European equities will benefit from more attractive valuations and a skew toward cyclicals.
Powered by unprecedented monetary and fiscal support, equities markets performed strongly in 2021. The coming year presents a complex picture as the global economy finds itself on an uncertain climb toward recovery. Monetary intervention is dwindling as inflation proves to be stickier than originally hoped; bond yields could surprise to the upside. Increased volatility is also looming, as equities markets rise and fall in response to the ebb and flow of the global pandemic, and in response to policy signaling.
We continue to favor equities compared with other asset classes, because they still offer relatively attractive excess returns. The equity risk premium (ERP) for developed markets, for example, stands at 4.8% as of September 1, 2021. This represents a drop compared with the same time last year; however, the ERP remains positive and, as of this writing, remains above long-term averages in both developed and emerging markets.
In a welcome change from prior years, earnings, not multiples, have driven equity performance so far in 2021 (see Figure 1). With risk to bond yields falling to the upside, earnings must continue to come through for equities markets to continue to rally further.
Equity Return Decomposition
There has been good news on that front in the most recent earnings season. Corporate earnings have surprised to the upside, and — perhaps even more importantly — forward guidance for 2022 has been strong. We believe companies are in a good position to deliver on that guidance. The average price-to-equity ratio for the MSCI World stands between 19 and 20 as of this writing1 — a level we consider to be sustainable (although we recognize that the recent ballooning of multiples could lead to a short-term contraction). We also believe that yields will remain below 2%. In short, the stage seems to be set for equity prices to continue to move up, and we believe that stock returns and prices will continue to be driven by earnings, dividends, and buybacks.
With this background in mind, here are the points that we believe are most important for equity investors to consider in 2022:
Volatility is making a comeback. Aggregate levels of volatility have settled in at a higher level in 2021 than we’ve experienced in recent years; caution is warranted heading into 2022. In particular, we think investors may benefit from seeking pockets of the equities market where reasonable valuations can give more of a cushion against volatility.
European equities are in a sweet spot. US stocks have led global equity performance for years – but we think Europe will pull ahead in 2022. In the search for reasonable bargains and strong return potential, we think European equities will represent a find in the coming year. European stocks offer attractive valuations relative to their US counterparts. The current price-to-earnings discount for MSCI Europe is below 10-year averages,2 and relative earnings per share (EPS) and relative prices for European stocks compare quite favorably to the same measures for US stocks.3 Furthermore, European equities currently boast the strongest earnings and growth expectations across developed markets. If our expectations for US equities exceeded those for Europe in the past, those expectations were based in part4 on anticipated earnings. With earnings growth in Europe now expected to outstrip the US, we think equity markets are poised to catch up.
Earnings Growth Expectations, Rebased to 2017
Cyclical stocks will benefit from hard infrastructure spending. A wave of infrastructure spending, exemplified by the recent passage of a $1 trillion infrastructure bill in the US, will benefit cyclical sectors including industrial, materials, energy, and financial firms. Indeed, a substantial portion of our confidence in continued earnings strength is based on our expectation that cyclical stocks will benefit from renewed government emphasis on hard infrastructure. These latest moves build on existing trends to further benefit cyclical stocks; industrials reported the strongest earnings in the most recent earnings season, while a gradual steepening of the yield curve has benefited financials. Note, too, that an upward trend for cyclical stocks is likely to benefit European equity markets, which skew toward cyclicals.
Caution is still warranted in emerging markets. If earnings are likely to be the primary fuel for equity-market growth in the coming year, emerging market equities will remain challenged. Emerging market companies have yet to fully benefit from the reopening trade, as their efforts to boost vaccination rates continue. For that reason, we expect growth in emerging markets to take shape later in 2022, as vaccination rates improve. We expect emerging markets to offer substantial opportunities in future, even as we remain neutral for now on emerging market equities.
It is important to note that we see China as distinct from other emerging markets; in fact the addition of a standalone China component to a global equity allocation has the potential to improve diversification, not just with respect to developed markets, but with respect to other emerging markets. For investors seeking diversification and the return potential of one of the world’s largest economies, separate consideration of China equity investment can help tailor return and risk exposures to particular objectives. Skilled active management may also allow investors in China equities to take advantage of relatively high dispersion among Chinese stocks and more effective management of the unique opportunities and risks that China’s equities market presents.5
Quality will surpass growth as inflationary pressures rise. Buoyed by a massive injection of monetary and policy stimulus, growth has been the clear factor winner through the pandemic, but we believe the baton will pass to quality as inflationary pressures continue to rise and monetary policy tightens. Given relatively flat yield curves, we think value will continue to be challenged (although value looks attractive on a historical basis), but small-cap companies are likely to prosper as fiscal policy moves from global to local action.
As we prepare this equity market outlook, we’re keenly aware of key points of uncertainty that pose risks to our base case. Markets are less complacent now than they have been recently, but they remain fragile and vulnerable to shocks. Any move toward tighter monetary policy in response to persistent, higher inflation could threaten markets’ fragile exuberance. For equity investors, commodity sectors and cyclicals represent the best hedge against inflation, while higher background volatility can be mitigated by managed-volatility and defensive equity strategies.
In light of these risks — and considering the growing dispersion in performance with respect to the fundamental measures, including earnings, that are most likely to drive returns — we see an opportunity for active management in the coming year.
In general, we’re keeping a close eye on the potential for rotation into a higher-inflation regime as we look forward to 2022. For the next year, we favor segments of the market that we believe are most likely to come through on earnings: European equities, cyclical sectors, and quality stocks.
1Source: Bloomberg LLP, as of October 31, 2021.
2Source: State Street Global Advisors, MSCI, FactSet, as of October 31, 2021.
3Source: MSCI, FactSet, State Street Global Advisors, as of October 29, 2021.
4The structural backdrop in Europe has also improved drastically in our view, as the restrictive Stability and Growth Pact gives way to the New Generation EU (NGEU) recovery instrument, which has ushered in challenges to traditional taboos connected to fiscal rules and debt mutualization. For more of our views on Europe’s investment potential, see Europe Comes in From the Cold (August 31, 2021).
5For more on China equity investment, see Key Considerations for Investment in China Equities (October 29, 2021).
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