The SP500 delivered a strong 4th quarter return of 11% to close 2021 with an impressive 28.75% in total returns. The majority of the Q4 gain was achieved in October and early November, when the market cheered on antiviral Covid pill news from Merck and Pfizer. In addition, both consumers’ personal income growth and US manufacturing data in October were better than expected, pointing to an improving economic environment despite supply chain bottlenecks and labor shortages. Since midNovember, however, the market has been dealing with inflation data that consistently exceeded expectations and is at decades high: US wholesale prices rose 8.6% year over year in October, tied for its highest print ever; the consumer price index (CPI) surged 6.2% from a year ago in October and 6.8% y-o-y in November; and core CPI increased 4.6% and 4.9% y-o-y in October and November respectively. Market participants were convinced the Fed will raise rates in 2022, which proved right as in mid-December the Fed for the first time stopped talking about “transitionary” inflation, and announced that it would accelerate the wind-down of its bond purchases, putting the program on track to end by March. In addition, Fed officials penciled in at least three quarter-percentage-point rate increases in 2022, at least three more rate increases in 2023 and two more in 2024. Amid the Fed’s more hawkish turn, there was also the discovery and quick dominance of Omicron in the last 5 weeks of 2021, which raised the debate whether Covid would continue to cause severe damage to the economy via lockdowns and massive restrictions. It is rather remarkable the large cap. US equity market stayed resilient in Q4 despite the clear prospect of higher interest rates and skyrocketing Covid infections.
Looking back at 2021, both the US economy and corporate America earnings were much stronger than initial expectations. Exiting 2020, the consensus called for US 2021 real GDP growth of ~4% and the unemployment rate to drop to 5% by year end. Analysts estimated the EPS for the SP500 to reach ~$169. Fast forward to now, 2021 real US GDP growth will likely approximate 5.5%, and the SP500 EPS in 2021 would likely reach ~$206. Unemployment was also materially lower than expectation at 3.9% in December. At the same time, inflation has surprised significantly to the upside. While the initial forecast for CPI and core CPI growth in 2021 was 2% and 1.8%, the final actual numbers will likely be ~5% and greater than 4% respectively.
Looking back at 2021, both the US economy and corporate America earnings were much stronger than initial expectations.
Another major surprise, to us at least, is the evolving understanding around the Covid vaccine. When the market rallied in 20Q4 at the miraculous efficacy various covid vaccine promised, the common belief was, the 2-dose Covid vaccines were highly effective in preventing infection. We would be getting double protection from antibody generated from the vaccine and the durable T cell response induced by the mRNA technology utilized by the novel covid vaccine. We thought, the battle against covid would be won in the US by the summer of 2021, once close to 70% of the population is inoculated. It turned out, the antibodies fade rather quickly, and minimum discussion was given to the T-cell response. Regardless, by this winter the advocacy on the vaccine has shifted from preventing infection to preventing severe outcome. These unexpected and rather unfortunate developments have significant ramification on the labor shortage and the “transitory” part of inflation in the US. It was widely agreed that the labor shortage in the US was mostly due to: 1) generous unemployment benefits, 2) Covid related hesitation to return to work and sickness/absence, 3) childcare challenges due to schools switching to distance learning. Ending extra unemployment benefit in September has alleviated the labor shortage and the employment-to-population ratio bounced a strong 0.4 percentage point to 59.2% in November, before Omicron hit, though still well below a pre-pandemic 61.1%. Reopening schools remained uneven last fall around the country but the prevalence of Omicron and the vaccine’s ineffectiveness against Omicron have already caused delays in in-person teaching in some major school districts for the new semester. With the seven-day average for newly reported cases in the U.S. topping 700,000 in recent weeks, almost triple the pre-Omicron record set a year ago, some estimate over 5 million Americans, or more than 3% of the country’s total workforce, could be isolating at home. It has certainly surprised us that almost two years into the pandemic, with massive vaccination and multiple treatment options, Covid still dominates our life and remains a dominant driver of the labor shortage.
Another surprise in 2021 to us is the Democrats controlled White House and legislature have failed to pass a big spending bill that would raise corporate and/or individual tax rates. With the mid-term election less than a year away and President Biden’s approval rating below 40%, the odds for the Build Back Better (BBB) bill to pass with aggressive spending and tax hikes are small, we believe.
Looking forward, the Fed’s hawkish pivot will certainly dampen demand, playing a part in solving the demand/supply imbalance which drove decades high inflation. At this point in time, we believe to combat inflation in the US, it is likely more important to solve the problem on the supply side. New policies from the federal to the states and local governments need to be formulated to help alleviate covid related labor problems. We are hopeful the pandemic will be downgraded to endemic in 2022, given the Omicron experience is materially less lethal though more contagious than prior variants. Ensuing policies tackling an endemic should be much less restrictive, which would help with labor shortages.
