US stocks delivered stellar returns in 2021, but globally returns were more mixed. We saw double-digit increases in Europe and the UK and many emerging markets bourses. However, poor performance in China, driven by government regulatory crackdowns and property sector woes, dragged down the emerging market index to negative returns. Japanese stocks were about flat for the year. US REITs and commodities were particularly strong performers this year (Figure 1), benefiting from their status as real assets during a period when inflation surged to levels not seen in decades. Bonds mostly posted negative returns, as yields bounced around but generally ended the year at higher levels. In the US, for example, the 10-year Treasury yield began the year at 0.9% and ended the year at 1.51%. The entire increase, however, came in the first quarter when the yield hit 1.74% on 3/31/2021 and has since traded back down.
The growth environment for 2022 looks to be supportive of risk assets. We believe above-trend global growth is still likely, although growth should slow from 2021’s torrid pace. The outlook for economic activity is somewhat clouded by the emergence of the Omicron variant. Experts are still studying the variant, but the data so far indicates it is much more transmissible but also less deadly. However, at this moment, we believe Omicron is more likely to represent another economic speed bump in an ongoing expansion.
That said, we believe 2022 will be a more turbulent and less rewarding year for US stocks in particular, as the Fed unwinds extraordinary monetary accommodation in response to above-trend growth, the rapidly falling unemployment rate, and elevated inflation. While solid economic growth is typically good for stock market performance, high valuations, elevated rates of inflation, and rising real rates seem likely to coincide with lower returns, higher volatility, and larger drawdowns than we saw in 2021.
Nonetheless, we maintain the view that stocks will outperform bonds in 2022 as yields on the long end are likely to rise in response to the shifting monetary policy environment. This should translate into another year of negative returns for the Bloomberg Barclays U.S. Aggregate Bond Index. Meanwhile, equities should be supported by a continued rise in corporate earnings. Moreover, stocks typically perform well in the early stages of Fed rate hikes. The real damage from higher rates tends to occur later in the tightening cycle when tighter policy flattens/inverts the yield curve; we are still not at that point¹. Things could be different this time, though, as the Fed is hiking rates after inflation is already running at levels substantially above its target.
We expect profit growth to continue but to slow from this year’s blistering pace. 2021 was a banner year for corporate earnings as profits rose globally by more than 50% due to several factors, including base effects, increased revenue from pent-up demand, operating margin expansion, and declining interest costs. Triple-digit earnings growth rebounds in emerging markets such as Latin America and EMEA (Europe, Middle East and Africa) were driven by sharply higher oil and commodity prices.
Given the tough comparison and expected slower economic growth, profit growth should come back to earth in 2022. US and global earnings are expected to grow at a high-single-digit pace next year (Figure 2).
Equity valuation multiples had risen sharply over 2020 as earnings collapsed due to the COVID recession, while stocks prices rose sharply in response to unprecedented monetary and fiscal policy stimulus, and in anticipation of a rebound in profits in 2021. During 2021, valuations improved with price/earnings (PE) multiples contracting as earnings growth in the 50%-70% range outpaced stock gains in the 10%-20% range. The forward PE ratio on the S&P 500 Index, for example, fell to 22 from 24 during 2020 (Figure 3). While this is still elevated relative to its 10-year average, we do not view it as excessive given the current level of interest rates and with profitability for S&P 500 firms at a record level.
Outside of the US, market valuations are much more favorable. As shown in Figure 4, multiples in non-US markets have generally fallen more decisively than those in the US from 2020 levels. Eurozone equities exhibit forward multiples closer to the 10-year average, while UK (FTSE) and Latin American stocks are trading at significant discounts to the same measure. As a result of the much better valuation starting point, non-US markets could see significant outperformance over US stocks in 2022. However, this has been the case for several years, and the momentum still favors the premium-priced and higher-quality US market. We are currently neutral on US, EAFE, and emerging market stocks.
Commodity futures stand out as one of the few major asset classes that remains historically cheap (it’s worth noting the Bloomberg Commodity Index fell nearly 75% from mid-2008 to April 2020), so even with this year’s strong performance, the commodity index is still nearly 60% below its prior peak. We think the pandemic marked the bottom in the secular bear market for commodities, and a new bull market should continue into 2022. Further, price gains should be driven by elevated inflation trends, constrained supply, (driven by a decade of underinvestment due to falling prices, environmental policies and ESG investing) and buoyant demand (due to economic normalization from the fading impact of the pandemic and past government fiscal and monetary stimulus).
¹ Taking the Tantrum out of the Taper, Credit Suisse Securities, Jonathan Golub, 12/13/2021