January 12, 2022
There was a wide variation in the global equity market during the fourth quarter of 2021. Renewed strength in the shares of the mega-sized technology companies led to a substantial gain for the Standard & Poor’s 500 Index. The developed markets outside the U.S. exhibited more limited gains while emerging markets declined. The U.S. benefitted from the recovering economy with accompanying strength in corporate earnings, even with the emergence of the Omicron variant of COVID late in the year, while monetary policy remained accommodative. These factors held forth to a lesser extent in developed markets in Europe and Japan. At the other extreme, evidence of weaker economic growth and regulatory crackdowns in China had a major impact on emerging markets, leading to negative returns in 2021.
In late 2021 and early 2022, the Omicron variant is causing a spike in new COVID cases. However, there is strong evidence that while Omicron is more contagious than earlier variants, it also produces less severe symptoms, particularly in vaccinated people. The incidence seems likely to peak over the near term, and the subsequent decline could be as dramatic as the earlier surge. The “silver lining” in Omicron is that the large numbers of infections could be leading to a degree of “herd immunity” and transfer the pandemic into an endemic. In this scenario, economic growth should experience a temporary slowdown with solid growth resuming later in 2022 and a return to “normality” not experienced since 2019.
In the U.S., the keys to equity market prospects for 2022 are the evolution of Federal Reserve monetary policy, the strength of corporate earnings, and fiscal policy. Inflation is likely to remain elevated relative to the past two decades but should decline during 2022. Supply chain bottlenecks should slowly improve during the year. Of more significant concern, a shortage of labor persists, with over 10 million unfilled jobs as of November. Since the 2020 recession, demand for workers has come soaring back while millions of workers either retired early or stayed on the sidelines. The imbalance of job openings greater than available workers will lead to wage increases (inflation) at a higher rate than has been the case over the past twenty years.
The 2020 recession had one of the fastest and slowest recoveries of any recession since World War II:
The Federal Reserve has pivoted from emphasizing full employment to controlling the rate of inflation. At its December meeting, the Federal Open Market Committee indicated that it would speed up tapering to complete the process by March rather than several months later. Interest rate increases could commence by mid-year 2022, with multiple increases expected in 2022 and 2023. This alteration still leaves monetary policy in an accommodative mode, and considerable time will elapse before monetary policy becomes restrictive at this pace. As long as monetary policy is accommodative, the Federal Reserve must be considered supportive of higher equity prices. The risk would emerge should the Federal Reserve become more aggressive in raising interest rates, which does not seem likely this year.
As for corporate earnings, potential surprises this year seem likely to be on the positive side. U.S. companies have shown a high degree of flexibility during the COVID pandemic in their ability to counteract the impact of supply chain problems and labor shortages on revenue and profits. This flexibility should enable earnings to continue to grow at a favorable rate in 2022, accompanied by solid increases in dividends, which would support higher share prices.
2021 had Record-High Earnings and Sales Growth, +45% and +15%, respectively. 2022 stands to be a solid year with 9% earnings growth and 7.5% revenue growth expected:
On the fiscal front, the passage of infrastructure legislation is a positive, although the impact will be spread over several years. The fate of “Build Back Better” is uncertain. The most likely outcome is for the passage of a scaled-back package of well under $1 trillion. Overall, the impact of fiscal stimulus will lessen in 2022, but monetary policy and corporate profits growth will more than compensate for this reduction.
Outside of the U.S., economic growth in China could continue to slow in 2022 as the government continues to pursue policies designed to reduce the impact of the real estate sector and assumes more significant control of the economy overall. However, there will be a continuing policy response, already reflected in several reductions in reserve requirements that could mitigate the impact of the slowdown on Chinese equities and emerging markets as a whole. Europe and Japan are showing increased willingness to utilize fiscal policy as a stimulus to counteract the impact of the COVID pandemic so that growth should be maintained at an above-average level, leading to higher share prices.
Our portfolios delivered strong results in 2021 with low turnover and tax efficiency. Last year, new portfolio additions focused on consumer spending and capital spending/infrastructure beneficiaries. We have lessened but maintain our “structural” overweights to the Technology and Health Care sectors, particularly innovative leaders benefitting from decades of research and development investments. Incrementally better global supply chains combined with pent-up demand should lead to more robust earnings in several manufacturing industries, including Machinery and Automation.
