Constructive, But More Discerning In ‘22
January 2022
2021 was a particularly profitable year for investors in U.S. stocks as well as in select European and emerging markets. While we anticipate gains for global stocks in ’22, returns will likely moderate meaningfully, drawdowns will almost certainly deepen, and volatility should rise relative to recent investor experience. The first half of this year could bring additional upside for stocks as investor optimism surrounding a return to ‘normal’ and further easing of supply chain bottlenecks boosts spirits and investor risk appetite. The latter part of the year, on the other hand, could present a choppier, more uncertain backdrop for equity investors as global central banks shift further away from ultra-easy pandemic-era policies, an environment that could benefit ‘defensive’ and reasonably valued secular growth-oriented stocks. Should a sentiment shift and reallocation occur in the back-half of ’22, investors taking a more discerning, valuation-aware approach should also benefit. Below we’ll look at themes we expect to play out within equity markets in ’22 and perhaps beyond, and potential implications for each of the four broader equity categories for which we publish capital market expectations.
The S&P 500 rallied 28.7% on a total return basis in ’21 as an “everything rally” in the first half of the year gave way to a more challenging, albeit still profitable, backdrop in the back half as COVID variants delta and omicron led to fits and starts for the U.S. economic recovery and sector rotations within the S&P 500. Notably, the max peak-to-trough drawdown for the S&P 500 was just 5.2% in ’21 as the “buy any dip” mentality that took root in 2020 continued to dominate investor psychology, limiting pullbacks and lowering volatility along the way. As we enter 2022, we are in more of a mid-cycle economic and market environment, a backdrop that should be supportive of improved relative performance for active managers relative to their chosen benchmark as a quality focus should be rewarded. In the initial stages of economic recovery, such as what investors experienced in the middle of 2020 through 2021, it’s common for lower quality companies/stocks, which we define as less profitable and more heavily indebted companies with declining cash positions, to outperform as easy monetary policies and an economic recovery prop them up and allow them to remain going concerns. However, as economic growth slows and monetary policies become less accommodative, which we expect this year, a bias toward ‘quality’ is often rewarded. Low debt/high cash, profitability (ROE, ROIC), and dividend growth/yield could be synonymous with outperformance over the coming year. After the rising tide lifts all ships-market of the past 21 months, diligence and selectivity will likely play a much bigger role in ’22.
U.S. mid-cap stocks outperformed small caps in ‘21, but both cohorts underperformed the S&P 500. Entering last year, we expected real or inflation-adjusted yields to rise and corporate credit spreads to compress, which would, in theory, be supportive of share prices for smaller companies. In hindsight, we only got the corporate credit piece of the equation correct as ‘real’ yields dipped further into negative territory, which led the Russell 2500 to drastically lag the performance of the S&P 500 on the year. While there’s often little difference between being wrong and being early in this business, we have reasons to believe we were just early and expect U.S. SMid to fare better relative to the S&P 500 in the coming year. ‘Real’ yields should rise as inflation moderates year over year and the Fed works toward policy normalization, while wage inflation, a major drag on profitability for smaller companies, should moderate somewhat due to a rising labor force participation rate. Mergers and acquisitions (M&A) activity could also act as a tailwind for SMid in the coming year as cash on corporate balance sheets remains elevated and could spur deal making in select pockets of the market. The Federal Trade Commission (FTC) has closely scrutinized recent deals due to anti-competitive concerns and has forced the break-up of a couple of larger transactions already, which may lead potential acquirers to look farther down the market cap spectrum for acquisition targets, benefitting SMid.
We remain constructive on international developed markets, favoring Europe, specifically, due to a combination of appealing valuations, relatively high dividend yields versus what can be found in the U.S., a cyclical bias to indices tied to the continent, and fiscal support provided by policymakers. Japan could also be poised to benefit as the Bank of Japan is in no hurry to tighten monetary policy to combat higher inflation, and additional fiscal stimulus appears likely. U.S. investors have been consistently underweight developed markets abroad over recent decades, which has proven to be a good call, but U.S.-based investors seeking relative value and yield from equities should kick the tires across the pond.
For emerging markets, the coming year could be a continuation of 2021’s low return, higher volatility regime that generated a -2.2% total return out of the MSCI EM index. China and Brazil were big drags on the index in ’21, with the MSCI China index down 21.7% and the MSCI Brazil index lower by 17.3% on the year. Weakness was partially offset by strength out of India, Russia, and Taiwan, which all saw 20%-plus gains during the year. In the coming year, we expect continued tightening of monetary policy out of emerging market central banks to combat rapidly rising food and energy prices, which should weigh on economic growth to varying degrees. Notably, we expect China to be an outlier in this regard as the country eases monetary policy further to combat slowing economic growth. However, while monetary policy should be supportive of equity prices/valuations, the country’s no tolerance policy toward COVID-19 could weigh on growth and challenge global supply chains in the process as the omicron variant is likely to spread there in ‘22, preventing a full reopening of the country’s economy.
We enter 2022 neutral across equity sub-asset classes relative to strategic targets; however, we expect opportunities to tactically tweak allocations to be presented over coming quarters as monetary policies are communicated/adjusted, global supply chain issues ease, and the global ‘new normal’ takes shape.
Source: Bloomberg, Factset
