Global stock markets rallied through the fourth quarter to finish 2021 with a bang, capping off an unexpectedly strong year. U.S. equities, as measured by the S&P 500 Index, returned nearly 11% in the fourth quarter alone, including dividends, bringing year-to-date performance to a whopping 29%. Non-U.S. stocks, as measured by MSCI’s All Country Worldwide Ex-U.S. benchmark, returned 2% in the fourth quarter including dividends, ending the year up a respectable 8%.
Continuing a trend we observed all year, the rising market tide did not lift all boats. In fact, performance at both the individual stock and sector level was quite divergent. Energy, Financials and Real Estate stocks led the market higher, marking a significant shift in market leadership. Likewise, four technology stocks make up nearly a quarter of the S&P 500 market capitalization and generated nearly 30% of the index’s return last year, a level of concentration we have not seen since 1999. These figures underscore the importance of broad sector diversification and owning a wide variety of different stocks in client portfolios, which allows for solid risk-adjusted returns – two longstanding aspects of Howland Capital’s investment process that are very much intact today.
Market drivers during the Quarter
When we look at the various dynamics driving aggregate market action in both the fourth quarter and full year, a few recurring themes stand out. The bottom line, however, as we highlighted in last quarter’s Economic & Market Commentary, is that it all comes down to corporate profits.
The S&P 500 Index’s 29% rally in 2021 may seem startlingly strong. However, this move makes sense in the context of corporate profit growth trends. Consensus expectations for 2021 aggregate S&P 500 Index earnings increased 26% from the end of December 2020 through the end of 2021. While fourth quarter results have not been reported yet, the strong annual earnings growth appears to have been driven by nearly 18% revenue growth and exceptional margin flow-through, or operating leverage, of sales to bottom line profit.
One change in 2021 versus prior years appears to have been an increasing focus by investors on valuations. With the prospect of Fed tightening and continued macroeconomic strength as the world looks beyond COVID, rising interest rates will be a near-term reality. One impact this may have on the stock market is that the high valuation premiums investors have been paying for growth are likely to come down. With growth less scarce – or at least the prospects thereof – and a number of sectors benefiting from rising rates, investors’ attention could be shifting.
We enter 2022 with a constructive long-term outlook for stocks. While we do not expect earnings growth in 2022 to be as strong as it was during 2021, the basic building blocks necessary for a rising market are intact. In fact, consensus expectations of 9% earnings growth in 2022 could be too low, setting the stage for a rising market this year. Here is our thinking on the consensus expectations mentioned above:
First, it is tough to imagine revenue growth decelerating so dramatically to 7% in 2022 versus 18% in 2021. GDP is expected to grow 4% in 2022. Pent up global demand for many different products should help drive stronger than expected sales growth as supply chain challenges abate. Consumer balance sheets are in excellent shape, helped by rising home values and record savings. The employment market is incredibly strong and wages are rising. As a result, the consumer is in phenomenal shape, which is key because consumption drives more than two thirds of GDP. We would not be surprised to see these dynamics flow through to stronger than expected revenue trends for the market.
Second, looking beyond revenues towards profit margins, we expect operating leverage, or incremental profits on additional sales, to remain strong in 2022 – albeit not as strong as what we saw in 2021. Moderating inflation, continued cost controls, and revenue growth exceeding pre-pandemic levels should all help here.
Third, beyond the prospects of further earnings improvements, we would not be surprised to see valuations remain resilient. The S&P 500 traded at 22.8x expected 2021 earnings one year ago. Today, it trades at 21.3x expected 2022 earnings, not taking into account that earnings expectations could be low. While these valuations are elevated versus history, they make some sense in the current low interest rate environment. Even with the prospect of rising interest rates, the relative attractiveness of stocks as compared to bonds and other asset classes remains compelling.
Despite our constructive long-term outlook for stocks, we are mindful of a number of risks that could present headwinds to the stock market in 2022.
The first risk is the sustainability of profit margins. Our biggest concern for margins is continued inflationary pressures. Inflation estimates continue to increase, and as of now, 2022 inflation is expected to be 3-3.5%. While that is high, it is not too worrisome since the current inflation run rate is already above 4%. Too much inflation could have a variety of negative effects, particularly on profit margins, if costs rise and companies are unable to pass these increases along through pricing.
Rising inflation also increases the likelihood of faster and larger-than-expected short-term interest rate increases by the Federal Reserve. As of now, the Fed is widely expected to start raising rates in June. Higher rates increase the risk of stifling economic growth, especially as long-term rates inch closer to mortgage rates. Higher rates also increase corporate borrowing costs, which would be an additional headwind to earnings growth. Finally, rising interest rates present a headwind to the market in that they will pressure valuations of high growth companies, which today make up a much greater proportion of the market than in times past.
While high inflation and rising rates pose some risk to profit margins and the market overall, we do not expect every company in every sector to experience equal amounts of pressure. When constructing and managing client portfolios, we are focused on high quality companies with secular growth tailwinds, strong pricing power, and a demonstrated ability to translate their competitive advantages into profitable growth.
In summary, stocks have been on a tear and we see a reasonable case to be made for further appreciation – albeit at a slower pace than in 2021 or even 2020. When, how, and why this epic rally will hit a wall is anyone’s guess, though there are some clues and we remind our clients to continue communicating cash needs and focus on the long-term.