2021 Beat Expectations in Many Ways… Good and Bad
Jobs, consumer spending, corporate earnings, stock prices, home values and even digital assets like crypto currencies and NFTs all grew to incredible heights in 2021. The highs did not come without consequences, though—inflation surged to levels not seen since 1992, well beyond what economists and the Fed believed was possible just a few years ago.
As the stock market continued to hit all-time highs, consumer sentiment plunged in the latter half of the year. An unusual disconnect but a reminder that companies can pass along price increases while consumers are largely stuck with the burden of inflation. Strong wage growth of 4.2% in 2021 would normally be celebrated but instead brought concern as higher inflation (CPI up 4.7%) more than neutralized those gains. Homeowners celebrated an almost 30% increase in home values over the past 2 years, but Millennials, who were just beginning to purchase homes pre-pandemic, were suddenly priced out of the market. Inflation is the consequence of the biggest demand shock for goods in 75 years, fueled by stimulus and cheap money. This year will likely see demand normalization, depressurizing an economy that recovered at warp speed, possibly too fast for its own good.
2022 Same Trend or New Bend?
For a variety of reasons, market prognosticators and economists tend to simply extrapolate current trends when making predictions. However, there are a couple of trends that will almost certainly come to an end in 2022. First, monetary stimulus is winding down and will provide less of a boost than over the past two years. The Fed announced they will end purchases of US Treasuries and Mortgages by March, effectively ending quantitative easing (QE) which has held interest rates artificially low. With inflation higher than expected, the Fed has pivoted to a more hawkish view and is moving more quickly toward rate hikes this year. Expectations are for three 25 basis point hikes in 2022, lifting the Fed Funds rate from 0% to 0.75%. Extremely accommodative monetary policy moves closer to neutral in 2022 but not tight with Real Fed Funds (inflation-adjusted) still negative, even after three hikes.
This particular move higher would have been considered insignificant in previous cycles, especially with economic growth this strong, but there is a risk the Fed moves too quickly and “inverts the curve.” Historically, when short-term rates (controlled by the Fed) have been higher than long-term rates, recessions have ensued. The Fed knows this and will act quickly to stop or reverse hikes if necessary. By ending QE early this year without yet hiking rates, the Fed is hoping a gradual rise in long-term interest rates coincides with continued strong GDP growth, steepening the yield curve, and providing additional runway for three more rate hikes in 2023.
The second trend coming to an end is pandemic related fiscal support. As you can see on the accompanying chart, these various spending programs represented 8% of GDP at the peak and will decline to 1-2% of GDP this year. Infrastructure spending becomes more significant next year and beyond, providing a small but growing boost to GDP.
Economic Cycle Maturing
We believe the US economic expansion is mid-cycle. The shift from early to mid-cycle will bring slower, but still strong, economic and earnings growth this year. Unemployment is back to multi-decade lows (despite a stubbornly low labor participation rate), jobs are plentiful, and wages are growing. The high level of IPOs, debt issuance, M&A activity, and weakening breadth of the market also reflect exuberance beyond early cycle and are related to the excess liquidity provided by the Fed.
High Profitability Provides Strong Fundamental Support for Stocks
High stock valuations often accompany later stages of a cycle and are typically supported by strong fundamentals, as they are today. Profit margins have reached new all-time highs, as seen on the accompanying chart. In addition to record profitability, we believe strong revenue growth and stock buybacks will continue to push corporate earnings per share meaningfully higher in 2022. Interest rates are expected to gradually move higher in 2022, favoring value stocks over growth stocks. However, we believe rates will be capped at levels low enough keep the economy growing and valuations from sharp contractions. Value sectors like Financials, Industrials, and Health Care are less exposed to higher rates and should begin to outperform growth sectors as rates rise. The Value to Growth rotation that began a year ago appears to be back on track in 2022.
Small companies should also benefit from this rotation. In addition, small companies look particularly attractive right now due to strong earnings growth last year and higher-than-average expected earnings growth in 2022. Valuations are also compelling, trading at 14.5x the 2022 EPS estimate, a 15% discount to their 25-year historical P/E. Large companies on the other hand, continue to be expensive on average, trading at 21.8x the 2022 EPS estimate, but with a similarly strong fundamental growth outlook. Overall, risk assets should overcome the headwind of higher rates, but expectations for returns should be more modest than experienced the last few years.
The Case for Prolonged Elevated Valuations
The current cyclically adjusted Shiller P/E Ratio (CAPE) of the U.S. equity market is expensive at 40x, in the 98th percentile relative to history. In the past, when the multiple for equities was this high, subsequent forward returns were lower than average over the next 10 years, and even negative over shorter time frames. Valuations have tended to mean-revert and at these high levels, many believe most of the market’s return in this bull market has already been harvested. But there is support for the belief that valuations may rebase at higher levels, at least for the foreseeable future.
