A balanced approach to equity investing that is focused on earnings seems to be the optimal strategy in an environment of continued uncertainty.
Global Market Strategist
2020 saw the equity market move higher against a backdrop of rising earnings expectations and declining valuations. However, with the U.S. equity market now sitting close to its all-time high, many investors are asking what is in store for 2022. By our lights, the coming year should see earnings act as the primary driver of returns as the U.S. equity market continues to grow into its above-average valuation.
Earnings growth has been nothing short of spectacular in 2021, with Standard & Poor’s currently estimating that S&P 500 operating earnings per share grew by 70%. The majority of this earnings growth came from margin expansion, as companies cut costs aggressively during the pandemic and subsequently benefited as revenues came roaring back earlier this year. Alongside this rebound in revenues, however, has been a continued increase in input costs and wages. This has led to concerns that profit margins may come under pressure next year and potentially lead earnings to decline.
Exhibit 7: Margins may come under pressure in 2022
annual growth broken into revenue, changes in profit margin & changes in share count
Despite these rising costs, however, companies may be able to defend their margins in two different ways. First, we have already seen companies pass along higher prices to the end consumer — while there are implications for inflation, this does help preserve profitability. At the same time, we have seen more and more managements mention a focus on productivity and efficiency. Historically, capital spending tracks earnings growth with a 12-month lag; this suggests that business investment may accelerate next year, helping offset rising input costs in a more sustainable way.
With economic growth set to remain above trend and earnings likely to be the primary driver of returns, we prefer those sectors and industries with earnings that are most sensitive to the underlying pace of economic activity. Importantly, this does not mean investors have to choose between value or growth — the best allocation will actually be a blend of the two. Earnings of companies in the technology, communication services, financial and industrial sectors have historically been most correlated to changes in real GDP; furthermore, we believe that the financial sector could benefit from higher interest rates and a resumption of buyback activity.
Exhibit 8: Investors should focus on sectors with earnings that are sensitive to growth
1Q 2009 - 2Q 2021
The emergence of the Omicron variant has reminded us that the pandemic is not yet behind us, and volatility could remain elevated into the end of 2021 and beginning of 2022. However, a balanced approach to equity investing that is focused on earnings seems to be the optimal strategy in an environment of continued uncertainty.