Jan 07, 2022
From a broad perspective, the world moved closer to normal over the past year. At the same time, there was very little about this year that seemed normal. Such is the process of putting the pieces back together, knowing the outcome won’t necessarily look like it did before the pandemic.
From an investment perspective, expectations were high coming into this year. Backed by massive government stimulus, vaccines gearing up for wide-spread distribution, and several quarters’ worth of easy comparisons for earnings growth, those hopes were more than validated. Stocks finished the year strongly, scoring 20% plus gains for the twelve months, despite soaring COVID infection rates and the highest inflation readings in 40 years.
In our commentary below, we discuss the key issues that affected the markets this year and our thoughts on what 2022 has in store. While we believe optimism is warranted again as we look ahead, we do so more cautiously, simply recognizing that the measures implemented to protect us from the pandemic are gradually and appropriately winding down.
Key Investment Issues
Jerome Powell, Inflation, and Fed Policy
The re-nomination of Fed Chair Powell provided continuity at an important juncture in setting and managing Fed policy. The response from the stock and bond markets would signal he is doing a good job; the reviews from other observers are mixed.
Many believe that the emergency measures to keep the economy from sliding into an abyss after the pandemic have been maintained far beyond their need. As a result, excess liquidity and zero interest rates have unleashed powerful inflationary pressures, putting the Fed behind the curve in its goal to contain inflation. This could eventually require a more aggressive approach to raising interest rates and tightening credit, undermining growth and raising the odds of a recession.
In the December Fed meeting, Powell pivoted in his positioning and acknowledged that his initial characterization of rising inflation as transitory was wrong. To assuage his critics, he has directed a faster wind down of liquidity, opening the way for raising interest rates six months sooner than last expected.
That said, Powell still believes that inflation has been exacerbated by forces that are temporary and are not solely the result of easy monetary policy. Less liquidity and higher interest rates will not solve the supply chain constraints, and even absent a pandemic, just-in-time inventory systems were never built to handle the surge in demand we’ve seen from consumers who are flush with cash and eager to resume normal activities.
Powell expects inflation will cool off on its own by the end of 2022 as supply imbalances ease and the work force normalizes. With the ongoing overhang of COVID on the economy, there is a risk that taking more aggressive action now may slow the economy prematurely, pulling forward the next recession. The market should fare better if new data supports Powell’s view, alleviating the pressure on him to do more, something he believes he would regret later.
Corporate Earnings and Valuation
While it is easy to point to Fed policy and stimulus as the primary source of the market’s strength, corporate earnings growth has underpinned the rise in stock prices over the past 18 months. After the market’s 5% decline in late September, stocks were rescued again by the release of 3rd quarter earnings in October. Concerns that the Delta variant had tempered consumer activity and that higher costs from raw materials and wages would pressure profit margins did not materialize. In fact, margins expanded to record highs against this backdrop and earnings growth came in at 45% year-over-year. While down from the 88% growth rate in the prior quarter, this was much stronger than expected.
Earnings growth for the 4th quarter is expected to be around 20%. For 2022, going against the tougher 2021 comparisons, earnings growth is expected to be in the mid to high single digits. With interest rates likely to drift higher, stocks are less likely to benefit from multiple expansion (richer valuations). The price/earnings multiples for stocks actually contracted in 2021 as earnings growth exceeded price gains. This leaves stock prices dependent on earnings growth continuing to exceed consensus expectations.
The Employment Conundrum
Restarting the economy was not supposed to be easy, but the ongoing tightness of the labor market has been shocking. Part of the conundrum is figuring out what happened to all the workers who are out of the workforce. Do they have enough in savings to not work? Will they eventually have to return to work and will they go back to the same type of jobs?
Numerous explanations for this reveal an issue far more complex than previously understood. At the outset, health concerns and direct government payments to subsidize income clearly played a role in keeping workers at home. When direct stimulus payments wound down, workers did not return to the workforce in the numbers expected.
This shined a light on the role of child care and the challenges of returning to work when schools and child care centers were closed or limited in their services. This remains an ongoing issue with child care workers questioning even more whether this kind of work is worth the low compensation they are paid.
There is another part of the broad explanation that was underestimated and less understood – early retirement, or as it is now known as – The Great Resignation. This term was coined by Anthony Klotz, a professor at Texas A&M, and his analysis offers some insight on what’s behind this. The reason it might not have been foreseen from historical employment data is because it is uniquely pandemic related.
