In December 2020, there seemed a universal feeling that 2021 couldn't come fast enough, most of us hoping we had reached bottom in lock-downs, isolation, business closures, job loss, cultural divides, etc. And 2021 proved to be a robust recovery year, primed by abundant liquidity and loosening of restrictions. The energy complex, inflation sensitive equities, alternative electronic currencies and US stocks paced markets globally, while Asian equities, the Euro, gold and bonds lagged. Pretty much makes sense given the US earnings performance, rising inflation profile and a tapering-signalling Fed.
VIEW is focused on direction and rate of travel as opposed to absolute level in most aspects of the market structure. We find the turning points in cycles constitute transition points from acceleration to deceleration and generally precipitate some level of disruption until a new trend is solidified. We see 2022 as a time of change in this respect, as we believe the recovery cycle from the spring 2020 lows has peaked. As such, we expect a declining rate of change in earnings growth throughout 2022 to be our base case. We believe that inclinations among governments to resort to clearly harmful economic and cultural pandemic control measures is waning but consider the big moves to have already happened and that we have experienced the biggest burst from "reopening". Our base case also holds that US central government stimulus will be more restrained in 2022 and given the current approval ratings among the controlling party, chances for a deadlock producing mid-term election cycle are high. Things can change quickly in politics but probably not so much so on the inflation front, which, along with difficult comparisons, nearly solidifies the downward trajectory in S&P 500 earnings growth.
This being our first public look-ahead for markets (VIEW has done this internally but privately for years), we are keen on being free from conflicts with prior positions (doesn't everyone hate to change their mind publicly?) or our internal "house" view (i.e. compiled by others). We title this piece the Surface of Risk in Transition and will put no single point estimates attached to dates (a loser's game in our view) but rather point out what we think are issues that the market will need to work through. And by extension, what investors may choose to try to navigate. These transition periods when the market "works through" phase changes can cause disruption and lead to increased volatility. As always, the plan does not matter much but planning, as always, really does.
Transition #1: Rate of Change of Liquidity Support and Inflation
Volatility and its behavior appears to be another facet of market structure that has been influenced by overactive central banks. Consider that the average level of the VIX for the 20 years from 1990 to 2010 was 15% higher than the most recent decade post the GFC. Not only that, the VIX itself was 20% more volatile during that period as well. Could this be a kind of quantitative descriptor for the influence of sustained central bank liquidity support and the accompanying one-way buying behavior of same? Maybe, and if that is the case, might a less-involved Fed be something the market will need to discount more fully in 2022? If we truly are at the start of a pathway to a slower rate of change in central bank balance sheet growth and addictive liquidity, VIEW guesses markets will need to factor this in more than they have already. Liquidity has been quite unprecedented with the Federal Reserve balance sheet 19% higher in just 2021 alone and M2 up 9% this year as well. Since the beginning of 2020, this puts the Fed's assets 11% higher in those two years and M2 +39%. Sufficient ink has been spilled on the extraordinary asset purchase behavior by the central bank but we should not ignore the spike in M2, growing at nearly quadruple the rate of the previous 28 years. Why all this money sloshing around would cause inflation shouldn't be a mystery. Especially for those who have some historical perspective on the simple dynamic of money supply. We find it interesting the crowd that has been dragged kicking and screaming into the light of "non-transitory" inflation is the same advocating for hyper-interventionist, politicized and ultra-stimulative central banking. The chasm in perception of the current market structure seems to have never been wider between the political economy crowd and market participants who realize that academic theories only go so far in explaining the real world pricing of risk and assets trading.
The political risks of inflation to incumbent administrations has always been high in whatever country they appear, the United States is no different. In confirmation of this, the Executive Branch has begun the deflection strategy of highlighting non-competitive behavior of US commercial actors as a cause for the current inflation pressure. Ignoring the monetary causes of inflation and switching blame from the government policy of liquidity flooding to monopolistic price gouging, is a tired play and once again betrays the command and control inclinations of the political class. It won't solve the inflation riddle, just give headline fodder for certain news outlets and factions of the incumbent's party. Our conclusion on why the Fed appeared so slow to message willingness to engage on this issue is that inflation is actually a good thing if you are heavily indebted and are operating with negative real rates. Yet, you need to remain in power to enjoy the benefits. But a trapped and conflicted central bank is not new and we don't anticipate this will change in 2022.
Transition #2: Corporate Profitability Mean Reversion-Revenue Growth Will Slow, More Goes to Labor and Earnings Growth has Peaked for this Cycle
Under cover of powerful stimulus juicing demand and the very real ability to take price, US corporate revenue growth rates have realized decade high levels and caused profitability to reach a new, higher plateau among S&P 500 companies. This makes perfect sense as fixed costs, although they remain less so over the long term, are positively leveraged to quick accelerations in the top line.
Expect profit margins to revert to more average levels as input costs continue to factor in, final price levels negatively affect demand growth and labor continue to demand an increasing portion of the profit formula.
Given our expected slowing of revenue growth and the concurrent reversion to the mean in profit margins we think a slower rate of earnings growth is all but assured. Absent some sort of renewed effort at fiscal or monetary stimulus, which is always a possibility it seems with the current cast of central bankers, S&P 500 earnings growth could well approach the long-term average we consider to be ~8.4% on a trailing 4 quarter basis since 1990. And as with any average line, the actual will trend above and below it so sub-8% growth could easily be contemplated after the forecast for +65% growth expected in 2021. What matters most in our view is more the shape of direction of travel in earnings growth, acceleration versus deceleration. Markets have tended to accord valuation to where relative growth is strongest, whether this is among sectors or between markets.
Transition #3: Forward Return Outlook Diminishes at Current Levels-Where to Go for Returns?
VIEW is not focused on one of the big debates in capital markets, which is what concoction of risk, earnings level, funds flow and comparative opportunities has as its residual the observed valuation in the market. We have yet to see a compelling, actionable set of drivers that can reliably forecast valuations and until we do, we would rather highlight implications of current valuations. These can be seen as we have actually been here before. Our own study of forward five-year geometric returns at various trailing 4-quarter P/E multiples tells us that since 1988, when the market multiple has been at or above the current TTM level of 23.6x, mean forward five-year returns average 0.13%. Of course, this may not be everyone's time horizon but regardless, we have seen academic work confirming that just as in a single stock, what one pays for an asset matters much for the subsequent returns, for even time periods up to ten years. So the transition we believe should occur is a serious discussion about risk allocation not only in the context of volatility of returns but of the expected level. Our base case is that alternatives will continue to be carried long in asset allocations as the traditional stock and bond assets classes will have a difficult time providing sufficient forward returns needed to achieve portfolio objectives.
Transition #4: Volatility-Expect an Increase in the Transition
VIEW considers risk in part a function of where we sit in the earnings cycle. Sure, we could fixate on volatility of volatility on an ultra short-term basis but we prefer the longer view and think of cycles as regimes. Different assets work in different regimes and we are focused on observing where we sit over the course of the cycle. In all of these since 1990, we identify just one where from the peak in earnings growth to the trough, the VIX has not increased materially. If current expectations for an earnings growth slowdown hold, VIEW expects a higher volatility regime across markets.
VIEW wishes all the very best of luck in 2022.
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