ANOTHER GOOD YEAR
We enter 2022 quietly confident that Global Equity markets can continue their strong run of delivering positive returns. Although expectations will have to be dialled down from the 20%+ returns experienced over the past 3 years, to a more normal 10-15% expected return for 2022. Stats show that market returns following a year of 20-25% returns, can be expected to be in the range of 10-11%.
As far as NVest Securities is concerned, we foresee the S&P 500 returning 15% for 2022; primarily driven by earnings growth. In addition, 2022 will likely be about selecting the correct stocks based more on fundamentals and mid-cycle growth beneficiaries.
GLOBAL RECOVERY CONTINUES
Global GDP growth exited 2021 at 5.9%. While we expect GDP growth around the world to slow from these heady levels, it will remain above pre-Covid trends across almost all geographies. Thus, being very supportive for business in general.
INFLATION DRIVING INTEREST HIKES
Above-trend GDP growth, coupled with an inflation rate of around 4%, means that there will be strong high-single digit nominal growth momentum driving top-line growth across many companies.
While 2021 GDP growth was extremely strong off the back of pandemic driven stimulus payments, it has been accompanied by levels of inflation that developed economies haven’t experienced in 40 years.
U.S. headline inflation for December came in at 7%, and while a big chunk on that number was driven by transitory factors – used Car Prices, Energy, etc – the non-transitionary core inflation was 3.9%; significantly above the Fed’s inflation benchmark of 2%.
Additionally, and more concerning to the Fed, is the fact that wage inflation is beginning to show signs of moving higher. This could potentially lead to more structural inflation.
The strong economic rebound in the U.S. as well as the inflation rate that has progressed beyond “transitionary”, has led the U.S. Fed to initiate the rate hiking cycle. As it currently stands, expectations are for the Fed to commence hiking in March, and to raise rates 4 times during the year. This scenario aligns with the current narrative expressed by the various Fed governors.
The market remains slightly nervous of the Fed’s ability to navigate the economy through a tightening cycle, while keeping inflation under control and maintaining full employment levels. 5-year forward inflation expectations (2.2%) as well as the 10-2-year yield spreads suggest the Fed will have difficulty accomplishing this feat and will have to backtrack at some point.
The good news for investors, is that history shows us that equity markets typically outperform in the first stages of a new rate hiking cycle. Given the fact that we are starting this cycle with real rates that are deep in negative territory, it adds to the view that monetary policy will remain very stimulative for a while – supporting risk assets.
CONSUMERS REMAIN WELL POSITIONED
In general, consumers have exited the global pandemic in a very strong position. The U.S. consumer is sitting on excess savings of ~$2trln, with disposable income growth north of 6%, and debt affordability that has never been lower. Taking all of these factors into account, it is not surprising that we have seen a huge jump in consumer spending; particularly durable goods. We continue to expect consumer spending to remain buoyant, but as people begin to move more freely, we forecast that focus will shift to spending on services & experiences, which has lagged and is yet to recover to pre-pandemic levels.
NEW CAPITAL SPENDING CYCLE
Capital investment has lagged for the past 5 years with Business Fixed Investment to GDP dropping beyond one standard deviation below average, to 8%. Given the rude awakening global business experienced due to the supply shortages and various other bottlenecks, the incentive to invest in new infrastructure & production has never been higher. Add to this the boost from fiscal infrastructure spending – Infrastructure Investment & Jobs Act and Build Back Better Act moving through congress – and you get an environment supporting mid-cycle growth.
As we head into 2022, we continue to believe that the current macro-overlay provides enough support to enable Global Equities to outperform again, and deliver another year of respectable returns.
EQUITIES POSITIONED FOR ANOTHER GOOD YEAR
Much has been said about current valuation levels of the S&P 500; this is misplaced in our minds. On the surface, the S&P 500 trades on a forward 12-month PE of 20.5x, versus an average of 18.5x – which is hardly exorbitant. Adjusting for potential earnings upside (estimates underestimated actual results by an average of 10% pts) gets you to 19x. Considering that the weighting towards technology stocks has increased 2- to 3-fold to more than 50% over the last few years, skews the average as technology stocks typically have significantly higher multiples than the rest of the market.
Being conservative, we don’t forecast any multiple expansion but see the market continuing to move along with earnings growth which we believe will be in the 10-20% range.
As always, investment is a relative game with many asset classes competing for the same dollar. In 2022, equities remain relatively more attractive than other assets in our view. Rising rates will pressure bond prices; interest rates remain low with over 50% of S&P 500 companies yielding more than U.S. treasuries; earnings yields are higher than high-yield credit spreads; and equity risk premiums remain within normal range given the current interest environment.
We expect to see a shift in the sectors that outperform. Shifting away from “Stay at Home” and technology stocks where demand has been sated and higher interest rates pressure the valuations of high flying non-profitable names, to companies benefitting from higher rates, and those that are able to push pricing through to consumers and companies to are more service focused.
In addition, we also see Clean Energy and the EV transition gaining more traction. The Digitization & Productivity shift will continue as firms look to offset the rising cost of labour. The roll out of fiscal stimulus and the increase in capital spending should also drive those companies servicing the Capex cycle. Another big theme we see playing out in the latter half of the year, is the recovery of beaten-up Chinese technology sector which have been crushed on the back of tightening regulation by Chinese authorities. We have begun to see a policy pivot to one focused on more stimulus in 2022. It may take some time for investor confidence to return, but there is no denying that these world class companies are just too cheap.
As with any investment, risks do exist, and it is worth noting our top risks for 2022. These include:
- Higher inflation compels Fed to accelerate rate hikes
- Inventory build-up as consumer spending stops
- Supply-chain imbalances lead to trade tensions and hoarding on a national scale
- Decreased labour force participation continues to pressure wages
- Vaccine proves ineffective against Covid variants
- China/U.S. relations deteriorate
- Republicans sweep U.S. Midterm Elections, paving the way for a 2024 Trump presidential campaign
All in all, despite the stellar performance global/U.S. equity markets have delivered over the last 3 years, we see the potential for a further double-digit return in 2022.