Klotz identified three factors: 1) a backlog of normal resignations had built up due to job security issues following the lockdown, 2) widespread burnout among frontline and essential workers, especially among women caregivers, and 3) time for workers to ponder broader life issues around their careers and personal satisfaction. Many workers decided that it was time to make a life change, which has temporarily or permanently taken many from the workforce. The prospect of rising wages may help bring some of them back. Either way, the basic assumptions around labor markets are changing.
Equity Leadership and Speculation
Amidst steady gains, there were distinct shifts in leadership over the course of the year and remarkable displays of speculation. Companies that benefited from the economy’s reopening led the market early in the year, before stalling out as the economy cooled around Delta concerns. Growth stocks reasserted their leadership for the balance of the year, with numerous shorter-term swings between the two styles as optimism around the economy shifted back and forth.
Beyond the headline returns of cap-weighted indices, there was significantly more volatility and pain below the surface. About 20% of the NASDAQ stood at 52-week lows in mid-December. Across the Russell 3000, 35% of the companies were 28% off their 52-week highs. On the other end of the spectrum, the top 10 names in the S&P 500 make up 30% of that index’s weight and contributed a disproportionate share of the year’s gains. In a three-day span in December, the increase in Tesla’s value exceeded the combined market value of Ford and GM.
A steep sell-off in growth momentum companies reversed the fortune for many of last year’s biggest winners. Some of these had benefited from the stay-at-home trends, while others had simply run up in price, fueled by momentum, lots of cash, and zero interest rates. The likelihood of higher interest rates brought valuation back in play, punishing companies with strong revenues but no immediate prospects of profitability.
2021 was also the year that brought investment meaning to memes, SPACS, NFTs, and an expanding roster of digital currency. The IPO market also got caught up in the early year optimism. Though 2021 saw record issuance in new public companies, they left most investors with disappointing losses. It is not unusual to see this kind of speculation in the heart of a bull market. All of this is consistent with equity gains becoming more selective and supported by higher quality fundamentals.
- Asset Mix: We are maintaining policy target equity weightings. It may be timely to consider paring back to target where exposure has become extended from stock appreciation. Fixed income return opportunities remain limited. We are maintaining shorter maturities with a bias to taxables over municipals for new purchases.
- Valuation: The broad market valuation is at lofty levels, though supported by last year’s very strong earnings growth. Value stocks are priced to perform well given expected above average GDP growth. The prospect of higher inflation and rising bond yields helped take the air out the many speculative growth stocks, though there has been little impact yet on the P/E multiple of the core S&P Growth Index.
- Economy: The Omicron surge has caused GDP estimates to be lowered for the first half of ’22. Consumer demand should stay strong, supporting a pick-up in growth in the second half as supply constraints ease and variant risk fades. Productivity improvements and the eventual normalizing of the workforce should contribute to above average growth for the year.
- Equity Style: An elongated reopening and higher yields should initially favor the value side. Growth styles should fare better if the Fed is compelled to move more aggressively to control inflation. Either way, we expect economic growth to eventually moderate, favoring a growth style tilt and less cyclicality.
- Stocks: Our quantitative work continues to favor strong free cash flow margins and high revenue growth. Valuation spreads are attractive, especially in smaller-cap opportunities. Likewise, the Quality factor should continue to be positioned well, though it has become more expensive.
A new year’s outlook is again clouded by a record surge in COVID cases, but there is also clearer sense that we are less vulnerable to economic shutdowns and more protected from severe health consequences. As rapid and broadly as Omicron is spreading, there is a chance that it will crest and pass more quickly. Behind it should be another phase of the reopening that unfolds as normal activity resumes and as bottlenecks in goods and services unwind.
Accompanying this transition is the harbinger of higher interest rates and the removal of measures that have served as a safety net to our markets. We expect markets to be more on edge as this transition progresses and we agree with consensus expectations for more modest, single digit equity returns and higher volatility. Since it is a rare event for any single year return to fall within the 5% – 10% range, we should not be surprised to see a broader range of outcomes.
Recent investor sentiment indicators recorded a second consecutive annual double-digit decline. From a contrarian standpoint, this disconnect to the market’s double-digit gains and strong economic growth for the same timeframe is not troublesome. Our concerns about the changes in Fed policy and liquidity are reasons for caution, but not an issue about staying invested. As long-term investors, we accept these risks are unavoidable and we remain confident in the market’s ability to deal with them and recover, as we have seen time and again.