types of investments would exist without the flood of liquidity provided by the Fed for the last 11 years.
Investors have lived by the “buy the dip” mentality during this time and it has proved to be successful as the markets continued their upward trend due to a lack of yield from alternative investments such as bonds. We believe this is still very much ingrained in investors minds and we will continue to see smaller corrections throughout the year rather than deep corrections as low interest rate and high inflationary environments will still exist. Although interest rates will be on their way up throughout 2022, the Fed is scaling back their bond buying program and plans to raise interest rates as the economy can support these rises and it is absolutely necessary to combat inflation before it becomes catastrophic to the economy.
We strongly believe the rotation out of growth companies with little to no earnings trading at very high valuations is long overdue and one of the healthiest market dynamics we have seen in a long time. Astronomical price to earnings (P/E) ratios or even worse, price to sales for companies with no earnings, have attributed to a dangerous market environment and we believe that a focus back on earnings and fundamentals is key to protecting downside risk resulting from dangerously high valuations and potentially exacerbated market sell-offs.
Is it finally time for value over growth?
In 2022, we see growth stocks cooling as the massive policy stimulus in response to the pandemic fades and the massive rotation to value continuing throughout the year. That does not mean that long-term investors should abandon technology and growth stocks. We are taking a market weight allocation on technology from an overweight allocation.
After record technology performance in 2020 and early 2021, equity markets have rotated aggressively toward cyclicals and other value-based strategies during the last few months. In our view, this rotation has broadened and strengthened the bull market significantly as the broader market is now partaking in the upside. This is imperative in preventing another tech bubble and setting the stage for another leg up in innovation-based strategies.
Cyclical companies can own assets like factories, equipment, and real estate whose value should grow as prices rise. They operate in sectors such as energy, financials, and utilities that often can raise prices to keep pace with inflation or interest rates.
By contrast, growth stocks, whose earnings investors expect to increase rapidly in the future, are more dependent on what happens years down the road.
In periods of rising inflation, value stocks have largely done better than growth, but not always. Value out-performed growth in the inflationary decades of the 1940s, 1970s, 1980s, and 2000s. Yet value underperformed growth stocks in the 1990s, even though the cost of living rose slightly faster in that decade than in the 2000s.
If inflation and supply chain pressures prove to be “transitory”, then maybe growth can continue to trounce value for a while. But concerns about inflation have a way of becoming entrenched and turning into a persistent trend as companies succeed in pushing through price increases and workers demanding higher pay. A search for “inflation” on media research site Factiva shows more hits in October, which isn’t yet over, than during any month in the past decade.
2022 Outlook
Which stage of the business cycle are we?
As a continuation to our research piece and investing thesis of “Seeking opportunities in business cycles”, we believe that we are now in the mid-cycle, however, showing some characteristics of the late-cycle.
The mid-cycle is often the longest phase of the business cycle and displays positive but more moderate growth than the early stage. Inflation has dominated the markets and is a key characteristic of the mid to late stages of the business cycle. Some characteristics of the late-cycle are beginning to enter markets and cause headwinds for equities. These are tighter credit, rising interest rates, higher inflation, and contracting policy. We still believe the economy has not reached peak GDP as there are many parts of the economy that have not taken part in a fully reopened economy.
S&P 500 over Nasdaq
We believe that 2022 will be the first year in many that investors should not be heavily overweight in tech. We believe that tech-heavy portfolios will have more volatility and potential downside risk. That being said, keep in mind how much tech has outperformed the market the last three to four years and there is nothing wrong with taking profits in a portfolio.
In 2020, the Nasdaq climbed 44%, while the S&P 500 rose just 16%. From the end of 2016 to the close of 2020, the Nasdaq won every year, rising a total of 139% compared to the S&P 500′s 68% increase.
Initiating Value Stocks
The coming year will be different, of course. Inflation is surging for the first time in a generation, potentially eating into profits of growth companies. Fed rate increases will force investors to reassess the earnings outlook, and of course the COVID-19 pandemic will likely take further twists and turns. We maintain our stance that any COVID related sell-off should be seen as a buying opportunity for long-term investors.
This means that profit growth will likely revert to more normal levels. The Wall Street estimate for S&P profit growth has fallen to 9% from 16% earlier in 2021.
Meanwhile, price to earnings multiples remain above their long-run average, though the ultra-low level of interest rates helps to explain that.
The main tailwind for equities over the past decade has been that there simply are no other options. “What else are you going to do? Putting money into bonds is dead money,” said Scott Ladner, chief investment officer at Horizon Investments.
The S&P 500 rose 27% in 2021, capping a third consecutive year of double-digit gains. Yet stocks are cheaper than they were a year ago: The S&P is trading at 21 times analysts’ projected earnings over the next 12 months, down from 22.8 times at the end of 2020.
Lower valuations, together with an expanding economy and ultra-low interest rates, help explain why most Wall Street forecasters predict the S&P 500 will continue to rise in 2022, even as the Federal Reserve prepares to raise interest rates for the first time since the pandemic struck. Goldman Sachs, RBC, Wells Fargo, Credit Suisse and others predict the S&P 500 will rise between 6% and 11%.
