Amid ongoing economic and COVID-related uncertainty, most global equity markets delivered double digit gains in 2021. The U.S., Canada, and Europe ex UK led developed market gains. Oil and other commodities also continued to advance, while the U.S. dollar rallied strongly versus most developed and emerging market currencies. The QV equity strategies produced excellent results in the year; not only on an absolute basis, but also outperforming their respective benchmarks. In addition, our fixed income positioning allowed us to protect capital in what was a challenging year for bond investors.
While 2021 was exceptional for equity investors, we anticipate 2022 will revert to average historical returns as market tailwinds diminish. This assumes a moderate and slow Fed tightening cycle, which may act as a major swing factor for market performance over the next 1-2 years.
Post the COVID recession of 2020, we’ve witnessed one of the most dramatic global economic recoveries in history. Even though it’s been sporadic and uneven across geographies, it has led to a strong “V” shaped earnings recovery. In 2021, the growth in year-over-year earnings was extremely outsized relative to historical averages. To put this into context, the average year-over-year operating EPS (earnings per share) growth for the S&P 500 has been 6% over the past twenty years. Last year, EPS growth surged by 72%!
Following recessions, a stronger than average snapback is typical, as is a significant slowdown in earnings growth after the initial rebound. For 2022 we expect a more average growth rate, somewhere in the mid to high single digit range.
While we expect economies and earnings to continue to grow at a reasonable clip, valuations have largely discounted much of the positive news. That said, there exists significant disparity by geography, by sector, and by the nature of businesses. The U.S. is by far the most stretched on a valuation basis, but there is a very wide range of multiples within the market itself. This is illustrated in the chart below.
Source: Compustat, FactSet, Standard & Poor’s, J.P. Morgan Asset Management, Dec. 31, 2021
Sectors of the economy are also trading at very different valuation multiples; some are highly in favor with investors, and some are not. High growth businesses and those with future promise but meagre profits have skewed the overall averages upwards. While valuation is high relative to history, interest rates are also near historical lows. As we’ve written about at length, this extremely stimulative monetary environment has both allowed for and driven valuations to such levels. Our conclusion on valuation is that investors need to be choosier, and preference reasonably valued, quality businesses.
The monetary background is changing. The most accommodative Federal Reserve policy in U.S. history has started to transition. Currently, short-term interest rates are near 0% and since the pandemic hit, the Fed has added nearly $5 trillion to its balance sheet in bond purchases, dwarfing its response during the 2008 Great Recession. A great deal of the volatility that investors should expect in 2022-2023 will hinge on how the Fed normalizes these abnormally stimulative policies. The massive monetary (and fiscal) tailwinds investors have benefitted from are still in place, but they too are diminishing.
Historically, slow and measured rate hike cycles have been reasonably digested by markets. Faster than expected ones have not. The jury is out on what this rate hike cycle will look like. Our conclusion is that even if economies and earnings do well, the stock market will be more sensitive to the pace of the tightening cycle than most other factors. To date, the market has not priced in much of the tightening. From our point of view, in many respects, there’s too high a degree of complacency on this front.
INFLATION AND COVID… NOT THAT EASY TO GET RID OF!
Inflation is running near 20-year highs globally, driven by a broad surge in pricing for what seems like almost everything. The common view on inflation is that it is pandemic-induced and therefore will wane in the near term as supply side disruptions are resolved and surging demand for goods by consumers normalizes. We would agree that the spike we’ve seen in 2021 will alleviate to some degree as inventory is re-stocked and buying patterns normalize. But there are elements of higher prices that are stickier and may provide a greater challenge going forward. For example, wages are driving up the prices of both products and services throughout the economy. In the U.S., wage inflation as measured by the Employment Cost Index has reached its highest level in over 35 years. A remarkably tight labor market is one of the driving forces behind this surge and it is unlikely to change anytime soon. Historically, wage inflation has been very sticky once it takes hold. We think there is a high likelihood that inflation will remain a bigger challenge than is currently anticipated.
COVID – While the dramatic impact of the pandemic on the markets seems to be behind us, the virus certainly continues to significantly influence our daily lives and the economy. Omicron is likely to cause some short-term economic weakness as businesses are affected by staff shortages and renewed lockdowns/regulations given the transmissibility of this variant. This may exacerbate supply chain problems and push out inventory restocking further into the year. It may also lead governments to provide further financial support and pile even more debt onto what has become a staggering figure.
OPPORTUNITIES AND POSITIONING
Today’s market environment is higher risk in terms of stock market return drivers – earnings growth, valuation, and monetary backdrop. The probability of more persistent inflation is being underestimated by market participants and in our view is one of the most material factors to upending the global asset inflation cycle we’ve witnessed. In addition, we’ve seen numerous examples of excessive risk taking and speculation that we’ve cited throughout our past commentaries. It is these areas of the market that will be at greatest risk. Like every cycle before this one, investors will come back to basics, investing based on fundamentals and quality characteristics. This is where investors should be positioned. Put another way, risk management will matter.
Our portfolios continue to be very different than the broad stock markets to which we refer. We have not invested in the fastest earnings growth companies, automatically assuming they will grow even faster next year. We have not invested in great concept stocks that lose money but maintain a promise to one day make a boatload. We have kept a keen eye on valuations to ensure we are able to provide a margin of safety and protect capital for more challenging times. Our portfolios are well diversified in quality businesses that generate strong cash flows and attractive returns on capital. We continue to see attractive risk adjusted returns going forward for our equity portfolios. On the fixed income side, we remain cautious given our inflation concerns and continue to focus on a shorter duration portfolio which should help mute the negative impacts of higher rates.
All of us at QV wish our clients and friends a healthy and prosperous 2022!