Higher interest rates are not a death spell to the equity market. Higher interest rates are good for the US economy right now, and what is good for the economy will eventually be good for corporate America.
While higher interest rates would result in lower intrinsic value for equities with everything else equal, everything else is never equal. Based on Applied Finance’s median Market Derived Discount Rates (MDDR) calculation, the median Equity Risk Premium (ERP) for industrial firms, was nearly 300 bps higher than the median since 1997, as the 10 Yr yield has crashed to ~1.5% from 5-6%. It is possible that ERP could decline, after interest rates settle at a higher level, which is deemed as appropriate and necessary for a fast-growing economy. YTD, the US 10 Yr treasury has quickly risen to yield ~1.8%. In the meantime, the SP500 has lost nearly 8% of its value, and the R1000 Value has declined in single digits. Equities will likely face volatility in the months ahead as long-term bond investors figure out the proper required rate of return they need for their investment and equity holders settle on a proper ERP. Though historically the SP500 has generated negative returns immediately after the first rate hike, the index has historically recovered to return an average of ~5% in the two quarters following the first rate hike. Higher interest rates are not a death spell to the equity market. Higher interest rates are good for the US economy right now, and what is good for the economy will eventually be good for corporate America. As always, our mantra is to avoid overpriced stocks and buy quality businesses, irrespective of the current interest rate environment. As we displayed in Table 4a, regardless of a stock’s sensitivity to interest rates, undervalued stocks deliver above average returns.
The greatest uncertainty is undoubtedly higher interest rates and what kind of discount rate equity investors would demand when the risk-free rate becomes more attractive.
Overall, we feel the backdrop for the equity market entering 2022 is rather healthy. First and foremost, US consumers’ balance sheets are in great shape and personal income growth is expected to continue. The current expectation is for the US to grow real GDP at 3.5% y-o-y in 2022 and 2.9% y-o-y in 2023. Analysts expect SP500 adjusted EPS to grow ~8% to $222. Secondly, the prospects for the Biden administration to successfully implement the policies he campaigned on, especially regarding taxation and the green economy, are much lower than 12 months ago. The greatest uncertainty is undoubtedly higher interest rates and what kind of discount rate equity investors would demand when the risk-free rate becomes more attractive. We feel the key is how fast the supply chain constraints and labor shortage in the US will resolve in the months ahead, which will help provide a clearer picture of sustainable inflation facing the country and help shape the expectation of interest rate levels. The negative impact from Covid is no longer growth oriented for the US or Europe as governments in those regions are wary of any substantial shutdowns. It is more of a negative to the inflation fight, due to ensuing labor shortage from sickness and isolation. Covid remains a growth concern to developing countries, however. In fact, in developing Asia, supply disruptions have been relatively less of an issue, allowing many economies to take advantage of strengthening demand in the west and keep their economies growing.
We continue to believe that for investors with a long term horizon, investing in companies with attractive valuations, credible management teams, and a strong wealth creation track record and strategy is key to outperformance.
Entering 2022, the S&P forward P/E was ~22 times vs 23 times entering 2021. The SP500 returned strongly in 2021 because both US economic growth and corporate earnings have surprised on the positive side, while discount rates remained largely flat based on Applied Finance proprietary discount rates calculation. If as a country we can make substantial progress improving the supply chain bottleneck in 2022, the majority of corporate America should be well positioned to generate continued top line growth from volume gains rather than price hikes. Corporate margins should also receive a boost due to less pressure on materials and labor.
Valuation and Wealth Creation is Timeless™. We continue to believe that for investors with a long term horizon, investing in companies with attractive valuations, credible management teams, and a strong wealth creation track record and strategy is key to outperformance. Separately, we stress the importance of approaching equity investing from a portfolio’s perspective. While short term investment themes and trends can be overpowering, (Is the hyperinflation a short term theme? we are yet to find out.) Valuation 50’s sector neutral discipline and our emphasis on diversification within a sector allows the strategy to have broad exposure to a wide spectrum of the economy, which tends to perform consistently through cycles, despite the impact some economic factors might have on certain industries at a given time, be that interest rates, inflation, or noneconomic factors such as Covid or regulations. We are confident the companies in the Valuation 50 will be resilient to thrive in a higher interest rate environment. In the meantime, we are conducting a detailed review of our holdings focusing on the growth implications in their current enterprise value and our detailed valuation models.