We expect that 2022 will be characterized by solid economic activity and continued growth in corporate profits.
Global Market Strategist
- Volatility has increased as investors refocus on challenges the market will face in 2022
- Fourth quarter earnings are off to a solid start and the more cyclical sectors are leading the charge
- Margins will come under pressure this year, but higher selling prices and a focus on automation will provide a partial offset
- In an environment of rising rates, valuations will come under pressure; this leaves earnings as the primary driver of returns
Equity investors are recognizing that there are a number of issues which will need to be resolved in 2022. How much will Omicron drag on the pace of economic growth? What should we expect from the Federal Reserve? Is Build Back Better dead, and with it, the child tax credit? How worried should we be about rising geopolitical tensions?
Nobody knows the answers to these questions, but one prevailing theme is that Washington may be not be as friendly to markets and the economy going forward. This dynamic, coupled with a sharp increase in interest rates, has driven equity prices lower and volatility higher.
We had been expecting volatility to pick up after an abnormally quiet 2021, and the first few weeks of 2022 have delivered. Importantly, this seems like a healthy pullback rather than the beginning of something more sinister, especially if corporate profits continue to grow over the course of the year.
With 73.9% of market capitalization reporting as of February 7, our current estimate for 4Q21 S&P 500 earnings per share is USD 55.08. If realized, this would represent year-over-year growth of 44.3% and quarter-over-quarter growth of 5.9%. So far, we have seen above-average beats on both revenues and earnings (77% and 69%, respectively) and above-average surprises as well. Defending margins will be key for profit growth to continue, and we are currently tracking operating margins of 13.3%.
As the pandemic fades into the background, many of the forces that have distorted markets will fade as well. We expect this will entail a further normalization of valuations, meaning that earnings will be the primary driver of returns. With inflation looking persistent and economic growth still above trend, we are most interested in those sectors and industries with earnings that stand to benefit from this macroeconomic environment.
Exhibit 1: Monthly stock market returns tend to decline as rates rise quicker
Monthly Shiller S&P Composite returns, 10-year U.S. Treasury (UST), April 1954 - present
We expect that 2022 will be characterized by solid economic activity and continued growth in corporate profits. We also acknowledge, however, that revenue growth will slow at a time when input costs, interest rates, wages—and potentially corporate taxes—are rising. This will inevitably put downward pressure on profit margins; the question is what companies can do to keep margins steady and prevent revenues falling too far. Fortunately, there are a handful of levers that management teams can pull to defend margins in 2022.
Inflation is front of mind in the current environment; inflation can erode consumer purchasing power, but is often reflective of an environment where companies have pricing power. In a world where input costs and wages are rising, being able to pass along these higher expenses to the consumer is one way to defend margins. Businesses are seeing higher input costs and raising selling costs in response. This stands in contrast to the prior expansion when companies were forced to absorb higher wages and input prices, as there was tremendous concern about the elasticity of demand.
In addition to being able to increase selling prices, companies will look for other ways of defending margins. Historically there has been a tight relationship between earnings growth and capital spending 12 months later. Furthermore, as management teams have acknowledged rising input costs and wages, they plan on responding by focusing on automation and efficiency. This requires investment and suggests that corporations will not be limited to price increases as they attempt to defend margins this year.
We expect that margins will be defended, and that the risk to earnings growth in 2022 is to the upside. But how should investors think about valuations against a backdrop of rising long term yields? Higher interest rates should, in theory, push valuations lower, thereby leaving earnings as the primary driver of returns. This is similar to the dynamic seen in 2021, when a 35% increase in earnings expectations more than fully offset a 7% decline in valuations, leading to a price return of 27% for the year as a whole.
In a rising rate environment, we are focused on sectors and industries that have earnings which benefit from moderate growth and sticky inflation. This leads us to industrials, materials and financials in the value space, and places like technology and health care in growth. Within technology, we are focused on companies that are able to generate consistent cash flows, rather than chasing companies that rely entirely on multiples expansion to drive returns. From a size perspective, we have a preference for large caps over small caps in 2022.