“It is better to know some of the questions than all of the answers.”
– James Grover Thurber
After a run of historically low interest rates, catalyzed by accommodative monetary and fiscal policy, signs are emerging that change is in the air as we move into 2022. Encouragingly, that change is happening against a backdrop of strong economic growth and record corporate profitability. From monetary and fiscal policy to Covid and supply chains, we see 2022 as a transformational year. How should investors be positioned as the winds of change blow through the capital markets?
For the last thirty years, declining interest rates have accompanied both rising equity valuations and higher corporate profit margins. Last year was no exception. Central banks responded to the pandemic by flooding markets with liquidity and pushing the federal funds rate to zero. But the winds of change are blowing. Inflation is running well ahead of the Fed’s comfort level, and QE (e.g., buying of bonds to suppress rates) seems to be coming to a logical end. In other words, a tightening cycle (rate increase) and QT (balance sheet runoff) are in store.
If the first few days of the year have taught us anything, it’s that the 2022 investment environment will be different. Fed officials continue to acknowledge the strength in the economy and persistent inflationary stresses in their public remarks. The bond market has taken notice, and yields have started to back up. Asset class rotations, responding to those higher rates, have been sharp and volatile.
Importantly, demand growth remains intact. While the fastest pace of the recovery now lies behind us, we continue to expect strong growth in coming quarters (e.g., 2022 GDP growth should remain well above long-term averages). A consumption boost from pent-up savings and inventory rebuilding spurred on by improving supply chains should provide the necessary tailwinds that counter tighter monetary policy and the uncertainties of Covid. Profit growth accounted for the entire S&P 500 return in 2021 and will continue to drive gains in 2022. We expect another year of above-consensus growth.
At BakerAvenue, we maintain analytical independence from pre-written market narratives. We remove preconceived biases from the equation and defer to our analytical output. Ultimately, our views are only as optimistic or pessimistic as our technical, fundamental, and macro analyses indicate. Currently, our short-term metrics are in a neutral position, and long-term trends continue to paint a more optimistic picture (positive).
For those who have been following our weekly market updates (view previous market update videos and commentaries), you will be familiar with several of our key concerns and opportunities. We have continually stated that the pandemic-related retrenchment in economic activity, while necessary, was self-inflicted, not structural, and prone to snapping back as re-opening resumed or vaccines entered the narrative. While we recognize a sustained expansion is quite different than the recent normalization, we suspect a run of favorable policy decisions, economic growth, and earnings will continue to support a further grind higher in equities. A more hawkish Fed, along with higher interest rates, has not changed that view. Consolidations and pullbacks, should they occur during the first few weeks of the year, should be bought.
The Fundamental Perspective:
Fundamentally, we continue to focus on the trend in corporate profits and credit metrics. In aggregate, they remain healthy. Our weekly series for forward revenues, earnings, and margins have risen to record highs. Concerns about rising input costs have meant little to the robust trend in profit growth. In fact, corporate margins are higher now than they were pre-pandemic. We see more of the same in 2022 and expect earnings growth to again outpace economic growth. Stubborn pricing pressure and supply constraints are headwinds, but strong demand has more than compensated. While the frequency and magnitude of earnings and sales beats will naturally moderate, consensus estimates look beatable, and another double-digit expansion in profits is within reach.
Valuations seem stretched in several pockets of the market but only slightly above long-term averages in others. The pace of the expansion in corporate profits has far exceeded stock prices, so multiples are now lower than they were at this point last year. Valuation dispersion remains at record levels with a sizable gap between the secular growers and the more economically sensitive recovery plays. We see opportunity in both and expect less dispersion going forward as investors embrace a more balanced view.
The credit backdrop remains supportive. Despite some widening over the past few weeks, both investment-grade and high-yield spreads vs. Treasuries remain near levels that are associated with strong equity markets. Dividend reinstatements (or increases) are running well ahead of dividend cuts. The record pace of deal activity (e.g., IPO’s, M&A, etc.) looks to continue well into 2022 as cash flows remain strong and corporate confidence stays elevated.
