The key question for equity investors is how moderately higher inflation and bond yields will affect corporate profits and valuations. Given significant pent-up consumer savings and elevated capex intentions, sales growth will likely be strong. When sales are strong, profits tend to rise, even if input costs are rising.
Higher bond yields could raise borrowing costs but this can also be offset by higher sales, while higher wages tend to boost sales as well as costs. Meanwhile, any additional taxes that hit the corporate sector are likely to be at least partially offset by the demand boost from additional government spending.
So, against the current economic backdrop, it seems unlikely that rising costs will fully offset the anticipated benefit from strong sales growth. Higher inflation is therefore likely to coincide with higher profits, as is normally the case (Exhibit 4).
Exhibit 4: Moderately higher inflation tends to be good for profits and stocks
US inflation and S&P 500 trailing earnings
The bigger concern for investors is whether higher bond yields will hurt equity valuations, since it raises the discount rate on companies’ future earnings. However if bond yields are rising because growth expectations are rising, then valuations don’t have to decline. Indeed, it is common for valuations to rise (and fall) at the same time as bond yields. Even if rising bond yields do lead to lower valuations, then as long as profits rise by more than valuations decline, stocks can still rise. Our base case is that rising corporate profits, driven by strong demand, will offset any decline in valuations for most stocks.
Growth versus value is another key debate as we head towards 2022. So far in 2021, last year’s losers have outperformed last year’s winners, with value stocks significantly outperforming growth stocks. Despite this, growth stocks still trade on high valuations compared with history and relative to value stocks (Exhibit 5).
Exhibit 5: Valuations for growth stocks are still much higher than value stocks
MSCI World Growth and Value forward price-to-earnings (P/E) ratio
Given that we believe 12-month forward earnings expectations are likely to keep rising for most stocks, the biggest risk to our continued optimism on equities is that valuations on the more expensive growth stocks decline by enough to offset the earnings upside.
However, our base case is that any further compression in the valuations of growth stocks will just limit the extent of their upside, rather than fully offset the expected increase in earnings. While we do not expect further price/earnings (P/E) expansion on value stocks, valuation compression seems less likely than for growth stocks, given much lower starting valuations.
For example, consensus expects 12-month forward earnings on the Russell 1000 growth index to be 19% higher by the end of next year, compared with 17% higher for the Russell 1000 value. Both indices should therefore rise, but even a modest decline in growth stock valuations relative to value stocks could lead growth stocks to underperform.
At the very least, it is worth being aware that a large part of the reason for the outperformance of growth stocks since 2009 has been the substantial increase in their valuations. A repeat of that tailwind seems unlikely from this starting point, and it is possible that it could now become a headwind, if valuations on growth stocks continue to decline. Value stocks, by contrast, are unlikely to see P/E compression, given valuations remain relatively modest.
It is also worth noting that financials are by far the largest part of value indices globally. Over the last decade, their relative performance has been highly correlated with 10-year bond yields. We therefore expect financials – and hence probably broader value indices – to outperform, if we’re right that bond yields will rise further from here.
Overall, we believe equities will move higher but at a slower pace, and with the potential for the usual bumps in the road. We also have a moderate preference for value over growth stocks, based on relative valuations and our view that bond yields will continue to rise.
At the index level, this means the US could underperform other regions, because of its large weighting to more expensive growth stocks. US value stocks could continue to perform well though, while more value-oriented markets such as Europe and the UK could outperform. For investors keen to avoid putting all their eggs in the value basket, we believe emerging markets offer long-term growth opportunities at a more reasonable price than some other markets.