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Oarsman Outlook: December 2021

January 24, 2022
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Following a lackluster July-September quarter, financial markets sprang back to life in the year's final three months. Large-company U.S. stocks leapt around 10%, on average, while their small-company counterparts did about half as well. Overseas equities were mixed, with developed markets posting solid local-currency gains (which were trimmed by an appreciating U.S. dollar), while emerging markets languished in negative territory. Among the best results were posted by U.S. real-estate securities, though overseas- and commodity-focused issues were less buoyant. Physical commodity prices rose modestly, with both industrial and precious metals posting single-digit gains; oil was flat (though three-month results masked a cooling of many prices from early-period peaks). Investment-grade bond returns were positive, on average, as longer-term yields and credit spreads were essentially unchanged (the 10-year Treasury finished at 1.51% compared with 1.53% at the end of September). Shorter-term yields rose, however, causing many short-maturity investments to post modestly negative results.

Among U.S. large-company stocks, constituents of the Basic Materials, Consumer Staples, Health Care, Technology and Utilities sectors provided relatively larger gains, while those in Communications Services, Consumer Cyclicals, Energy and Financial Services lagged. The growth investment style solidly outperformed value among both large- and small-company shares.

Review

The October-December quarter featured both frustrating and frightening pandemic developments, rebounding economic growth, soaring inflation, hawkish shifts by major central banks and persistent political dysfunction. Nevertheless, investors seemed largely unfazed, sending stocks to new highs.

The COVID pandemic continued to exert a malign influence on the global economy. Though the delta-variant wave waned in the U.S. during the autumn, infection rates soared anew in Europe, resulting in new restrictions on activity and commerce. Likewise, China's zero-tolerance policy caused intermittent shutdowns of port facilities and factories. By December, the highly transmissible omicron variant was ascendant in many regions, pushing infection rates to record levels (though hospitalizations and deaths remained lower). Soaring infections threatened to inundate health-care systems and began to disrupt commerce (see: commercial flight cancellations), as burgeoning numbers of workers fell ill or tested positive and were obliged to self-isolate.

The U.S. economy reaccelerated markedly, following a summer slowdown amid supply-chain disruptions and surging delta-variant infections. Purchasing-managers surveys signaled robust industrial growth, as improving supply-chain conditions allowed production to ramp up to meet surging demand. Employment was white-hot: net job creation averaged better than 350,000 per month, driving unemployment down to just 4.2%; unfilled job-openings reached record highs while new unemployment claims plumbed record lows. High prices and persistent public-health setbacks weighed on consumer confidence, however, which fell well below levels recorded during spring and early summer. Rising prices meant that seemingly strong nominal personal-income and -spending gains were in fact flat or down slightly in inflation-adjusted (real) terms.

Summer's above-trend recovery continued in Europe, though spreading pandemic-related disruptions began to stifle activity. Japan emerged from a sharp, COVID-induced summer slump to experience what looks to be its best growth since early-2018. The Chinese economy was hampered by a broadening real-estate slump and sporadic COVID outbreaks and related disruptions, though acute power shortages seen earlier in the year abated; a closely watched manufacturing-sector gauge dipped into negative-growth territory for only the second time since early 2020. On the latest trends, global GDP looks to have expanded by around 5.5% across calendar 2021 – the strongest gain in nearly 50 years and, importantly, meaningfully better than year-ago expectations.

After seeming to plateau during the summer, inflation exploded higher. The U.S. consumer-price index notched an eye-popping +6.8% gain in the twelve months to November – the highest reading in four decades. European prices recorded only marginally less alarming spikes, though Asian gains were more muted. Some of the latest surge stemmed from "base effects" (i.e., comparisons with depressed year-ago data) and outsize gains among a handful of somewhat esoteric index constituents (e.g., used vehicles); month-to-month data hinted at a gradual lessening of inflationary pressures – albeit at elevated levels – a trend seemingly corroborated by easing energy prices and dissipating supply-chain snarls.

Belatedly acknowledging the not-so-transitory nature of surging prices, developed-world central bankers took a decidedly hawkish turn in their approach to monetary policy (many of their emerging-market counterparts beat them to this punch earlier in the year). The U.S. Federal Reserve, Bank of England and European Central Bank all announced tightening moves that seemed to augur an end to the pandemic-induced regime of ultra-easy money. The Fed's mid-December shift was particularly aggressive, signaling an intention to wind down ('taper') bond purchases at an accelerated pace and moving up the timing and increasing the magnitude of interest-rate hikes penciled in over the next two-plus years. Responding to a clearly slowing economy, the People's Bank of China bucked the global trend, taking steps to ease policy late in the period.