The Macro Perspective:
The macro discussion must start with a view on the global economic recovery. Incoming data over the past few weeks has supported our sustainable recovery narrative (e.g., unemployment reached 3.9% last month, a post-Covid low). Recent worries have centered on the mix of higher inflation, combined with slowing growth and the beginning of the Fed exit. While these certainly have our attention, we expect the inflation scare will subside as conditions generating the price spikes ebb (e.g., bottlenecks ease, labor supply increases) and economic growth continues. Real-time estimates for 2022 GDP growth are running around 5%, a slowdown from last year but ahead of long-term averages.
Interest rates will be the fulcrum by which investors express their economic growth views, and we expect them to move gradually higher throughout the year. The Fed has acknowledged that aggressive bond purchases (QE) are not a policy that fits well with a supply-constrained economy. They recently announced plans to taper those purchases (to help address inflation), removing the largest suppressor of rates. Further, they recently adjusted their views by indicating inflation could stay longer than expected, and they could speed up its tapering process. We believe a faster taper (i.e., fewer bond purchases) is more of a capital market concern than an economic one, but if history is a guide, it will add to volatility.
Regarding the Omicron variant, we are encouraged by the latest developments. While infections are picking up, symptoms seem milder by comparison. We continue to believe US shelter-in-place mandates are both socially and politically unsought and therefore lower the odds of a self-induced US recession. The high-frequency data we monitor (e.g., hotel occupancy rates, restaurant bookings, retail spending, etc.) support the notion that, while volatile, the recovery is intact.
The Technical Perspective:
Longer-term, the current technical backdrop remains in decent shape. Most major indices remain at, or very close to, all-time highs, and corrections over the past few weeks have done little to alter the longer-term trend. Longer-term moving averages (e.g., the 200-day moving average) remain in good standing, with approximately 65% of stocks trading above this key threshold (a healthy level). Shorter-term, there has been quite a bit of damage done internally over the past couple of weeks (e.g., almost 40% of Nasdaq issues are off 40% or more from their 52-week high) as terminal values adjust to the higher rate backdrop.
The market remains a bit top-heavy, with the top twenty companies in the S&P 500 making up over 40% of its market cap and the top five over 25%. The “average stock” simply hasn’t kept pace with the largest, predominately technology companies. We expect the market to broaden as we move further into 2022. Healthier markets tend to have strong participation rates, so we will be looking for improvement here.
Rotation within market internals continues to be a weekly theme and has been quite pronounced to start the year. Leadership is bouncing back and forth between defensives and more economically sensitive groups as macroeconomic influence remains elevated. We expect this churning behavior to continue as long as macro uncertainty remains but see relative value in the groups less represented last year (e.g., small caps, value, economically sensitive groups, etc.).
Investor sentiment seems balanced to us. Surveys (e.g., AAII bull-bear survey, Investors Intelligence surveys, etc.) point to a skeptical investor base, and positioning data (e.g., put-call ratios, cash balances, etc.) lean defensive. Money flows into equities remain strong but far behind the inflows into bonds and cash over the past few years (e.g., there is still more than $4 trillion in money market funds available to invest).
We have championed a ‘barbell’ approach by investing with secular winners while simultaneously allocating capital toward assets that will benefit most in a recovery. We see no reason to change that view as we move into a new year. We do believe the frequency by which investors can actively tilt portfolios towards those pockets of opportunity or away from risk will become more pronounced as the recovery matures and the winds of change materialize.
Volatility should stay somewhat elevated, but systemic risks that could result in recessionary or bear market conditions remain low given the accompanying growth backdrop. Our forecast for a maturing but sustained economic expansion strengthens our belief that investor focus should be on “how” one is positioned, not “if” they should have exposure at all. That “how” should continue to include both secular growth and cyclical allocations.
Our investment philosophy is based on a dual mandate of growing, and protecting, client assets. With our cash positions now residual in nature, we are focusing on strategy positioning vs. our respective benchmarks to control risk. Should our base case hold, we plan to maintain our steady positioning. Of course, should the backdrop start to destabilize, we will take a more defensive stance.
Given the volatile and ever-changing backdrop, we believe a strategy that combines disciplined fundamental, technical, and macro analyses has the best chance of generating superior risk-adjusted returns. While our forecasts are subject to revision, our commitment to client service is rock solid.
Should you have any questions, please contact BakerAvenue. We are happy to share our thoughts in greater detail and welcome your questions or comments.
Disclosure: Past performance is not indicative of future performance.