Since the financial crisis, Value stocks have underperformed Growth stocks, exacerbated in 2020 due to the pandemic. However, in 2021 we saw signs of Value stocks emerging from their slump. Several “classic” Value industries performed strongly (e.g., Energy & Financials), and Small & Mid Cap Value stocks bested similar-sized Growth stocks.
Although we define Value stocks as stocks trading below their long-term potential, we see signs that classic Value stocks will perform better in 2022 and have added several to our investment lists. Value style stocks are defined by low price-to-earnings ratios, high dividend yields, and slower historical revenue growth. Stocks with these characteristics have historically performed better in a steepening yield curve environment. Value stocks are effectively short-duration stocks, while Growth stocks are long duration, especially unprofitable companies anticipating future earnings. Rising long-term interest rates should have less impact on Value stock valuations.
The low-interest-rate environment of the last several decades boosted Growth stock valuations:
Source: Bernstein Research, FactSet, CRSP, MSCI
International stock valuations have captured our attention, and we are looking for catalysts to get more constructive in our global portfolios. In the global stock market index (MSCI All Country World), the U.S. has swelled to a 61% weight, and Japan is the only country with a weighting larger than Apple (5.5% vs. 4.1%)! The major deterrents to International performance have been less “Growth” sector exposure, the strong U.S. dollar, and less accommodative regulations. Recently Europe and Emerging Markets (ex-China) earnings growth has exceeded the U.S. driven by the regions’ higher exposure to cyclical sectors (e.g., financials, industrials, materials, consumer sectors). Technological innovation, electrification trends, and demographic opportunities outside the U.S. Ideally, we are looking for multi-national international companies similar to U.S. peers with more attractive valuations. Conviction in the Chinese stock market remains challenging due to the regulatory environment, which incentivizes companies not to deliver strong earnings growth.
Following a 14 year regime of U.S. outperformance, International stocks are trading at twenty-year relative lows on most valuation metrics (>30% P/E discount and 1.6% higher dividend yield):
Entering 2022, we anticipate an environment similar to the final months of last year; positive returns led by earnings growth, episodic volatility, and wild equity style and factor rotations (the volatility portion has kicked off 2022!). Discipline will be an essential investing virtue in 2022, with uncertainty related to the pandemic’s course, inflation, and the Federal Reserve set to raise interest rates multiple times. We will continue to build diversified portfolios focused on quality companies with growing dividends.
During the fourth quarter, U.S. Treasury security interest rates continue to rise. The shorter the maturity, the more dramatic the increase, reflecting the expected pivot of the Federal Reserve to deal with inflation by eventually raising the Federal Funds rate, most likely several times in 2022 and 2023. The yield on one-year Treasury obligations rose from 7 to 37 basis points (.07% to .37%) during the quarter, while yields on two-year obligations rose from 27 to 73 basis points. The increase in longer-dated Treasuries was proportionally less. Yields on five-year Treasuries rose from 96 to 126 basis points (0.96% to 1.26%) and ten-year Treasuries from 1.48% to 1.51%. For 2021 as a whole, Treasuries with maturities of five years or less exhibited a total return of -1% and fixed income securities of seven years or less a return of -1.4%, while the return on longer-dated Treasuries (20 years or more) was -4.6%. These returns are nominal—when compared with core inflation rates (PCE deflator) or 4.6% for this year, the inflation-adjusted return on Treasuries was the lowest since the 1970s. In contrast, tax-exempt securities fared better, with a composite index showing a positive return of 1.8%.
Given the likely path of the Federal Reserve toward less accommodation and the significant difference between an elevated rate of inflation and Treasury interest rates which remain low by historical standards, there is a high likelihood that rates on taxable securities will continue to rise in 2022. Bonds have not lost money in back-to-back years since the 1950s. However, we believe a second consecutive year of negative total returns in bonds seems probable, as low-interest payments may not be enough to offset lower prices.
Source: BlackRock, Morningstar
With this outlook in mind, we adhere to a short-duration strategy in our taxable and tax-exempt portfolios with a higher-than-average level of cash being held and exposure to inflation-protected and floating-rate bonds. Should yields continue to rise, we expect to extend maturity as the year progresses.
This report is for informational purposes only and contains data based on information from Princeton Global Asset Management (PGAM) believed to be accurate. However, PGAM cannot assure the accuracy of the data. Past performance is not a guarantee of future results. Portfolio holdings and characteristics are subject to change. The information in this report should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of these securities transactions or holdings that may be cited were or will prove to be profitable or the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of securities cited.