“Earnings can’t maintain the 2021 pace, but it should still be a growing environment,” said Rob Haworth, a senior investment strategy director at US Bank Wealth Management. This doesn’t bode well for growth stocks as their likelihood of significant double digit earnings growth decreases. Quality, value stocks with predictable, stable earnings typically perform well as growth slows.
We have had a strong tilt to growth for client portfolios through the Nasdaq 100 and FAANG stocks in client portfolios for the past five years. The top five stocks in the S&P 500 make up more than 25% of the entire market cap of that index. We believe that in order for the market to continue its bull run, the remaining 495 in the index will need to participate.
We believe that value stocks are now in favor as the Fed pulls liquidity and investors focus once again on fundamentals and valuations. We began purchasing cyclical sectors (ie. industrials and financials) for clients in the second half of 2021 and we will continue to do so in 2022. We will focus on reducing exposure in technology to equal weight and rotating those assets to value equities.
Initiating European Stocks
For the past five years, we have had an extremely strong view that the US will outperform global equities significantly due to their leading technology companies and have held little to no global equities in client portfolios. However, we are beginning to add exposure to European equities for a number of reasons.
Valuation
European stocks have never been this cheap compared to the U.S. market, with Morgan Stanley strategists seeing more upside for the region’s equities. Strategists also highlight that European equities trade at a record low valuation versus real bund yields, with the gap between 10-year real bund yields and Europe’s forward dividend yield at 500 basis points. Morgan Stanley expects 10% earnings-per-share growth for the MSCI Europe in 2022, above the 7% consensus, and sees 8% upside for the index.
Morgan Stanley is not the only European equities bull. JPMorgan Chase & Co. strategists recommend being overweight Europe against the US., Pictet Wealth Management cites valuations in favor of European stocks, while Goldman Sachs Inc. strategists said last week the European rally had further to run.
Fed pulling liquidity
While global equity markets are potentially vulnerable, US equities are particularly exposed.
A decade of extremely easy liquidity has driven down discount rates, a mechanical support for equity market multiples that drove duration to secular highs. This poses a risk as rates begin to rise, especially for companies with very strong priced-in earnings growth and cash flows far in the future. Companies have also grown reliant on the ongoing flow of ample liquidity: a growing cohort is borrowing to deploy buybacks and support earnings-per-share, and a significant and growing tail of the market is cash flow negative and relying on ongoing new investments to finance their business. With less money flowing into the system, that funding will be harder to come by.
If tech weakens, Europe should outperform as their equity markets are tilted more towards cyclical sectors such as financials, energy, industrials, and materials.
Growth and Liquidity Sensitivity Can Be Important Drivers of Performance Differences Between Sectors and Countries
To illustrate these different sensitivities, we zoom in on the US equity market, splitting up performance in the past two years into periods when real yields were falling and when they were rising (a cut-through measure of what was happening to liquidity versus growth). The first chart below covers easing liquidity/falling growth (most of 2020 and April-July 2021), and the second shows tightening liquidity/rising growth (January-March 2021 and August 2021 to today). We plot sector performance against our internal measure of sensitivity to a tightening-liquidity and rising-growth environment to highlight which sectors do well in each period.
As shown, performance generally directionally aligned with what we would expect. In the major periods of falling real yields (generally periods of falling growth and rising liquidity), we saw tech sectors outperform and more cyclical sectors underperform.
And then, during recent periods of rising real yields, performance looked like the mirror opposite.
How to protect against inflation and rising interest rates
There has been a tremendous amount of research in regards to investing during periods of high inflation and rising interest rates. Jeremy Siegel is a Professor of Finance at the Wharton School of the University of Pennsylvania and in his book “Stocks for the Long Run” he analyzes the returns on stocks, bonds, gold, and cash over long periods of time (from 1802 through December 2006) in both the US and other countries. The chart below is from Siegel’s research and depicts the total return indexes for these asset classes. Siegel defines total return as "all returns, such as interest and dividends and capital gains, are automatically reinvested in the assets and allowed to accumulate over time."
The clear outcome from the chart is that holding equities for the long-term is the best protection against inflation, rising interest rates, and the different stages of the business cycle.
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this newsletter (article), will be profitable.
Outlook
We strongly believe the rotation out of growth companies with little to no earnings trading at very high valuations is long overdue and one of the healthiest market dynamics we have seen in a long time. Astronomical price to earnings (P/E) ratios or even worse, price to sales for companies with no earnings, have attributed to a dangerous market environment and we believe that a focus back on earnings and fundamentals is key to protecting downside risk resulting from dangerously high valuations and potentially exacerbated market sell-offs.
We believe that US equity markets will continue to be volatile but are in the process of finding a bottom for this correction cycle. Investors should have a balanced approach and not act emotionally. Technology, growth, and value all have a place in a well diversified portfolio.
We strongly recommend that investors should stay disciplined to their long-term investing goals, with very little bonds in their portfolios as the price of these bonds is likely to fall significantly over the next 3-18 months. Investors should not react to market corrections by selling equities as we believe the long-term trend of a bull market is still intact as the economy is set to fully reopen in Q1/2 of 2022.
We believe investors should focus on large-cap equities with quality earnings, mega-cap technology companies, value stocks, and European equities. Sectors we are overweight in are industrials, financials, consumer staples, consumer discretionary, real estate, and energy.
As always, if you have any questions, or would like to discuss your portfolio/current situation, please feel free to set up a call by clicking here.