Equity markets recovered dramatically from a September swoon: the U.S. S&P 500 Index recorded 16 new highs on the quarter, bringing the 2021 total to 70. The Index's 11% surge brought its twelve-month total return to nearly 30% and cumulative advance since March 2020 to better than 110%. The latter figure, coming in just 435 trading days, represented the rapidest rise of any bull market since the Second World War (per Bespoke Investment Group research). Among U.S. large-company stocks, mega-cap technology/ media/ telecom stocks were again among the strongest performers, though respectable showings from companies in an array of other sectors/industries, particularly late in the period and continuing into early January, hinted at a salutary broadening of the advance.

Other developments suggested markets were becoming marginally less speculative (or complacent, risk-embracing, greed-dominated – take your pick). Cryptocurrency bellwether bitcoin fell 30% from an early-November high; SPACs (a.k.a. blank-check companies) fell out of favor; many 2021 initial-public-offering (IPO) stocks were mired below their listing prices; a Goldman-Sachs index tracking unprofitable technology companies swooned (as did Cathie Wood's Ark Investment funds, which specialize in such long-shot names); there was a dearth of new "meme" stocks touted by 'diamond-handed' 'hodlers' on social media. Such anecdotes heralded an "end of silliness" (to a Financial Times columnist) or perhaps the passing of "peak insanity" (according to Leuthold Group analysts). Meanwhile, a December Bank of America survey of professional investors revealed the most defensive positioning (i.e., highest cash levels) since May 2020. Likewise, late-year surveys of individual investors seemed to indicate tempered exuberance.

Profits reported by U.S. publicly traded companies continued to expand at an eye-watering pace. The most recent results for S&P 500 constituents (mostly covering the July-September period) showed a year-over-year gain of 42%. Wall Street analysts expect the pace to slow to a still-blistering +34% in the fourth quarter, which would produce a calendar 2021 total 64% above 2020's lockdown-depressed figure and nearly 27% above 2019's record tally.

What's Changed?

To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:

  1. Dividend Income (for three months this is the annual yield divided by four)
  2. +/- Change in Earnings per Share* (average for S&P 500 companies)
  3. +/- Change in Valuation (Price/Earnings Ratio)

= Total Return

* based on forecast earnings for next 12 months (Source: S&P Outlook)

So, what changed during the recent quarter to produce the +11.0% S&P 500 total return?

Fourth Quarter (October-December) 2021
Dividend Income+0.3%+11.0%
+ Change in Earnings+4.9%
+ Change in Valuation+5.8%
= Total Return+11.0%

Our read: After a flat third quarter, prices played catch-up with red-hot earnings in the fourth. As profit growth slows in the year ahead, maintaining stretched valuation may become a challenge – especially if bond yields rise.

Outlook

The remarkable investment returns of the past 21 months have been fueled by exploding earnings compounded by expanding valuations – the former driven by better-than-anticipated economic growth and rising prices, the latter by receding pandemic-related uncertainty and a deluge of central-bank liquidity anchoring ultra-low bond yields. These tailwinds seem poised to subside, if not reverse, during 2022. Can markets hold up?

Investors seem to have concluded the COVID pandemic is receding as a driving force in the markets. The almost imperceptible shrug in response to the emergence of the omicron variant suggests investors expect nascent trends – soaring infections producing relatively mild disease – to persist. Many also seem sanguine that the new variant's parabolic spread will be followed by an equally abrupt decline in infections. Overall, the calm state of financial markets in December and early January seems to discount a new, less disruptive endemic (versus pandemic) future. While we share this optimism, this benign outlook could easily be challenged by incoming news.

Global economic activity is all but certain to decelerate from 2021's banner pace, though conditions should remain generally supportive. In the U.S., consumer finances are strong and a return to more normal spending habits would ease supply-chain pressures while boosting service-sector demand. Industrial activity should be supported by pent-up capital-goods demand and the need to rebuild inventories. On the other hand, reduced government outlays (compared with 2021's massive relief measures) will exert a drag, while the Fed's new-found hawkishness gradually tightens financial conditions. Prognosticators expect these countervailing forces to net out to healthy growth of around 3%, but there may be some downside risk to this figure, in our view. Recent IMF and OECD projections see both Europe and Japan enjoying above-trend growth rates slightly above 3%. The Chinese economy – limping into the New Year, but with scope for looser policy settings – is a significant wild card. Observers think Beijing will favor stability-enhancing growth over pain-inducing reform in the lead-up to November's historically significant 20th Communist Party Congress, where Xi Jinping's primacy will likely be extended another five years.

