2022 Market Outlook

Blend Quality and Value in the Core

Having posted 58 new all-time highs so far in 2021, global equities are on pace to register their third consecutive year of double-digit returns — a startling run given it has occurred throughout a pandemic.1 Unlike in past years, strong earnings-per-share (EPS) growth has fueled these gains. The 50% projected earnings growth rate for global equities in 2021 is the highest since 2010.2 And in the US, S&P 500 firms posted a record-setting three consecutive quarters of 30% or greater growth on their way to likely registering a decade-best 44% growth rate for 2021.3

With forecasts still projected to be above the 15-year average,4 earnings likely will remain a tailwind for US stocks in 2022, even if they do not reach 2021’s double-digit peaks. Yet, as the new year progresses, sentiment and growth sustainability may become a bigger focus in earnings reports.

Firms may no longer surprise to the upside at 2021’s record rates (over 80%),5 without easy comparisons and the COVID-19 wild card having resulted in disparate analyst estimates to start 2021. In fact, as the cycle matures, monetary policy slowly normalizes in parts of the world, and partisan conflicts heat up, both with the kickoff of the US midterm election cycle and the possibility that the UK invokes Article 16 and reignites the Brexit battle,6 equities may need to adjust to a higher macro volatility regime that could impair sentiment.

However, buying growth in light of lower growth forecasts is not the answer. Broad-based valuations remain elevated, and growth stocks are overly extended and likely to face headwinds from a variety of sources. Therefore, blending quality and value may allow investors to better navigate this peak-growth terrain.

Growth Is Positive, but Becoming More Challenging

Forecasts for 2021 global economic growth are projected to peak at 5.9%, with expectations for 2022 and 2023 to fall to 4.9% and 3.6%, respectively.7 While those rates are lower than the figures for 2021, they are still above the average growth rate for the past fifteen years.8

From a relative growth perspective, US stocks trailed the rest of the world in 2021 (44% versus 59%). But in 2022, US stocks are projected to grow their bottom line by 8.04% (above their 15-year average) compared to just 5.80% for non-US equities (below their 15-year average).9

The global figures are being dragged down by weak sentiment in emerging markets (EM) where low vaccination rates present reopening challenges in some nations. As a result, EM stocks have witnessed nearly the same amount of upside revisions to downside for their 2022 estimates (1.1), as shown in the following chart.10 EM stocks also have the worst recent one-month change to their forecasts — declining by 24 basis points in October, following September’s nearly 2% decline.11

2022 EPS Upside-to-Downgrade Revisions

Developed international equities have a 1.7 upside-to-downside revision, while US equities have a 2.4 ratio.12 The US also has the upper hand in terms of the changes in its forecasts; developed international forecasts were lowered in September before rebounding slightly in October, while the US has held steady with no declines, only lesser increases.13

For those reasons, the US is our preferred region, followed by developed international. Meanwhile emerging markets remain a challenge, given the weak earnings sentiment, uneven COVID responses, and lingering questions on the Chinese economy (33% of a broad EM exposure).14 China’s ”credit impulse,” a measure of new lending as proportion of GDP and a gauge of economic activity, has yet to trough — falling for nine consecutive months.15 When the impulse reading is negative, Chinese stocks have returned 5% less, on average, over the subsequent six months than when the impulse is positive — with negative returns occurring nearly half of the time.16

Focus on Quality, Not Quantity

With growth transitioning to a simmer from a boil, there has been a greater emphasis on firms with higher quality balance sheets and reliable profitability. This differs from the behavior in the early part of the recovery.

During the first part of the pandemic rally, profitability was less of a concern. From May 2020 to May 2021, US stocks with negative earnings over the prior 12 months outperformed firms with positive earnings by 34%.17 Since May 2021, that performance trend has flipped. Unprofitable firms have trailed profitable ones by 7%.18 Unfortunately, that trend has not forced more firms to become profitable, as there are now over 1,100 firms with negative trailing 12-month EPS compared to 843 before the pandemic.19 As growth slows, this is unlikely to drastically change — at least not in the near term.