Demographics, and specifically Baby Boomers, provide the primary rationale for a new higher level of valuation support for stocks and the continuation of the current bull market. The percentage of the population turning 65 is increasing and will continue to grow for another 10 years. With bond yields at historic lows, retirees will continue to search for attractive returns elsewhere. The substitution of bonds for high quality stocks generating predictable dividends is a powerful trend. While this trade increases overall portfolio risk, it also supports the view that the secular bull market in equities could last a lot longer in a “TINA” (There Is No Alternative) market environment.
Tax Hike Bullet Dodged… For Now
The Build Back Better (BBB) bill failed to garner enough votes to get through the Senate and with its failure, also removed the threat of higher tax rates. The market welcomed the news that the corporate tax rate would stay where it is with a strong rally. Very high income households were also spared tax increases. On the one hand, the market likes more stimulus and was disappointed. On the other hand, removing the threat of significantly higher corporate taxes that would have immediately caused 2022 earnings expectations to decline by 5-10% was a market positive. The failure to pass BBB does not significantly alter the growth outlook for an economy that is likely to grow close to 4% this year without it. There is a chance, however, a smaller and less expensive bill could pass this year that would be fully funded with new taxes, although most likely scaled down from the ambitious BBB proposal.
We continue to believe stocks will outperform bonds in 2021, as they have for the past few years. We are maintaining our “Normal” long term risk allocation, despite high valuations, to take advantage of the continued recovery. While we believe the economic cycle has moved from early to mid-cycle, growth should continue through 2022. Earnings growth of over 20% last year and another 10% expected this year will provide support for stocks, helping pull multiples back down to more palatable levels while still providing some upside. Powerful small cap earnings over the past year combined with flat performance over the past 9 months have reduced P/Es to attractive levels. The style rotation has experienced fits and starts but appears to be favoring value once again as we begin 2022. Higher interest rates tend to penalize valuation multiples of growth and emerging markets stocks the most. However, emerging markets stocks are much less expensive today than growth so may perform well despite rising rate headwinds.
While the return potential for safe bonds continues to be poor, made worse by higher rates, certain credit sectors still have upside in our view. We continue to favor emerging markets debt given attractive yields, low debt ratios, economic recoveries, rate normalization, increased manufacturing activity, and high-priced commodity exports. Last year was an exceptional year for both real estate and direct lending, both of which we continue to be bullish on this year. These two investment categories are exceptionally good inflation hedges due to rents that can be adjusted to CPI and floating rate loans that automatically adjust higher when interest rates rise. Last, our liquid alternative investment strategies performed as designed in 2021, and will continue to provide similar risk to bonds but with a much higher likelihood of achieving our return objectives. The search for strategies with the potential to earn annualized returns north of 5% with risk levels similar to bonds continues.
4Q 2021 Performance
- Stocks ended the year on a strong note as many of the dominant trends of the year continued in Q4. A new COVID scare near the end of the year added some volatility in the latter half of quarter, but the US large cap indexes ultimately ended the year at all-time highs. The scare had a larger effect on companies further down the market cap spectrum and those outside the US.
- US stocks led the way (↑9.28%) for the quarter, driven mostly by large cap equities (↑10.12%). US mid cap (↑7.98%) and US small cap (↑3.87%) equities also finished in the green for the quarter. Global stocks ex US (↑1.82%) had a bumpy quarter, dragged down by a poor quarter for Emerging Markets (↓ 1.31%).
- The Dividend Growth strategy had a very good quarter to end an impressive year. The top contributors for the quarter were led by companies in the Consumer Discretionary and Health Care sectors and the top detractors were overweights in companies in the Financial sector.
- Despite a steep and sudden drop in yields after the onset of Omicron, yields quickly recovered and ended the quarter higher as the market began looking past the new COVID wave. High Yield Corporates (↑.68%) led the way, followed by Municipal Bonds (↑.55%) and Securitized Credit (↑.28%). Investment Grade Bonds (↓.37%) and Emerging Markets Debt (↓.23%) finished slightly in the red.
- The alternatives category had another solid quarter, led by our less liquid strategies (Private Credit and Private Real Estate) but hampered by Managed Futures. Private Real Estate and Private Credit had strong months of October and November—they were up ↑7.47% and ↑2.15%, respectively. We are still waiting for the final December numbers. Event Driven (↑1.00%) had a solid quarter while Multi Strategy (↓ .01%) had a lackluster quarter. Managed Futures (↓1.68%) experienced a rough quarter due to added volatility in stocks and bonds and a couple steep drops in oil prices throughout November.
As always, contact us if would like to discuss these topics further.
Royce W. Medlin, CFA, CAIA
Chief Investment Officer