A solid global economy (and even elevated inflation) would support top-line (sales) gains, but can near-record profit margins be sustained? Many companies, especially the global, industry-dominating names that comprise a large share of capitalization-weighted market indices, are demonstrating a high degree of pricing power, and cost pressures have so far been moderate. Wall Street analysts are optimistic these trends will persist, having penciled in a further healthy advance in S&P 500 profits. Again, incoming data – a renewed rise in energy prices, surging labor costs, spiking interest rates – have the potential to dent a rosy outlook.

The looming shift toward "less accommodative" monetary policy will be carefully scrutinized. When they embark on policy tightening, central bankers always seek a vaunted "soft landing" that will allow rates to rise without killing growth. But in practice this has proved a difficult feat. Prior to the past decade or so, nearly every Fed tightening cycle ended with the economy in recession – and stocks in a correction or bear market. Since the 2007-2008 recession, "rioting" markets have spooked the Fed into prematurely abandoning intended tightening (in those recent instances, however, the Fed's target wasn't too-high inflation, but rather an interest-rate regime that was deemed undesirably low). As a generalization, however, investors should not be unnerved by rising rates as long as they don't foresee a growth- (and profit-) killing "policy error."

Strong stock prices and bond-market internals currently signal investor confidence the Fed is not "behind the curve" and will be able to cap inflation without pushing yields to punishing levels. Though Fed officials have indicated they expect to hike short-term rates above 2% by mid-2024, Treasury-yield futures show investors doubt the U.S. central bank will be willing (or able) to follow through with these plans. Meanwhile, market-derived measures of future inflation have been drifting lower in recent months and are only marginally above the level that prevailed in 2018 – when reported inflation was persistently below the Fed's comfort zone. Taken at face value, these indicators suggest investors foresee the return of slow-but-steady growth accompanied by tame inflation – i.e., the same environment that characterized the decade-plus before COVID. This, too, is a relatively sanguine view that could come into question as incoming data provide clues to its waxing or waning accuracy.

The past year's relative performance of various investments only exacerbated yawning valuation discrepancies. At this point, it seems almost everything is meaningfully cheaper than the common stocks of the largest U.S. companies concentrated in the technology/ media/ telecom mega-sector. According to JP Morgan calculations, the 10 largest U.S. stocks were recently priced at an average of more than 33 times 2021 estimated profits; the corresponding figure for the remainder of the S&P 500 index was under 20 (and for the unloved Financial Services sector it was less than 11, according to a similar calculation by Bespoke Investment Group). Small-company stocks comprising the S&P 600 Index traded at less than 20 times earnings – the first time since 2001 that index has had a lower multiple than the S&P 500. Likewise, large-cap U.S. stocks traded at a 49% premium to similar foreign equities (as measured by the MSCI World ex-US index) – another near-record discrepancy. A recent Leuthold Group analysis highlighted a telling global-stock factoid: having started at nearly identical figures in the aftermath of the 2008-2009 global bear market, by December 2021 the multiples for Large-cap U.S., overseas developed-market, and emerging-market stocks stood at 22, 15 and 12, respectively.

An old Wall Street nostrum holds that investment markets often seem to climb a "wall of worry." In that contrarian vein, we find more to like in the current environment – amid a worrisome pandemic situation and surging inflation – than we did last spring, when the prospect of "miracle" vaccines may have made investors overly complacent. Today's list of widely acknowledged challenges is long: slowing growth, high inflation, hawkish central bankers, surging "retail" participation in markets (often a harbinger of trouble) – and of course, a seemingly unending pandemic. But a litany of fears means ample opportunity for the future to unfold in surprisingly benign ways. Nevertheless, we also remain wary of potential disappointments and high valuations. Accordingly, it is prudent to maintain a moderate portfolio posture with room to increase exposure to stocks if volatility yields opportunity. And we will continue to tilt marginally away from the most highly valued assets (U.S. large-cap growth stocks) in favor of less stretched categories (small-caps, non-US stocks), which we expect to perform well in a world of receding pandemic and gradually rising bond yields.

As always, we encourage you to call or email any member of the Oarsman team to discuss our management of your investment portfolio. We wish you a healthy and prosperous New Year!