by Tony DeSpirito, BlackRock Fundamental Active Equity Investment Team
“Normal” is in the eye of the beholder. But if it entails elements of “ordinary,” “expected,” or even “boring,” it will be a welcome change for financial markets. We think 2022 could feature some of these long-missed traits. As the calendar turns the page, we see:
- Moderation in both the headwinds and tailwinds for stocks
- Positive, but more muted, market returns
- Stock selection having a bigger bearing on outcomes
Market overview and outlook
2021 was remarkable in many respects. Three market dynamics to note: value rivaling growth for the first time in half a decade, earnings growth and positive surprises of historic proportions, and inflation readings unlike any seen by many present-day investors.
What next? We see growth and value running neck and neck in 2022, offering opportunity for both camps. Earnings should remain strong as companies look to meet pent-up demand for products and services. Earnings surprises, however, are already moderating toward the long-run trend (see chart below). Inflation is the one dynamic that may continue to overdeliver. While inflation is a concern and source of volatility, it also makes stocks the most compelling choice among the major asset classes. Individual companies will manage through differently, highlighting the importance of a stock-by-stock approach.
Sizing up the positives and impediments
As we assess the pros and cons in the broad stock market picture, we note some moderation in both the tailwinds that have given stocks a notable boost in 2021 and the headwinds that have served as offsetting variables. This sets the stage for a more balanced backdrop as 2022 begins.
Positives
1. Policy support
Swift, significant and globally coordinated fiscal and monetary policy stimulus was delivered early in the COVID crisis and maintained throughout. This served as a powerful force in propping up economies and staving off financial crisis.
Central banks are now making strategic moves away from emergency measures. In the U.S., the Fed has started to taper its monthly asset purchases, with interest rate hikes in contemplation but not an immediate action item. We acknowledge the strong risk that inflation may force the Fed to act sooner rather than later. Importantly, however, rates would be rising from a historically low base and are likely to remain negative after inflation. This is still a supportive backdrop for stocks.
2. Pent-up demand
Consumers had built up savings during lockdowns, and reopenings spurred a robust activity restart and a vigorous spending cycle. It’s not over yet, but we are past the initial swell and expect activity to settle into a trend over the course of 2022.
We’re watching inflation and its potential effect on consumer behavior. So far companies have been able to pass on rising input costs, as demonstrated by historically large sales beats. Yet this type of revenue surprise is unprecedented, and we already see it reverting toward more normal levels.
3. Sidelined cash
Both businesses and individuals held cash aside amid the height of the pandemic uncertainty. Renewed confidence in 2021 led companies to deploy excess cash in dividends and share buybacks. Half of dividend payers in the Russell 1000 Index have raised or initiated a dividend so far this year. We see even better prospects for capital returns through share buybacks and growing dividends in 2022.
Household income statements and balance sheets are in good shape. Unemployment is down and wages are up. Even if rates rise, consumers’ big payments are fixed (think mortgage and car loan rates). Even a 1% rise in credit card rates would have minimal impact on spending power.
Excess cash has been finding its way into equity markets. After at least a decade of anemic flows, equity ETFs and mutual funds attracted $900 billion so far this year, more than the past 19 years combined, according to BofA Global Research and EPFR data. We see room for more, even if the bulk have already been realized.
Impediments
1. Inflation
Inflation takes the #1 spot on our list of concerns. So far companies have been more than able to pass on rising costs, but we’re watching inflation’s potential to squeeze profit margins, particularly if consumers grow less willing to pay up for goods and services. An even bigger consideration: the impact on monetary policy and potential change in the Fed’s track. Should inflation and nominal rates rise to the point where real (after-inflation) rates are no longer negative, that poses the greatest relative threat to the risk/reward in stocks.
Stocks are one of the best places to be in a rising inflation world. Our review of data back to the 1920s finds that equities perform well as long as inflation isn’t out of control (over 10%, which is both historically rare and not our expectation). In moderate inflation environments (5%-10%), value stocks have performed particularly well.
2. Valuations
U.S. stocks appear expensive relative to their history, based on price-to-earnings (PE) ratios. This gives some pause. Yet more important for investors building a diversified portfolio is that U.S. stock pricing remains very compelling versus bonds. This is reflected in the equity risk premium (ERP), which values stocks based on the prevailing 10-year Treasury rate. Currently, based on our models, the 10-year Treasury yield (below 1.5% at Nov. 30) would have to approach 3% to compete with equities on a risk/reward basis.
Global bonds are poised to deliver a negative total return in 2021 versus sizable gains for stocks, a scenario seen only twice since 1999. At a November forum of BlackRock investors, the majority saw the potential for another down year for bonds in 2022 versus single-digit positive returns for stocks. All of this is to say that stocks should remain a favored asset based on both the short-term outlook for the alternatives and long-run data supporting the case for stocks in a low-rate, high-inflation environment.
3. COVID-19
The identification of the omicron variant in late November, and the market’s strong immediate reaction to it, was a stark reminder that the novel coronavirus is a persistent risk. COVID-19 has been and is likely to remain unpredictable, thus requiring attention and respect for its potential to upend businesses and markets. On the positive side, vaccine boosters are approved for wide distribution in the U.S. and COVID therapeutics are likely the next medical innovation to see the world into a post-pandemic “normal.” Announcements from two major drug makers on this front are encouraging.
In a recent poll of BlackRock investors, roughly half felt that market reactions to rolling waves of COVID-19 would diminish over time as investors grow accustomed to the ebbs and flows of a more endemic virus.
“2022 starts with higher valuations,
higher margins and a higher bar for
stocks in general. We want to own
companies that can clear that bar
today and deliver over the long term.”
What’s an investor to do?
Last year we favored pairing cyclical value exposures (e.g., energy and financials) with long-term structural growers (e.g., tech and healthcare). We maintain this bias and would apply a more discerning lens in 2022. We highlight some specific ideas across each sector in our full Q1 outlook.
In an environment transitioning from unprecedented to something more “normalized,” we believe selectivity across sectors and individual stocks, with a focus on quality, has the potential to make an important difference in portfolio outcomes.
After heavy retail investment in 2021 drove momentum into a narrow segment of the U.S. equity market, we expect underlying company fundamentals will re-emerge as the key driver of returns in 2022 ― an ideal environment for fundamental-based stock pickers.
Tony DeSpiritoBlackRock Fundamental Active Equity Investment TeamAntonio (Tony) DeSpirito, Managing Director, is Chief Investment Officer, U.S. Fundamental Equities. In addition, he is head of the U.S. Income & Value Team ...
