2022 has arrived with uncertainty. Here's how analysts are positioning: Editor's Note
Analysts are predicting lower equity returns amid rising rates, uncertain growth and steep valuations.
Over the last 10 years, the "place to be" for investors has been a no brainer: the US. While Australian and Global Markets (ex-US) have delivered very respectable double-digit equity returns since 2012, the world’s largest economy is in a class of its own, returning over 20% annualised on a 10-year basis. Technology has been a standout sector alongside consumer cyclicals thanks to big gains from mega caps like Tesla, NVIDIA, Apple and Amazon.
But US markets have had a bumpy ride so far this year. The most expensive corners of the markets took the hardest punches. While the Morningstar US Market Index lost 2.4% in the first 10 days of 2022, the Morningstar US Technology Index lost 5.3%. Meanwhile, value stocks and sectors such as energy and financials rallied strongly.
The Morningstar US technology and communication services index has now seen 19% of the stocks correct more than 50% off their 52-week highs.
For the reasons behind the volatility, Morningstar's chief markets editor Tom Lauricella provided us some clues in an article this week. He says it all ties back to the relationship between the financial markets, the Federal Reserve and the economy.
Remember all that talk last year about inflation–team transitory vs team permanent? Forecasters were betting on whether the $20 trillion in fiscal stimulus pumped into the US economy in response to the covid-19 pandemic would result in sustained price increases at the grocery store and the petrol pump. Today the jury is in. Figures from the Labor Department showed US inflation jumped at its fastest pace since 1982 in December, a 7% spike from a year earlier. Increased household expenses are eating into wage gains and putting pressure onto the Federal Reserve to address this growing threat to the US economy by raising interest rates. At the December policy meeting, the Fed signalled a hard pivot toward a more aggressive pace of interest-rate increases in 2022.
Easy money policies from the Fed, coupled with cash from fiscal stimulus programs, underpinned the stock market’s 2021 rally, for growth stocks in particular, says Lauricella. But with government stimulus winding down and interest rates set to rise, growth stocks have retreated and value stocks advanced. This is because when inflation accelerates and policymakers raise rates, the value of companies' future earnings drops and investors have more alternatives for places to make money. This particularly hurts technology stocks that promise expanding future profits. Morningstar technology sector director Brian Colello explains:
"We are now in a world where we have higher interest rates, leading to a higher discount rate, which leads to investors being more likely to place a lower value on future earnings than they would have in a very low-interest-rate environment."
Lower growth expectations
So, is the US market still the place to be? Many analysts say conditions are good but predict lower equity returns in a world of rising rates, uncertain growth and steep valuations compared to the rip-roaring rallies of the past two years.
Analysts are concerned by the balancing act ahead of policymakers in 2022: removing stimulus fast enough to rein in inflation without hitting the brakes on an economic recovery already easing off the breakneck pace set post-pandemic, Lewis Jackson wrote in a survey of equity market analyst outlooks for 2022.
Jason De Sena Trennert, chief investment strategist at Strategas Securities, told Lauricella that he expects 2022 to be a year where stock market returns are also going to be harder to come by. “You’re not going to be able to get 20%-plus just for showing up in the next three years,” he says. Smart stock-picking and correct calls on performance among stock sectors will be the key to stronger performance, he believes. “It’s hard to get bearish on stocks, but I do think people should manage their expectations.”
Funds management giant Vanguard sees an average of no more than 4% annually on Wall Street. Central banks are aiming for the 'Goldilocks scenario' of maintaining growth and containing inflation, but a range of issues from supply chain bottlenecks to tight labour markets could force them to act faster than markets anticipate, says Joe David, global chief economist at Vanguard.
It’s not all bad news. Morningstar senior analyst Preston Caldwell says investors should only expect a "slight hit to economic growth" from the omicron variant, although he anticipates an impact to inflation due to exacerbated supply chain issues. Long-term, he sees little reason why supply constraints won't eventually be resolved and believes inflation forecasters is overreacting to near-term issues.
Value in the unloved
Overall, Morningstar estimates the US stock market is heading into 2022 overvalued by 5%, and many of the best-performing names are trading at especially frothy prices. Only one corner of the market--small-value stocks--looks cheap. However, analysts still see opportunities in a range of names across sectors. This week, we put together two comprehensive lists of ideas to explore, both in the US and at home: Morningstar's 33 US stocks for 2022; 11 Australian stock ideas for 2022.
Writing in this week's Your Money Weekly, Peter Warnes anticipates the rotation from growth to value style stocks will continue this year, and that income, rather than the capital component, is likely to dominate total shareholder returns in the foreseeable future.
Strategas's Trennert says his firm is continuing with calls to favour energy, basic materials, and financials. “One of the points that we’ve made is that the [sustainable investing] movement is making energy stocks better investments,” Trennert says. Morningstar’s fair value estimates peg energy stocks broadly as the most undervalued sector in the market.
On the technology sector, Colello sees opportunities in the sell-off but urges investors to focus on high-quality businesses. "There are highflyers in our coverage universe that did extremely well in 2020 and 2021, and in this pullback, some of those names are now cheap," he says. "We would probably point investors to wide economic moat, high-quality software names that have been beaten up as a part of this sell-off."
Outside of the US, China’s regulatory crackdowns on the technology and property sectors in 2021 have driven sharp underperformance of Chinese equities versus other emerging markets and heightened risk. However, State Street Global Advisers says China's equity market appears "structurally undervalued", and that while the growth trend is decelerating, its growth rate will "will remain far above that of developed markets and slightly above that of other emerging markets". They also believe European equities are in a "sweet spot" and have "better growth prospects than the US market".
For my own portfolio, the massive run-up in US equities has seen my international equity exposure grow from a planned 35% to around 43% today, according to Morningstar's X-ray tool. This is likely similar for passive, broad-market investors, with US making up 70% of country exposure in the Vanguard MSCI Intl ETF (VGS). This week, Morningstar's director of personal finance Christine Benz put together a Guide to Reviewing Your Portfolio in 2022. Morningstar's Tim Murphy also delivered his thoughts on the importance of portfolio rebalancing late last year.
Proxy advisers can be akin to the pebble in the shoe of a company, painful and difficult to ignore. However, new regulations rushed into law prior to the end of the Australian parliamentary year may prevent the pebble from lodging in the first place writes Morningstar ESG analyst Erica Hall.
Australia's largest miner was briefly the fourth most shorted stock on the ASX this week. It seems hedge funds are on the hunt for arbitrage opportunities ahead of BHP's proposed unification of its UK and Australian listings, writes Lewis Jackson. Shareholders will vote on the plan next week, although not everyone is happy.
Finally, from poultry shortages to a revised takeover bid for Crown Resorts, Jackson rounds up the most important stories for investors from 2022’s second working week.
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