Profitability, however, is different than growth. A firm can have a 40% year-over-year growth rate but still be unprofitable, as its EPS could have improved only from -$0.75 to -$0.45 per share. The ability to generate a profit is just one consideration of the quality factor, however. The other is centered on the reliability of growth. Or rather, the volatility of earnings. And pure high-quality stocks have started to noticeably outperform low quality stocks, as shown in the following chart. Yet, the relative performance ratio has yet to re-test pre-pandemic levels and just recently broke through its 50-moving day average — indicating there still may be more room to run even though high quality has outperformed low quality by 6.5% over the past three months.20

High Quality to Low Quality US Equity Performance

Value Has Value with Markets Rallying

With their recent runup, the valuations of traditional quality stocks have started to look a bit frothy like traditional growth stocks and the broader market. In an apples-to-apples comparison, firms within the MSCI USA Quality Index are trading in the 97th percentile relative to their own history, based on a composite metric of valuation indicators.21 And on a relative basis to the MSCI USA Index, they are in the 71st percentile — not overly rich but not cheap either. Quality now appears to come at a price, and it is not alone.

Under the same analysis, growth stock valuations are also stretched on an absolute basis and relative to the broader market. For the latter, growth stocks are trading in the relative 97th percentile and 1.8 standard deviations rich to the market.22 These valuations are ever so slightly shy of dot-com extremes. The numbers are worse when comparing growth to value. As shown in the following chart, growth is trading rich to value by over 2 standard deviations when using the same z-score process for the composite valuation metrics. This is consistent across the cap spectrum, as the premium difference of growth-to-value fundamental ratios is in the average 90th and 80th percentiles for mid- and small-cap stocks, respectively.23

Z-Score of Growth Minus Value Valuation Metrics

One explanation for value trading at cheaper valuations than growth could be that investors are seeking more of a discount given the lower expected future growth. However, 2022 EPS growth forecasts show that the differential of growth projections for the next year between the two styles is quite similar, with value slightly higher at 10.0% versus 9.5% for a composite of value and growth styles throughout the cap spectrum.24 In fact, small-cap value stocks have the highest 2022 growth projections (16%) of any of the six style market segments.25 Value may now be a better growth option given the price to access it.

Beyond the fundamental case made above, there are macro reasons to favor value as opposed to growth. Over the past 30 years, growth stocks’ monthly excess returns to the broader market have a negative correlation to changes in interest rates (-17%), whereas value excess returns are positively correlated (+18%).26 With the prospect for higher rates resulting from tighter monetary policy, longer-duration growth exposures (cash payments further out in maturity like a long-duration bond) could be further challenged from a total return perspective.

Fiscal policy could also detract from growth stocks’ luster in 2022. The financing of President Biden’s Build Back Better (BBB) spending package calls for corporations with over $1 billion in revenue in the past year to pay a minimum 15% tax. Based on our analysis, the magnitude of stocks affected is low (11% of the S&P 500).27 Yet, there are parts of the market that could be impacted on a more granular level.

The Technology and Communication Services sectors hold 33% of the 56 potentially impacted stocks.28 Even though some stocks in those sectors may not be directly impacted, those two sectors make up roughly 60% of a traditional growth exposure.29 Regulatory restrictions, another major focus during Biden’s presidential campaign, also could be in play. And, if BBB is passed, regulatory oversight on “Big Tech” could become more of an emphasis in Biden’s domestic agenda.30

Implementation Ideas

While the growth witnessed in 2021 is likely to be the high point in this cycle, we are by no means approaching a trough. But the path ahead may become a bit more challenging than it was during the early stages of the recovery when less attention was paid to firm fundamentals and the “stocks only go up” mantra drove market action.

To navigate among the peaks of the next part of this rally, consider blending quality and value in the core with:

Quality and Value Multi-Factor Funds 

High-Quality Dividend Strategies

Value Exposures